Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

example

Redfern Refineries (RR), which sells oil products to retail

as well as wholesale customers, uses credit scoring to

make its consumer credit decisions. Each applicant

fills out a credit application. RR enters data from the

application into an expert system, and a computer

generates the applicant’s final credit score, creates a

letter indicating whether the application was approved

and (if approved) issues a credit card to the customer.

Table 18.2 demonstrates the scoring of a

consumer credit application, and Table 18.3 describes

RR’s predetermined credit standards. Because the

applicant in Table 18.2 has a credit score of 83.25, he

or she will be extended RR’s standard credit terms

(see Table 18.3).

TABLE 18.2 CONSUMER CREDIT APPLICATION CREDIT SCORE BY REDFERN REFINERIES

Financial and credit characteristics (1) Score (0—100) (2) Predetermined weight (3) Weighted score [(1) × (2)]

Credit references 80 0.15 12.00

Home ownership 100 0.15 15.00

Income range 75 0.25 18.75

Payment history 80 0.25 20.00

Years at address 90 0.10 9.00

Years on job 85 0.10 8.50

Total: 1.00 Credit score: 83.25

Notes: In column (1), scores are assigned by an analyst or by a computer based on information supplied on the credit application; scores range from

0 (lowest) to 100 (highest). In column (2), weights are based on the company’s analysis of the relative importance of each characteristic in predicting

whether or not a customer will pay its account in a timely fashion; the weights must add up to 1.00.

TABLE 18.3 REDFERN REFINERIES’ CREDIT STANDARDS

Credit score Action

Higher than 75 Extend standard credit terms

65–75 Extend limited credit; if account is properly maintained, convert to standard credit terms after one year

Lower than 65 Reject application

Changing Credit Standards

The vast majority of sales by corporations are made on credit. Thus, as a practical matter, it is important

to understand how establishing and changing credit standards affect sales, costs and overall cash

flows for a given company. As we discussed earlier, it is essential that companies accurately assess the

creditworthiness of individual customers who buy on credit. This does not mean that a company should

extend credit only to those customers who are certain to repay their debts. Following such an excessively

conservative strategy will cost the company many profitable sales, especially if industry practice is to

be more generous in extending credit. Instead, the company should accept a degree of default risk

in order to increase sales – but not so much that the additional profit from sales is overwhelmed by

additional accounts receivable investment and bad debts. The financial manager is typically responsible

for estimating the cash flow and financial impact of a proposed change in credit standards.

Fortunately, measuring the overall financial impact of changes in credit standards is fairly

straightforward. Any change may yield both benefits and costs; the decision to change standards will

depend on whether the benefits exceed the costs. We can describe the general impact of changes in

credit standards as follows.

LO18.5

What financial trade-offs

are typically involved when

considering a change in credit

standards?

thinking cap

question