Accounts receivable consist of the credit a business grants its customers when selling goods or services.1They take the form of either trade credit, which the company extends to other companies, or consumer credit, which the company extends to its ultimate consumers. The effectiveness of a company’s credit policies can have a significant impact on its total performance. For example,Monsanto’s credit manager has estimated that a reduction of only one day in the average collection period for the company’s receivables increases its cash flow by $10 million and improves pretax profits by $1 million. For a business to grant credit to its customers, it has to do the following:
In this section we develop the establishment of optimal credit and collection policies. In the following section, we discuss procedures for evaluating individual credit applicants.
Shareholder Wealth and Optimal Investments in Accounts Receivable
When a company decides to extend credit to customers, it is making an investment decision, namely, an investment in accounts receivable, a current asset. As with the decision to invest in long -term assets, the primary goal is the maximization of shareholder wealth. Recall from the discussion of the basic framework for capital budgeting decisions in Chapter Capital Budgeting and Cash Flow Analysis that the optimal capital budget is determined by accepting all investment projects whose marginal returns, as measured by the internal rate of return, are greater than or equal to the marginal costs of the funds invested in the projects, as measured by the marginal cost of capital.
Such a decision rule maximizes shareholder wealth because the projects accepted will earn a return greater than or equal to cost of the funds to the owners of the firm. Following similar reasoning, a company will maximize shareholder wealth by investing in accounts receivable as long as the expected marginal returns obtained from each additional dollar of receivables investment exceed the associated expected marginal costs of the investment, including the cost of the funds invested.
The establishment of an optimal credit extension policy requires the company to examine and attempt to measure the marginal costs and marginal returns (benefits) associated with alternative policies. What are the marginal returns and costs associated with a more liberal extension of credit to a company’s customers? With respect to returns, a more liberal extension presumably stimulates sales and leads to increased gross profits, assuming that all other factors (such as economic conditions, prices, production costs, and advertising expenses) remain constant.
Offsetting these increased returns are several types of credit-related marginal costs, including the opportunity costs of the additional capital funds employed to support the higher level of receivables.Any increase in sales resulting from a more liberal credit extension policy may also result in increased inventory levels and associated inventory investment costs. Checking new credit accounts and collecting the higher level of receivables also results in additional costs. And finally, a more liberal credit policy frequently results in increased bad-debt expenses because a certain number of new accounts are likely to fail to repay the credit extended to them.
In determining an optimal credit extension policy, a company’s financial managers must consider a number of major controllable variables that can be used to alter the level of receivables, including the following:
The remainder of this section discusses each of these variables in more detail.
Credit standards are the criteria a company uses to screen credit applicants in order to determine which of its customers should be offered credit and how much. The process of setting credit standards allows the firm to exercise a degree of control over the “quality” of accounts accepted. The quality of credit extended to customers is a multidimensional concept involving the following:
The average collection period serves as one measure of the promptness with which customers repay their credit obligations. It indicates the average number of days a company must wait after making a credit sale before receiving the customer’s cash payment. Obviously, the longer the average collection period, the higher a company’s receivables investment and, by extension, its cost of extending credit to customers. The likelihood that a customer will fail to repay the credit extended to it is sometimes referred to as default risk. The bad-debt loss ratio, which is the proportion of the total receivables volume a company never collects, serves as an overall, or aggregate, measure of this risk. A business can estimate its loss ratio by examining losses on credit that has been extended to similar types of customers in the past.The higher a firm’s loss ratio, the greater the cost of extending credit.
Credit Evaluation Data Compiled by Bassett Furniture Industries
For example, suppose that Bassett Furniture Industries is considering making a change in its credit standards. Before reaching any decision, the company first must determine whether such a change would be profitable. The first step in making this decision involves an evaluation of the overall creditworthiness of the company’s existing and potential customers (retailers) using various sources of information. on illustrates the credit sales, average collection period, and loss ratio data for various credit risk groups of the company’s customers in its northwest region.
Otherwise, the loss ratio should be adjusted to take account of expected future economic changes. This procedure also assumes that credit extension and repayment information is available on a sufficiently large sample of accounts to provide a company with a reliable estimate of its loss ratio. Without this information, the financial manager simply has to make an “educated guess” as to the size of the loss ratio.
Under its current credit policy, Bassett extends unlimited credit to all customers in Credit Risk Groups 1, 2, and 3, and no credit to customers in Groups 4 and 5, meaning that the customers in these latter two groups must submit payment along with their orders. As a result of this policy, Bassett estimates that it “loses” $300,000 per year in sales from Group 4 customers and $100,000 per year in sales from Group 5 customers. Bassett also estimates that its variable production, administrative, and marketing costs (including credit department costs) are approximately 75 percent of total sales; that is, the variable cost ratio is 0.75.7 Thus, the profit contribution ratio per dollar of sales is 1.0 – 0.75 = 0.25 or 25 percent. The company’s required pretax rate of return (that is, the opportunity cost) on its current assets investment is 20 percent.
One alternative Bassett is considering is to relax credit standards by extending full credit to Group 4 customers. Bassett estimates that an additional inventory investment (i.e., raw materials, work-in-process, and finished goods) of $120,000 is required to expand sales by $300,000. In evaluating this alternative, the financial manager has to analyze how this policy would affect pretax profits. If the marginal returns of this change in credit standards exceed the marginal costs, pretax profits would increase, and the decision to extend full credit to the Group 4 customers would increase shareholder wealth. contains the results of this analysis. In Step A, the marginal profitability of the additional sales, $75,000, is calculated.
Next, the cost of the additional investment in receivables, $9,863, is calculated in Step B.8 In Step C, the additional bad-debt loss, $21,000, is computed. Then, the cost of the additional investment in inventory, $24,000, is calculated in Step D. Finally, in Step E, the net change in pretax profits is determined by deducting the marginal costs computed in Steps B, C, and D from the marginal returns found in Step A. Because this expected net change is a positive $20,137, the analysis indicates that Bassett should relax its credit standards by extending full credit to the Group 4 customers. This analysis contains a number of explicit and implicit assumptions of which the financial manager must be aware.
One assumption is that the company has excess capacity and thus could produce the additional output at a constant variable cost ratio of 0.75. If the company is currently operating at or near full capacity, and additional output could be obtained only by paying more costly overtime rates and/or investing in new facilities, this analysis would have to be modified to take account of these incremental costs. This analysis also assumes thatthe average collection period of the customers in Groups 1, 2, and 3 would not increase once the company began extending credit to Group 4 customers. If it became known that the Group 4 customers had 60 days or more to pay their bills with no penalty involved, the Group 1, 2, and 3 customers, who normally pay their bills promptly, might also start delaying their payments. If this occurred, the analysis would have to be modified to account for such shifts.
Bassett Furniture Industries’ Analysis of the Decision to Relax Credit
It was also assumed that the required rate of return on the investment in receivables and inventories for Group 4 does not change as a result of extending credit to these more risky accounts. A case can be made for increasing the required rate of return to compensate for the increased risk of the new accounts. Finally, this example assumes that an increase in inventory investment is necessary as a result of changes in the firm’s credit policy. In summary, for this type of analysis to be valid and to lead to the correct decision, it must include all the marginal costs and benefits that result from the decision.
A company’s credit terms, or terms of sale, specify the conditions under which the customer is required to pay for the credit extended to it. These conditions include the length of the credit period and the cash discount (if any) given for prompt payment plus any special terms, such as seasonal datings. For example, credit terms of “net 30” mean that the customer has 30 days from the invoice date within which to pay the bill and that no discount is offered for early payment.
Credit Period The length of a company’s credit period (the amount of time a credit customer has to pay the account in full) is frequently determined by industry customs, and thus it tends to vary among different industries. The credit period may be as short as seven days or as long as six months.Variation appears to be positively related to the length of time the merchandise is in the purchaser’s inventory. For example, manufacturers of goods having relatively low inventory turnover periods, such as jewelry, tend to offer retailers longer credit periods than distributors of goods having higher inventory turnover periods, such as food products.
A company’s credit terms can affect its sales. For example, if the demand for a particular product depends in part on its credit terms, the company may consider lengthening the credit period to stimulate sales. For example, IBM apparently tried to stimulate declining sales of its PCjr home computer by extending the length of the credit period in which dealers had to pay for the computers. In making this type of decision, however, a company must also consider its closest competitors. If they lengthen their credit periods, too, every company in the industry may end up having about the same level of sales, a much higher level of receivables investments and costs, and a lower rate of return.
Analyzing the possible effects of an increase in a company’s credit period involves comparing the profitability of the increased sales that are expected to occur with the required rate of return on the additional investment in receivables and inventories. Additional bad-debt losses must also be considered. If a company continues to accept the same quality of accounts under its lengthened credit terms, no significant change in the bad-debt loss ratio should occur. For example, suppose that Nike, a distributor of athletic shoes and sportswear, is considering changing its credit terms from “net 30” to “net 60” in its western Michigan sales territory.
The company expects sales (all on credit) to increase by about 10 percent from a current level of $2.2 million, and it expects its average collection period to increase from 35 days to 65 days. The bad-debt loss ratio should remain at 3 percent of sales. The company also estimates that an additional inventory investment of $50,000 is required for the expected sales increase. The company’s variable cost ratio is 0.75, which means that its profit contribution ratio (per dollar of sales) is 1.00 – 0.75 = 0.25. Nike’s required pretax rate of return on investments in receivables and inventories is 20 percent.
contains an analysis of Nike’s decision.Many of the calculations in this table are similar to those in, which analyzed the effects of a change in credit standards. The marginal returns ($55,000) computed in Step A represent the marginal profitability of the additional sales generated by the longer credit period. The marginal costs (obtained in Steps B, C, and D) consist of the cost of the additional receivables investment ($44,000), the additional bad-debt losses ($6,600), and the cost of the additional inventory investment ($10,000). The net increase in pretax profits (Step E) that would result from the decision
Nike’s Analysis of the Decision to Change Its Credit Terms from
Cash Discounts A cash discount is a discount offered on the condition that the customer will repay the credit extended within a specified period of time. A cash discount is normally expressed as a percentage discount on the net amount of the cost of goods purchased (usually excluding freight and taxes). The length of the discount period is also specifiedwhen discount terms are offered. For example, credit terms of “2/10, net 30” mean that the customer can deduct 2 percent of the invoice amount if payment is made within 10 days from the invoice date.
If payment is not made by this time, the full invoice amount is due within 30 days from the invoice date. (In some cases, the discount period may begin with the date of shipment or the date of receipt by the customer.) Like the length of the credit period, the cash discount varies among different lines of business. Cash discounts are offered (or increased) to speed up the collection of accounts receivable and, by extension, reduce a company’s level of receivables investment and associated costs.9 Offsetting these savings or benefits is the cost of the discounts that are taken, which is equal to the lost dollar revenues from the existing unit sales volume.
For example, suppose that Sony Music (a subsidiary of the Sony Corporation) is considering instituting a cash discount. The company currently sells to record distributors on credit terms of “net 30” and wants to determine the effect on pretax profits of offering a 1 percent cash discount on terms of “1/10, net 30” to record distributors in its southwestern Ohio region. The company’s average collection period is now 50 days and is estimated to decrease to 28 days with the adoption of the 1 percent cash discount policy. It also is estimated that approximately 40 percent of the company’s customers will take advantage of the new cash discount.
Sony’s annual credit sales in the southwest region are $2.5 million, and the company’s required pretax rate of return on receivables investment is 20 percent. contains an analysis of Sony’s proposed cash discount policy. The marginal returns ($30,137) computed in Step A represent the earnings Sony expects to realize on the funds released by the decrease in receivables. The marginal costs ($10,000) found in Step B represent the cost of the cash discount. Subtracting the marginal costs from the marginal returns (Step C) yields a net increase in pretax profits of $20,137, indicating that Sony should offer the proposed 1 percent cash discount, if it is confident about the accuracy of the estimates used in this analysis.
Seasonal datings are special credit terms that are sometimes offered to retailers when sales are highly concentrated in one or more periods during the year. Under a seasonal dating credit arrangement, the retailer is encouraged to order and accept delivery of the product well ahead of the peak sales period and then to remit payment shortly after the peak sales period. The primary objective of seasonal dating is to increase sales to retailers who are unable to finance the buildup of inventories in advance of the peak selling period because of a weak working capital position, limited borrowing capacity, or both. For example, O.M. Scott & Sons, manufacturers of lawn and garden products, has used a seasonal dating plan that is tied to the growing season.
Payments for winter and early spring shipments are due at the end of April and May, depending on the geographical area, and payments for shipments during the summer months are due in October or November. Payments for purchases made outside the two main selling seasons are due on the 10th of the second month following shipment. A cash discount of 0.6 percent per month is offered to encourage payments in advance of these seasonal dates. The arrangement enables and encourages dealers of lawn and garden products to be fully stocked with Scott products in advance of the peak selling periods.
The collection effort consists of the methods a business employs in attempting to collect payment on past-due accounts. Some commonly used methods include the following:
Another approach, which is also effective in some cases, is for the firm to refuse to make new shipments to the customer until the past -due bills are paid. Although the objectives of the collection effort are to speed up past-due payments and reduce bad-debt losses, a company must also avoid antagonizing normally creditworthy customers who may be past due for some good reason —for example, because of temporary liquidity problems. A collection effort that is too aggressive may reduce future sales and profits if customers begin buying from other businesses whose collection policies are more lenient.
When determining which methods to use in its collection effort, a company has to consider the amount of funds it has available to spend for this purpose. If the firm has a relativelysmall amount of money available for collecting past-due accounts, it must confine itself to less costly (and less effective) methods, such as sending letters and making telephone calls. If it has a larger budget, the firm can employ more aggressive procedures, such as sending out representatives to personally contact past-due customers. In general, the larger the company’s collection expenditures, the shorter its average collection period and the lower its level of bad-debt losses. The benefits of additional collection efforts, however, are likely to diminish rapidly at extremely high expenditure levels.
Sony Music:Analysis of the Decision to Offer a 1 Percent Cash Discount
The marginal benefits of the decision to increase collection expenditures consist of the earnings on the funds released from the receivables investment as a result of the shorter average collection period, plus the reduction in bad -debt losses. A business should increase its collection expenditures only if these marginal benefits are expected to exceed the amount of the additional collection expenditures.
Monitoring Accounts Receivable
For a company to effectively control its receivables investment, the credit manager must monitor the status and composition of these accounts.An aging of accounts is a useful monitoring technique.10 In an aging analysis, a company’s accounts are classified into different categories based on the number of days they are past due. These classifications show both the aggregate amount of receivables and the percentage of the total receivables outstanding in each category. Aging of accounts receivable provides more information than such summary ratios as, for example, the average collection period. Comparing aging schedules at successive points in time (for example, monthly, quarterly, or semiannually) can help the credit manager monitor any changes in the “quality” of the company’s accounts.
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