30 Accounts Receivable Management A Switch in Time Saves Nine Simon sat at his office desk pondering over what was discussed at his last meeting with the Treasurer, Angela Krampf. The working capital of their firm, Progressive Farm Equipment Incorporated, had increased at an alarming rate over the past couple of years making the directors and top managers very concerned. Despite the implementation of a just in time" inventory system and more efficient cash management methods, the working capital continued to rise. This time, however, it was the accounts receivable that needed attention. Angela received a memo from the board asking her to review and rectify the credit management problem as soon as possible. One of the sentences in the memo read " "...we simply cannot continue to carry our customers as long as we have been" Angela had therefore called on her assistant, Simon Martinez, and briefed him of the situation. Progressive Farm Equipment Inc. had been in business since 1945, producing small and medium sized tractors, tillers, and other farm equipment. Its customer base included various local and regional 159 Case 30 A Switch in Time Saves Nine hardware stores, farm equipment stores, and repair shops. Most of the clients were strapped for cash and were accustomed to fairly flexible credit terms. The firm had been hard pressed to offer terms of net 60 to its clients, primarily to counter competition from national suppliers and to maintain good customer relationships. Sales had steadily increased over the years but over the past year, higher interest rates and a weakening economy had caused a slump in the agricultural sector leading to a drop in sales of farm equipment. Moreover, the number of farmers filing for bankruptcy had been increasing at an alarming rate. As Angela and Simon reviewed the accounting statements (see Tables 1 and 2) and the aging schedule of receivables, they realized that despite the fairly liberal credit terms of net 60, on average, 40% of the credit sales were being collected 10 days late. The company had not implemented a policy of charging interest or late fees for fear of losing customers. They also noticed that over the past year the number of bad debts had gone up from 1% of sales to its current level of 2% of sales. Angela told Simon that the directors expected to see a proposal that would be realistic and effective. "On the one hand, we have to be careful about not turning customers away, said Angela. "But on the other hand, we simply cannot afford to continue the current policy of allowing customers to pay late. Some credit will have to be given, but collections have to be tightened up. I guess the time has come for us to switch or suffer." About six months earlier, Angela Krampf had recruited Simon Martinez, a certified financial manager, to assist her in managing the company's working capital. Initially, it was the management of cash and inventory that needed modification. After much debate and discussion, a more conservative policy of cash management was implemented, followed by a successful integration of a just-in-time inventory management system. The quarterly statements showed that the modifications had worked. Angela and Simon were aware that the company's collection policy was rather liberal. However, given the economic conditions and sensitivity of the issue, they had refrained from suggesting any changes. As Simon pondered about what changes in the firm's collection policy he should recommend he realized that he would have to get some more data. He called up the folks in marketing and inquired about what 60 Case 30 A Switch in Time Saves Nine ffect a tighter collection policy would have. Upon being asked to be ore specific, he told them that he was considering two alternatives: 1) 2/10 net 30, and 2) 2/10 net 60. le was told that under the first alternative, sales would probably decrease y about 10%. The sales people had built up a very good relationship rith their customers and were confident that, despite the tighter credit erms, they could retain most of the accounts provided there was some ncentive for paying early. Moreover, they informed Simon that most etailers could avail of commercial loans from banks at an average rate of terest of 14% per year. If the second alternative were implemented, the ccounts receivable figure would be reduced without any loss of sales. bviously, the sales people preferred the second approach. Simon stimated that under the new terms approximately 50 percent of sales ould be collected within 10 days. Of the remaining 50% of sales, ughly 60% would be collected within the credit period and the maining 40% would be approximately 10 days late, as usual. Simon gured that he had better prepare pro forma statements showing the pact that these policies would have on the company's bottom line and the accounts receivable balance, before recommending any harsh enalties and so on. Table 1 Progressive Farm Equipment Incorporated Latest Fiscal Year's Income Statement ('000s) Sales Cost of Goods Sold Gross Profit Op. Expenses Earnings Before Interest and Taxes Interest expenses (10% per year) Earnings Before Taxes Income taxes Net Income 45000 29250 15750 7200 8550 1300 7250 3420 3830 Table 2 Progressive Farm Equipment Incorporated Latest Fiscal Year's Balance Sheet ('000s) Cash Accounts Receivable inventory 2000 Accounts Payable 7890 Notes Payable 6000 Total Current Liabilities 3200 6000 9200 Total Current Assets Fixed Assets Total Assets 15890 Long-Term Debt 8000 20000 Stockholders' Equity 18690 35890 Total Liabilities and equity 35890 7. Develop the pro forma financial statements for the company under the two credit policy alternatives, i.e. 2/10, net 60; and 2/10 net 30 using the assumptions given. What would be the impact on the firm's return on sales, return on investment, and return on equity