Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVII. Short−Term Financial
Planning and Management- Credit and Inventory
Management
(^748) © The McGraw−Hill
Companies, 2002
Figure 21.2 illustrates part of a Dun and Bradstreet credit report, called a payment
analysis report (PAR). As you can see, quite detailed firm and industry payment infor-
mation can be obtained if more basic, summary information is inadequate.
Credit Evaluation and Scoring
There are no magical formulas for assessing the probability that a customer will not pay.
In very general terms, the classic five Cs of creditare the basic factors to be evaluated:
1.Character.The customer’s willingness to meet credit obligations.
2.Capacity.The customer’s ability to meet credit obligations out of operating cash
flows.
3.Capital.The customer’s financial reserves.
4.Collateral. An asset pledged in the case of default.
5.Conditions.General economic conditions in the customer’s line of business.
Credit scoringis the process of calculating a numerical rating for a customer based
on information collected; credit is then granted or refused based on the result. For ex-
ample, a firm might rate a customer on a scale of 1 (very poor) to 10 (very good) on
each of the five Cs of credit using all the information available about the customer. A
credit score could then be calculated by totaling these ratings. Based on experience, a
firm might choose to grant credit only to customers with a score above, say, 30.
Firms such as credit card issuers have developed statistical models for credit scoring.
Usually, all of the legally relevant and observable characteristics of a large pool of cus-
tomers are studied to find their historic relation to defaults. Based on the results, it is
possible to determine the variables that best predict whether a customer will pay and
then calculate a credit score based on those variables.
Because credit-scoring models and procedures determine who is and who is not cred-
itworthy, it is not surprising that they have been the subject of government regulation.
In particular, the kinds of background and demographic information that can be used in
the credit decision are limited.
COLLECTION POLICY
Collection policy is the final element in credit policy. Collection policy involves moni-
toring receivables to spot trouble and obtaining payment on past-due accounts.
Monitoring Receivables
To keep track of payments by customers, most firms will monitor outstanding accounts.
First of all, a firm will normally keep track of its average collection period, ACP, through
time. If a firm is in a seasonal business, the ACP will fluctuate during the year, but unex-
pected increases in the ACP are a cause for concern. Either customers in general are tak-
ing longer to pay, or some percentage of accounts receivable is seriously overdue.
CONCEPT QUESTIONS
21.5a What is credit analysis?
21.5bWhat are the five Cs of credit?
CHAPTER 21 Credit and Inventory Management 721
five Cs of credit
The five basic credit
factors to be evaluated:
character, capacity,
capital, collateral, and
conditions.
credit scoring
The process of
quantifying the
probability of default
when granting consumer
credit.