326 Corporate Finance
selling decision. Faith in the customer usually blurs the credit granting decision unless the company has a
trading history to fall back on. Usually sales executives are appraised on the volume of sales generated and
not on the ‘successful sales’. A salesman is successful only if he collects dues within the notified period.
Some of the elementary ways of assessing credit risk are:
- Obtaining bank reference (without the customer’s knowledge),
- Obtaining reference from other reliable third parties,
- Financial statement analysis, and
- Obtaining formal credit rating from agencies such as Dun & Bradstreet, Duff & Phelps.
Analysis of profitability, solvency and activity ratios can provide useful insight into the financial performance
of the customer in question.
Bad Debts
Delinquent accounts are called bad debts. When there is reasonable certainty that a customer will not pay dues,
it is prudent to write off the amount as bad debt loss. A company may have a policy of charging off a fixed
percentage of credit sales—say 2 percent—as bad debts at the end of the accounting year, or perform an
analysis of all the accounts to ascertain the exact amount of bad debts. Selling goods on credit to high-risk
customers may increase sales but it will also depress profits if the account terms are bad. It is of course pos-
sible that a bad debt may turn good at a later point in time. But conservatism requires a company not to book
profits until they are reasonably certain.
The impact of bad debt on profit will not be the same for all companies. It depends on the cost structure,
more specifically, the operating leverage. A company that has high amount of fixed costs gains by selling to
marginal customers (assuming that fixed costs have been recovered already). Every rupee of sales recovers
variable costs and contributes to profits.
A company that has high variable costs doesn’t profit much from selling to marginal customers. Any bad
debt loss will offset the increase in revenue.
Aging Schedule
Consider a company that has the following receivables pattern:
Rs lac (percent)
Receivables
Month (Rs lac) 0 1 2 3
May 35.0 21 (60)* 3.5 (10) 7 (20) 3.5 (10)
June 40.0 26 (65) 6 (15) 5 (12.5) 3 (7.5)
July 42.0 25 (59) 7 (16) 6 (14) 4 (9.5)
August 45.0 28 (62) 9 (20) 5 (11) 3 (7)
- Figures in brackets indicate receivables as a percentage of the total receivables outstanding in that month.
The aging schedule provides a snapshot of receivables outstanding for various periods. As shown in the
aging schedule, in May, the total receivable outstanding was Rs 35 lac, of which 10 percent was overdue for
3 months, 20 percent for 2 months and 10 percent for 1 month.