Chapter 15 Working Capital Management 491(^13) Credit analysts use procedures ranging from highly sophisticated computerized “credit-scoring” systems, which
calculate the statistical probability that a given customer will default, to informal procedures, which involve going
through a checklist of factors that should be considered when a credit application is processed. The credit- scoring
systems use various! nancial ratios, such as the current ratio and the debt ratio (for businesses), and income, years
with the same employer, and the like (for individuals), to determine the statistical probability of default. Credit is
then granted to those with low default probabilities. The informal procedures often involve examining the “5 Cs of
Credit”: character, capacity, capital, collateral, and conditions. Character is obvious; capacity is a subjective estimate
of ability to repay; capital means how much net worth the borrower has; collateral means assets pledged to secure
the loan; and conditions refers to business conditions, which a# ect ability to repay.
lead customers whose business is pro! table to take their business elsewhere.
Again, a balance must be struck between the costs and bene! ts of different
collection policies.
Firms generally publish their credit terms, de! ned as a statement of their credit
period and discount policy. Thus, Allied Foods might have stated credit terms of
2/10, net 30, which means that it allows a 2% discount if payment is received
within 10 days of the purchase; if the discount is not taken then, the full amount is
due in 30 days. Credit standards and collection policies are relatively subjective, so
they are not generally discussed in the published credit terms.
15-8b Setting and Implementing the Credit Policy
Credit policy is important for three main reasons: (1) It has a major effect on sales,
(2) it in" uences the amount of funds tied up in receivables, and (3) it affects bad debt
losses. Because of the importance of the policy, the! rm’s executive committee, which
normally consists of the president in addition to the vice presidents of! nance and
marketing, has the! nal say on setting the credit policy. Once the policy has been
established, the credit manager, who typically works under the CFO, must carry it
out and monitor its effects. Managing a credit department requires fast, accurate,
and up-to-date information. Several organizations, including Experian, Equifax, and
TransUnion, use computer-based networks to collect, store, and distribute credit
information. For businesses, Dun & Bradstreet provides detailed credit reports over
the Internet for a fee. The reports include the following information:
- A summary balance sheet and income statement
- A number of key ratios with trend information
- Data obtained from the! rm’s suppliers telling whether it pays promptly or
slowly and whether it has recently failed to make any payments - A verbal description of the physical condition of the! rm’s operations
- A verbal description of the backgrounds of the! rm’s owners, including any
previous bankruptcies, lawsuits, or divorce settlement problems - A summary rating ranging from A for the best credit risks to F for! rms that
are deemed likely to default
For individuals, credit scores, which are numerical scores from 0 to 10 that are
based on a statistical analysis, provide a summary assessment of the likelihood
that a potential customer will default on a required payment. Computerized ana-
lytical systems assist in making better credit decisions; but in the! nal analysis,
most credit decisions are exercises in informed judgment.^13
We have emphasized the costs of granting credit. However, if it is possible to sell
on credit and to impose a carrying charge on the receivables that are outstanding, credit
sales can actually be more pro! table than cash sales. This is especially true for consumer
durables (e.g., automobiles and appliances), but it is also true for certain types of
industrial equipment. Thus, GM’s General Motors Acceptance Corporation (GMAC)
unit, which! nances automobiles, is highly pro! table, as are other companies’ credit
Credit Terms
Statement of the credit
period and any discount
offered.Credit Terms
Statement of the credit
period and any discount
offered.Credit Score
A numerical score from
1 to 10 that indicates the
likelihood that a person or
business will pay on time.Credit Score
A numerical score from
1 to 10 that indicates the
likelihood that a person or
business will pay on time.