Bidco Traders: Raising a Stressed Customer's Credit Limit
Tuzo Distributors sells on 30-day terms. Bidco Traders, its largest customer, holds a limit of KSh 2,500,000 and currently owes KSh 2,300,000 - 60% of that balance is older than 60 days. Annual credit sales to Bidco are KSh 10,800,000. Bidco now asks for its limit to be raised to KSh 4,000,000 to service a new KSh 3,200,000-a-year contract; gross margin is 22% and Bidco's terms would remain 30 days. Bidco's draft accounts show a current ratio of 1.05, a quick ratio of 0.62 and debt/equity of 2.4. A credit insurer will indemnify 70% of proved losses on insured receivables, capped at KSh 3,000,000. Your credit committee estimates a 12% probability of default and 25% recovery in liquidation. Tuzo funds receivables on an overdraft costing 16% a year.
1. Compute the expected credit loss on the proposed additional exposure, net of insurance, and compare it with the gross profit the new contract brings.
Read the worked answer
Step 1 - Exposure at default (incremental). EAD = proposed limit − current exposure = 4,000,000 − 2,300,000 = KSh 1,700,000
Step 2 - Loss given default. LGD = 1 − recovery rate = 1 − 0.25 = 0.75
Step 3 - Gross expected loss. EL = PD × LGD × EAD = 0.12 × 0.75 × 1,700,000 = KSh 153,000
Step 4 - Effect of the policy. Insurer pays 70% of proved loss = 0.70 × 153,000 = KSh 107,100. Maximum indemnity = 0.70 × 3,000,000 = KSh 2,100,000, so the cap does not bite. Net EL = 153,000 − 107,100 = KSh 45,900
Step 5 - Financing cost of the longer exposure. Extra receivables = 1,700,000 × 78/365 = KSh 363,288. Cost at 16% = KSh 58,126
Step 6 - Reward. Gross profit = 22% × 3,200,000 = KSh 704,000
Step 7 - Net benefit. 704,000 − 45,900 − 58,126 ≈ KSh 600,000
The proposal is value-creating on a risk-adjusted basis - but note that the existing 2,300,000 already carries an expected loss of 0.12 × 0.75 × 2,300,000 = KSh 207,000 which the new order does not create and cannot be credited to it.
2. Decide whether to grant the increase. State the decision and the conditions you would attach, giving your reasoning.
Read the worked answer
Decision: no increase today; a conditional, staged increase instead.
Reasoning:
- The arithmetic supports the business (risk-adjusted benefit ~KSh 600,000), so a flat refusal destroys value.
- But the account breaches policy now: 60% of a KSh 2,300,000 balance (KSh 1,380,000) is over 60 days on 30-day terms. Extending more unsecured credit to a customer who is already financing itself from you rewards non-payment.
- The balance sheet confirms fragility: quick ratio 0.62 means inventory-dependent liquidity; debt/equity 2.4 leaves little cushion before our debt is impaired.
Conditions
- Overdue 60-day tranche of KSh 1,380,000 cleared by four instalments of KSh 345,000 over four months before any limit movement.
- Limit raised in steps: KSh 3,000,000 now, reviewed to KSh 4,000,000 after three consecutive months of payment within 45 days.
- Security: directors' personal guarantees plus a deed of assignment over the new contract's receivables.
- Credit insurance endorsement naming Tuzo as insured on Bidco risks.
- Interest at 2% a month on balances past 30 days; supply suspended automatically at 85% utilisation unless the balance is reduced first.
- Quarterly management accounts within 45 days of quarter end.
3. What monitoring triggers and immediate actions would you put in place on this account, and why those rather than others?
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Immediate actions (next 30 days)
- Written confirmation of the instalment plan and a fresh credit application capturing the new contract.
- Site visit and a check of the contract counterparty's payment record - our real repayment source is the end debtor.
- Verify no statutory demands, tax arrears or bank defaults have appeared since the draft accounts.
Triggers that force automatic review (not discretionary)
| Trigger | Threshold |
|---|---|
| Days beyond terms | two consecutive invoices paid after 60 days |
| Utilisation | above 85% for 30 days without a payment |
| Instrument failure | any returned or dishonoured cheque |
| Liquidity | current ratio below 1.00 on any management accounts |
| Information | management accounts more than 45 days late |
| Adverse event | receiver, statutory demand, insurance exclusion |
Why these They are objective, observable and lead the loss rather than lag it. Balance-sheet ratios measure the customer's capacity; payment behaviour and instrument failure measure willingness and are the earlier warning. A trigger the credit officer must exercise judgement on ("poor relationship") will be rationalised away; a numeric trigger will not.
Escalation Any trigger freezes the limit, moves the account to cash-with-order for new business, and forces a decision by the credit committee within 10 working days.