Case 33

Upscale Toddler, Inc.

Working Capital Management

Upscale Toddlers, Inc., manufactures childrens clothing, including such accessories as socks and belts. The company has been in business since 1955, mainly supplying private label merchandise to large department stores. In 1990, however, the company started producing its own line of childrens clothing under the brandname Yuppiewear. An increasing number of two-income families has been accompanied by an increasing demand for high-status childrens clothing, and Toddlers was the first in its field to recognize this trend.

When Toddlers sales were primarily for private labels, the firms financial manager did not have to worry much about its overall credit policy. Most of its sales were negotiated directly with department store buyers, and the resulting contracts contained specific credit terms. The new line, however, represents a significant change. It is sold through numerous wholesalers under standard credit terms, so credit policy per se has become important. Elizabeth Hardin, the assistant treasurer, has been assigned the task of reviewing the companys current credit policy and recommending any desirable changes.

Toddlers current credit terms are 2/10, net 30. Thus, wholesalers buying from Toddlers receive a 2 percent discount off the gross purchase price if they pay within ten days, while customers who do not take the discount must pay the full amount within thirty days. The company does check the financial strength of potential customers, but its standards for granting credit are not high. Similarly, it does have procedures for collecting past-due accounts, but its collections policy could best be described as passive. Gross sales to wholesalers average about $15 million a year, and 50 percent of the paying wholesalers take the discount and pay, on average, on Day 10. Another 30 percent of the payers generally pay the full amount on Day 30, while 20 percent tend to stretch Toddlers terms and do not actually pay, on average, until Day 40. Two percent of Toddlers gross sales to wholesalers end up as bad debt losses.

Nathan Langly, the treasurer and Hardins boss, is convinced that the firm should tighten up its credit policy. According to Langly, good customers will pay on time regardless of the terms, and the ones who would complain about a tighter policy are probably not good customers. Hardin must make an analysis and then recommend a course of action. For political reasons, she has decided to focus on a tighter policy, under which a 4 percent discount would be offered to customers who pay cash on delivery (COD) and twenty days of credit would be offered to customers who elect not to take the discount. Also, under the new policy stricter credit standards would be applied, and a tougher collection policy would be enforced. This policy has been dubbed 4/COD, net 20.

Langly likes this policy. He believes that increasing the discount would both bring in new customers and also encourage more of Toddlers existing customers to take the discount. As a result, he believes that sales to wholesalers would increase from $15 million to $16.5 million annually, that 60 percent of the paying customers would take the discount, that 30 percent of the payers would pay on Day 20, that 10 percent would pay late on Day 30, and that bad debt losses would be reduced to 1 percent of gross sales. Langlys is not the only position, though. Arnold Quayle, the sales manager, has argued for an easier credit policy. Quayle thinks that the proposed change would result in a drastic loss of sales and profits.

Toddlers variable cost-to-sales ratio is 80 percent; its pre-tax cost of carrying receivables is 12 percent; and the company can expand without any problems (or any cost increases) because it can subcontract production that it cannot handle in-house. Further, Langly is convinced that neither the variable cost ratio nor the cost of capital would change as a result of a credit policy change. Arnold Quayle, however, thinks that the variable cost ratio might increase significantly if sales rise so much that the company is forced to use outside suppliers. Also, after discussions with the cost accounting staff, Quayle thinks that the variable cost ratio might rise as high as 90 percent this coming year, even without an increase in sales, due to higher labor costs under a contract now being negotiated. Everyone agrees that there is little chance that costs will decline, regardless of the credit policy decision. Toddlers federal-plus-state tax rate is 40 percent.

Now Hardin must conduct an analysis to estimate the effect of the proposed credit policy change on Toddlers profitability. She and Langly are very much concerned about the analysis, both because of its importance to the company and also because of its political implications. The sales and production people have been lobbying against any credit tightening because they do not want to take a chance on losing sales and having to cut production, and also because they question the assumptions Langly wants to use. Therefore, Hardin knows that her report will be critically reviewed and a thorough analysis is required. She is especially concerned about being prepared for follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed. The report should consider all relevant factors, including an analysis of both the current and proposed credit policies and a recommendation as to what Toddlers should do.

Hardin has requested that you assist with the report. She is not certain what risks are involved with a credit policy change or if such risks can even be assessed and incorporated in the analysis. Meanwhile, Langly has expressed concern that if the firm changes its credit policy, Toddlers competitors may react by making similar changes in their terms. Thus, Toddlers would have a new credit policy without any change in sales.

As with every report presented to management, there probably will be a number of questions regarding the assumptions used in the analysis. Specifically, Hardin expects both the sales and production managers to question the assumptions, so she would like to know which variables are most critical in the sense that profitability is very sensitive to them. No one has yet determined just how far off the assumptions could be before the change to a tighter credit policy would be incorrect. Also, if she could, Hardin would like to have a better basis for the assumptions used in her report - as it stands, all she has to rely on is Langly's judgment, which is contrary to that of two other senior executives. However, she is not sure whether any additional actions could be taken to improve the accuracy of the forecasts.

Langly gave you a portion of a letter he recently received from Ivana Tinkle, a member of Toddler's board of directors. Ivana who also sits on the Board of Face Cosmetics, Inc., has been involved in numerous credit policy decisions. The decisions made by Face were always successful from a profitability standpoint. Thus, Ivana suggests that Toddlers use the same algebraic approach used by Face, in addition to constructing projected profit statements. Pages two and three of Ivana's letter are set forth in Exhibit 1. Ivana is a very influential member of the board, so be prepared to address her suggestion.

Working with Langly, she prepared the following set of questions for use as a guide in drafting her report. Put yourself in her position and answer the following questions. As you answer each question, think about follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed.

As an alternative to constructing profit statements, an algebraic approach has been developed that focuses directly on the change in profits. To use this approach, it is first necessary to define the following symbols:

S0 = current gross sales

SN = new gross sales after the change in credit policy. Note that SN can be greater than or less than S0 V = Variable costs as a percentage of gross sales. V includes production costs, inventory carrying costs, the cost of administering the credit department, and all other variable costs except bad debt losses, receivables carrying costs, and the cost of giving discounts 1 V = contribution margin, or the proportion of gross sales that goes toward covering fixed costs and increasing profit k = cost of financing the firm s receivables

DSO0 = current days sales outstandin

DSON = new average days sales outstanding after change in credit polic

B0 = current bad debt losses as a proportion of current gross sale

BN = new bad debt losses as a proportion of new gross sale

P0 = proportion of current-collected gross sales that are discount sale

PN = proportion of new-collected gross sales that are discount sale

D0 = current discount offered

DN = discount offered under new policy

T = Tax Rate

Calculate values for the incremental change in the firms investment in receivables, I, and the incremental change in after-tax profits, DP, as follows:

Formula for I if Sales Increase: I = V[(DSON - DSO0)(S0/360)] + V[(DSON)(SN - S0)/360].

Formula for I if Sales Decrease: I = V[(DSON - DSO0)(SN/360)] + V[(DSO0)(SN - S0)/360].

Formula for P: P = (1 - T)(SN - S0)(1 - V) - kI - (BNSN - B0S0) - [DNSNPN(1 - BN) - D0S0P0(1 - B0)].

Note that, in the profit equation, the first term {(1 - T)(SN - S0)(1 - V)} is the incremental after-tax gross profit, the second term {kI} is the incremental cost of carrying receivables, the third term {BNSN-B0S0} is the incremental bad debt losses, and the last term {DNSNPN(1 - BN) - D0S0P0(1 - B0)} is the incremental cost of discounts taken based on the percent of discounts taken by paying customers.

Use the equations presented here to estimate the change i profits associated with the new policy. I hope this provides you with enough information. I will be out of the country on business for three months and will not be available to answer any further questions on this approach. Sincerely, Ivana Tinkle

Questions

What are the four variables that make up a firms credit policy? How likely (and how quickly) are competitors to respond to a change in each variable, and is their response likely to be the same for a change toward tightness as one toward looseness?

What is Toddlers current days sales outstanding (DSO) [also called average collection period (ACP)]? What would the expected DSO be if the credit policy change were made?

What is the dollar amount of bad debt losses under the current policy? What would be the expected losses under the proposed policy?

What is the cost of granting discounts under the current policy? What would be the expected cost under the new policy?

What is Toddlers dollar cost of carrying receivables under the current policy? What would be the expected cost under the new policy? (Use a 360 day year.)

What is the expected incremental profit associated with the proposed change in credit terms? Should Toddlers make the change? (Hint: Construct income statements under each policy and focus on the expected change. See Table 1 for a guide.)

Does your analysis up to this point consider the risks involved with a credit policy change? If not, how could risk be assessed and incorporated into the analysis?

Suppose the firm makes the change to 4/COD, net 20, but Toddlers competitors react by making similar changes in their terms. The net result is that Toddlers gross sales remain at the current $15 million level. If the remainder of Hardins assumptions are correct, what would be the impact on Toddlers profitability?

Hardin expects both the sales and production managers to question her assumptions, so she would like to know which variables are most critical in the sense that profitability is very sensitive to them. Then, she would like to know just how far off her assumption could be before the change to a tighter credit policy would be incorrect. If you are using the spreadsheet model, do some sensitivity analyses, changing one variable at a time while leaving the others at their base case values. Which variables are most important in terms of their effects on profits, and how large an error could there be in the assumptions which you regard as being most critical before the decision should be reversed?

Also, if she could, Hardin would like to have a better basis for the assumptions used in her reportas it stands, all she has to rely on is Langlys judgment, which is contrary to that of two other senior executives. What are some actions that Hardin might take to improve the accuracy of her forecasts?

The following question presents an algebraic approach to analyzing changes in credit policy. Answer it only if it is assigned by your instructor.

As an alternative to constructing profit statements, an algebraic approach has been developed that focuses directly on the change in profits. Use the equations presented in Exihibit 1 to estimate the change in profits associated with the new policy

Projected Income Statements

Proposed Policy Current Policy Deffernce

Gross Sales X $15,000,000 X

Discounts X 147,000 X

Net Sales X $14,853,000 X

Production Costs X 12,000,000 X

Net Earnings Before X $2,853,000 X

Credit Costs

Credit-related Costs:

Receivables carrying cost X 88,000 X

Bad Debt Losses X 300,000 X

Net earning before tax X $2,465,000 X

Taxes (40%) X 986,000 X

After-tax profits X $1,479,000 X