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their accounts are large, if the customers need time to ascertain the quality of the goods, and if the goods are not quickly resold.

To induce customers to pay before the final date, it is common to offer a cash discount for prompt settlement. For example, pharmaceutical manufacturers commonly require payment within 30 days but may offer a 2 percent discount to customers who pay within 10 days. These terms are referred to as “2/10, net 30.”

Cash discounts are often very large. For example, a customer who buys on terms of 2/10, net 30 may decide to forgo the cash discount and pay on the thirtieth day. This means that the customer obtains an extra 20 days’ credit but pays about 2 percent more for the goods. This is equivalent to borrowing money at a rate of 44.6 percent per annum.3 Of course, any firm that delays payment beyond the due date gains a cheaper loan but damages its reputation for creditworthiness.

You can think of the terms of sale as fixing both the price for the cash buyer and the rate of interest charged for credit. For example, suppose that a firm reduces the cash discount from 2 to 1 percent. That would represent an increase in the price for the cash buyer of 1 percent but a reduction in the implicit rate of interest charged the credit buyer from just over 2 percent per 20 days to just over 1 percent per 20 days.

For many items that are bought on a recurrent basis, it is inconvenient to require separate payment for each delivery. A common solution is to pretend that all sales during the month in fact occur at the end of the month (EOM). Thus goods may be sold on terms of 8/10, EOM, net 60. This arrangement allows the customer a cash discount of 8 percent if the bill is paid within 10 days of the end of the month; otherwise, the full payment is due within 60 days of the invoice date.4 When purchases are subject to seasonal fluctuations, manufacturers often encourage customers to take early delivery by allowing them to delay payment until the usual order season. This practice is known as “season dating.”

32 . 2 COMMERCIAL CREDIT INSTRUMENTS

The terms of sale define when payment is due but not the nature of the contract. Repetitive sales to domestic customers are almost always made on open account and involve only an implicit contract. There is simply a record in the seller’s books and a receipt signed by the buyer.

If you want a clear commitment from the buyer, before you deliver the goods, you can arrange a commercial draft.5 This works as follows: You draw a draft ordering payment by the customer and send this draft to the customer’s bank together with the shipping documents. If immediate payment is required, the draft is termed a sight draft; otherwise, it is known as a time draft. Depending on whether it is a sight or a time

3The cash discount allows you to pay $98 rather than $100. If you do not take the discount, you get a 20-day loan, but you pay 2/98 2.04 percent more for your goods. The number of 20-day periods in a year is 365/20 18.25. A dollar invested for 18.25 periods at 2.04 percent per period grows to 11.0204218.25 $1.446, a 44.6 percent return on the original investment. If a customer is happy to borrow at this rate, it’s a good bet that he or she is desperate for cash (or can’t work out compound interest). For a discussion of this issue, see J. K. Smith, “Trade Credit and Information Asymmetry,” Journal of Finance 42 (September 1987), pp. 863–872.

4Terms of 8/10, prox., net 60 would entitle the customer to a discount if the bill is paid within 10 days of the end of the following (or “proximo”) month.

5Commercial drafts are sometimes known by the more general term bills of exchange.

draft, the customer either pays up or acknowledges the debt by adding the word accepted and his or her signature. The bank then hands the shipping documents to the customer and forwards the money or the trade acceptance to you, the seller.6 You may hold the trade acceptance to maturity or use it as security for a loan.

If your customer’s credit is for any reason suspect, you may ask the customer to arrange for his or her bank to accept the time draft. In this case, the bank guarantees the customer’s debt. These bankers’ acceptances are often used in overseas trade; they have a higher standing and greater negotiability than trade acceptances.

If you are selling goods overseas, you may ask the customer to arrange for an irrevocable letter of credit. In this case the customer’s bank sends you a letter stating that it has established a credit in your favor at a bank in the United States. You then draw a draft on the customer’s bank and present it to your bank in the United States together with the letter of credit and the shipping documents. The bank in the United States arranges for this draft to be accepted or paid and forwards the documents to the customer’s bank.

If you sell goods to a customer who proves unable to pay, you cannot get your goods back. You simply become a general creditor of the company, in common with other unfortunates. You can avoid this situation by making a conditional sale, whereby title to the goods remains with the seller until full payment is made. The conditional sale is common practice in Europe. In the United States it is used only for goods that are bought on an installment basis. In this case, if the customer fails to make the agreed number of payments, then the goods can be immediately repossessed by the seller.

32 . 3 CREDIT ANALYSIS

Firms are not allowed to discriminate between customers by charging them different prices. Neither may they discriminate by offering the same prices but different credit terms.7 You can offer different terms of sale to different classes of buyers. You can offer volume discounts, for example, or discounts to customers willing to accept long-term purchase contracts. But as a rule, if you have a customer of doubtful standing, you should keep to your regular terms of sale and protect yourself by restricting the volume of goods that the customer may buy on credit.

There are a number of ways to find out whether customers are likely to pay their debts. For example, you are likely to have more confidence in those existing customers that have paid promptly in the past. For new customers there are three broad sources of information about their creditworthiness. You can seek the views of a specialist credit analyst, you can look at the information embedded in the firm’s security prices, or you can use the firm’s financial statements to make your own assessment.

Specialist Credit Analysts The simplest way to assess a customer’s credit standing is to seek the views of a specialist in credit assessment. For example, in Chapter 24 we described how bond rating agencies, such as Moody’s and Standard and Poor’s, provide a useful guide to the riskiness of the firm’s bonds.

6You often see the terms of sale defined as “SD-BL.” This means that the bank will hand over the bill of lading in return for payment on a sight draft.

7Price discrimination, and by implication credit discrimination, is prohibited by the Robinson-Patman Act.

Bond ratings are usually available only for relatively large firms. However, you can obtain information on many smaller companies from a credit agency. Dun and Bradstreet is by far the largest of these agencies and its database contains reports on more than 10 million companies.

Credit agencies usually report the experience that other firms have had with your customer. Alternatively, you may be able to get this information by checking with a credit bureau or by contacting the firms directly. You can also ask your bank to undertake a credit check. It will contact the customer’s bank and ask for information on the customer’s average balance, access to bank credit, and general reputation.

Security Prices In addition to checking with a credit agency or your bank, it may make sense to check what everybody else in the financial community thinks about your customer’s credit standing. Does that sound expensive? It isn’t if your customer is a public company. For example, you can learn what other investors think by comparing the yield on the firm’s bonds with the yields on those of other firms. (Of course, the comparison should be between bonds of similar maturity, coupon, etc.) You can also look at how the customer’s stock price has been behaving. A sharp fall in stock price doesn’t mean that the company is in trouble, but it does suggest that prospects are less bright than they were formerly.

In Chapter 24 we saw how information on security prices can be used to put a figure on the chances of default. Companies have an incentive to exercise their option to default when the value of their assets is less than the amount of their debt. So, if you know how much the value of the firm’s assets may fluctuate, you can estimate the probability that the asset value will fall below the default point. In Chapter 24 we looked at an example of how one consulting firm, KMV, uses this market-based approach to estimate default probabilities.

Financial Statements Security price data may not be available for many customers, and in these cases you will need to rely on the customers’ financial statements to make your own assessment of their credit standing. In Chapter 29 we saw how managers calculate a few key financial ratios to measure the firm’s financial strength. Firms that are highly leveraged, illiquid, and unprofitable generally don’t make dependable customers.

If you have a large number of customers, it may be useful to combine different financial indicators into a single measure of which companies or individuals are most likely to default. For example, if you apply for a credit card or a bank loan, you will be asked various questions about your financial position. The information that you provide is then used to calculate an overall credit score. One widely used system, designed by the consultancy firm Fair Isaacs, takes account of five factors:

(1) How promptly the applicant has paid in the past (35 percent of score); (2) how much debt of each type is outstanding (30 percent of score); (3) the length of the applicant’s credit history (15 percent of score); (4) the number of credit cards and recently opened credit accounts that the applicant has (10 percent of score); and

(5) the mix of regular credit cards, store cards, and margin accounts (10 percent of score). Applicants who fail to make the grade on the score are likely to be refused credit or subjected to more detailed analysis.

Suppose you want to devise a scoring system that will help you to decide whether to extend credit to small businesses. You suspect that there is an aboveaverage probability that firms with a low return on assets and a low current ratio

Those companies with a Z-score of less than 1.20 were predicted to go bankrupt. Companies with Z-scores between 1.20 and 2.90 were hovering in the grey area between decline and recovery.

Updated and refined versions of Altman’s Z-score model are regularly used by banks and industrial companies. We wish we could show you one of these recent versions, but they are all top secret. A company with a superior method for identifying good and bad borrowers has a significant leg up on the competition.12

Credit scoring systems should carry a health warning. When you construct a risk index, it is tempting to experiment with many different combinations of variables until you find the equation that would have worked best in the past. Unfortunately, if you “mine” the data in this way, you are likely to find that the system works less well in the future than it did previously. If you are misled by the past successes into placing too much faith in your model, you may refuse credit to a number of potentially good customers. The profits that you lose by turning away these customers could more than offset the gains that you make from avoiding a few bad eggs. As a result, you could be worse off than if you had pretended that you could not tell one customer from another and extended credit to all of them.

Does this mean that you should not use credit scoring systems? Not a bit. It simply implies that it is not sufficient to have a good credit scoring system; you also need to know how much to rely on it. That is the topic of the next section.

32 . 4 THE CREDIT DECISION

Let us suppose that you have taken the first three steps toward an effective credit operation. In other words, you have fixed your terms of sale; you have decided on the contract that customers must sign, and you have established a procedure for estimating the probability that they will pay up. Your next step is to work out which of your customers should be offered credit.

If there is no possibility of repeat orders, the decision is relatively simple. Figure 32.2 summarizes your choice. On one hand, you can refuse credit. In this case you make neither a profit nor a loss. The alternative is to offer credit. Suppose that the probability that the customer will pay up is p. If the customer does pay, you receive additional revenues (REV) and you incur additional costs; your

11EBIT is earnings before interest and taxes. Z-score models for predicting bankruptcy were originally developed in E. I. Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance 23 (September 1968), pp. 589–609. The equation cited here comes from E. I. Altman, Corporate Financial Distress, John Wiley, New York, 1983.

12 When a British bank laid off a number of employees, one unhappy staff member decided that the best way to retaliate was to leak details of the bank’s credit scoring system to the press. See V. Orvice, “Would You Get a Loan?” Daily Mail, March 16, 1994, p. 29.

customers with a record of slow payment are much more likely to default on the next order than those with a record of prompt payment. On the average 20 percent of the slow payers subsequently default, but only 2 percent of the prompt payers do so.

Suppose Cast Iron reviews a sample of 1,000 customers, none of whom has defaulted yet. Of these, 950 have a record of prompt payment, and 50 have a record of slow payment. On the basis of past experience Cast Iron should expect 19 of the prompt payers to default in the future and 10 of the slow payers to do so:

Now the credit manager must make a decision: Should the company refuse to give any more credit to customers that have been slow payers in the past?

If you are aware that a customer has been a slow payer, the answer is clearly yes. Every sale to a slow payer has only an 80 percent chance of payment 1p .82. Selling to a slow payer, therefore, gives an expected loss of $40:

Expected profit pPV1REV COST2 11 p 2PV1COST2.812002 .211,0002 $40

But suppose that it costs $10 to search through Cast Iron’s records to determine whether a customer has been a prompt or slow payer. Is it worth doing so? The expected payoff to such a check is

Expected payoff (probability of identifying a slow payer

to credit check gain from not extending credit) cost of credit check1.05 402 10 $8

In this case checking isn’t worth it. You are paying $10 to avoid a $40 loss 5 percent of the time. But suppose that a customer orders 10 units at once. Then checking is worthwhile because you are paying $10 to avoid a $400 loss 5 percent of the time:

Expected payoff to credit check 1.05 4002 10 $10

The credit manager therefore decides to check customers’ past payment records only on orders of more than five units. You can verify that a credit check on a fiveunit order just pays for itself.

Our illustration is simplistic, but you have probably grasped the message: You don’t want to subject each order to the same credit analysis. You want to concentrate your efforts on the large and doubtful orders.

Credit Decisions with Repeat Orders

So far we have ignored the possibility of repeat orders. But one of the reasons for offering credit today is that you may get yourself a good, regular customer by doing so.

Figure 32.3 illustrates the problem.13 Cast Iron has been asked to extend credit to a new customer. You can find little information on the firm, and you believe that

13Our example is adapted from H. Bierman, Jr., and W. H. Hausman, “The Credit Granting Decision,” Management Science 16 (April 1970), pp. B519–B532.

The credit manager keeps a record of payment experiences with each customer. Thus the manager knows that company Alpha always takes the discount and that. Omega generally takes 90 days to pay. When a customer is in arrears, the usual procedure is to send a statement of account and to follow this at intervals with increasingly insistent letters or telephone calls. If none of these has any effect, most companies turn the debt over to a collection agency or an attorney. The fee for such services is usually between 15 and 40 percent of the amount collected.

There is always a potential conflict of interest between the collection department and the sales department. Sales representatives commonly complain that they no sooner win new customers than the collection department frightens them off with threatening letters. The collection manager, on the other hand, bemoans the fact that the sales force is concerned only with winning orders and does not care whether the goods are subsequently paid for.

There are also many instances of cooperation between sales managers and the financial managers who worry about collections. For example, the specialty chemicals division of a major pharmaceutical company actually made a business loan to an important customer that had been suddenly cut off by its bank. The pharmaceutical company bet that it knew its customer better than the customer’s bank did. The bet paid off. The customer arranged alternative bank financing, paid back the pharmaceutical company, and became an even more loyal customer. It was a nice example of financial management supporting sales.

It is not common for suppliers to make business loans to customers in this way, but they lend money indirectly whenever they allow a delay in payment. Trade credit can be an important source of short-term funds for indigent customers that cannot obtain a bank loan. But that raises an important question: If the bank is unwilling to lend, does it make sense for you, the supplier, to continue to extend trade credit? Here are two possible reasons why it may make sense: First, as in the case of our pharmaceutical company, you may have more information than the bank does about the customer’s business. Second, you need to look beyond the immediate transaction and recognize that your firm may stand to lose some profitable future sales if the customer goes out of business.14

Factoring and Credit Insurance

A large firm has some advantages in managing its accounts receivable. There are potential economies of scale in record keeping, billing, and so on. Also debt collection is a specialized business that calls for experience and judgment. The small firm may not be able to hire or train a specialized credit manager. However, it may be able to obtain some of these economies by farming out part of the job to a factor.

Factoring works as follows: The factor and the client agree on credit limits for each customer and on the average collection period. The client then notifies each customer that the factor has purchased the debt. Thereafter, for any sale, the client sends a copy of the invoice to the factor, the customer makes payment directly to the factor, and the factor pays the client on the basis of the agreed average collection period regardless of whether the customer has paid. There are, of course, costs

14Of course, banks also need to recognize future opportunities to make profitable loans to the firm. The question therefore is whether suppliers have a greater stake in the continued prosperity of the firm. For some evidence on the determinants of the supply and demand for trade credit, see M. A. Petersen and R. G. Rajan, “Trade Credit: Theories and Evidence,” Review of Financial Studies 10 (1997), pp. 661–692.