CASE: Stanley Products Credit Policy

SP has something of a regional reputation, and sales reached nearly $1 million in the most recent fiscal year. At the suggestion of a colleague, Faith Allen, Stanley set up exhibits at a number of trade shows. He was at first reluctant to take the time from the day-to-day operation of the business to do so, but Allen persuasively argued that this was a relatively inexpensive way to gain expo sure. Good advice, it appears, judging by the expected sales for the next three years. (See Exhibit 2.)

Based on advance orders and the unusually large number of product inquiries, Stanley believes that sales will increase by over 40 percent next year (1997) and will more than double in three years. These forecasts flatter Stanley's scientific side because they imply that users recognize the technical superiority of SP's products. His business side is more cautious, however. Such large growth will undoubtedly require external financing, and Stanley is unsure how best to raise any needed funds, especially since his ability to supply capital is quite limited.

BANK FINANCING

Stanley's first reaction is to approach First National, SP's bank. No formal request has been made, but conversations with Tina McClellan, a loan officer, indicate that the best rate Stanley can expect is 13 percent, somewhat higher than Stanley expected. She cautioned, however, that SP might not be able to obtain any loan whatsoever. The main problems, McClellan explained, are the soft economy and regulators who are forcing banks to be stricter. Tighter credit standards are simply an inevitable consequence of all this, with the result that a sort of two-tiered loan structure develops. Larger, more stable businesses are on one tier. Because they are considered to be more creditworthy, they get the loans. And they get a reasonable rate because they generate transaction revenue well over five figures per year. Small businesses, like SP, are the second tier. Lenders will require of them greater loan documentation, more collateral, and higher rates. And in many cases small firms will be denied any loan at all. McClellan urged Stanley to make any request "very well justified" and suggested he shop around and look at other banks.

OTHER OPTIONS

1. Pass up trade discounts and use suppliers with the longest pay period. Most of SP's purveyors offer 2/10, net 30. That is, SP receives a 2 percent cash dis count if it pays within 10 days and is allowed 30 days if it passes up the dis count. A few suppliers offer 1/10, net 20 and, in some cases, SP receives 2/10, 45. Stanley would, of course, be careful not to take so long to pay as to endanger his credit standing.
2. Offer more enticing credit terms in order to shorten the firm's average collec- tion period. SP currently offers net 30, and would consider 3/10, net 30.
3. Limit growth to what can be internally financed.
4. Take in a partner.
5. Reduce the firm's inventory and fixed-asset requirements.

Stanley quickly dismisses the fifth possibility. He is quite capable at the production side of the business and feels that there is little slack in these items. Though Stanley finds the limit-growth and partner options distasteful, he can see advantages to each. By capping annual growth, it is more likely that the firm will not get out of control. He is painfully aware of one area company that went under a few years ago because of (according to the corporate grapevine) too much growth too fast.

Taking in a partner represents the flip side of the preceding option. Stanley believes that, with some searching, he could find an individual who would not only supply capital but also would be willing to assume managerial responsibilities. Such a person-properly selected-would allow Stanley to concentrate on the technical side of the company that he enjoys so much.

Roberts thinks the first two options are worth pursuing and proceeds to state their case. "Look at it this way," he muses. "Think of your purveyors as mini banks, each capable of providing you a bit of credit. True, no single one of these minibanks provides much financing, but put them all together and I bet you'll end up with a sizeable amount, especially if you can locate more suppliers willing to let you take 45 days to pay. And think of your receivables as miniloans you make. If these loans are paid earlier, that means more cash for you. Put all this together and, who knows, perhaps you can tell your bank to take a hike politely, of course." And Roberts has a suggestion regarding SP's credit standards. He is a bit alarmed at the firm's bad debt expense, which is 1.3 percent of sales. "It's clear you need to stiffen credit standards since your bad debt per centage seems pretty darn high for a firm in your line of business."

STANLEY'S REACTION

Impressed with Roberts's arguments, Stanley decides to pursue these options first. After some thought he decides to consider altering SP's credit terms from net 30 to 3/10, 30; that is, he would offer a 3 percent discount to customers who pay within 10 days, and 30 days of credit would be offered to customers who pass up the discount. At the same time he would also tighten SP's credit standards, as Roberts suggested.

Stanley believes that 60 percent of sales will involve the 3 percent discount, and these buyers will take the full 10 days to pay. He also thinks that 30 percent of the sales will be paid on day 30 and 10 percent will be late on day 50. Further, bad debt expense, including collection costs, is predicted to be 0.7 percent of sales.

The proposed changes in SP's credit terms and standards should affect sales in two ways. On one hand, the cash discount will attract new customers. On the other hand, the tighter credit standards will result in SP losing some customers. Stanley believes, however, that the sales-enhancing effect will dominate, and he predicts an increase of 5 percent in sales. (Note: The forecasts in Exhibit 2 are based on the existing credit policy.)

Variable cost is predicted to remain at 75 percent of sales. The percent of sales method can be used to determine inventory requirements, and the appropriate after-tax cost of capital (required return) is 12 percent for any funds tied up in receivables and inventory. Plant and equipment needs will remain unaffected by the relatively modest sales changes that might result from the credit changes. As Stanley ponders these issues, a number of points cross his mind. He notices that there are really two separate questions to answer: Is it a good idea to alter the terms of credit? Is it a good idea to tighten credit standards? For the time being, he decides to evaluate them together but thinks it makes more sense to evaluate each one separately. And he also wonders about the reaction of SP's competitors to the price discount. While SP's present credit terms are more typical of what goes on in the industry, cash discounts are not unheard of. Stanley realizes that his sales projections implicitly assume little reaction from SP's competitors, which he thinks is "very likely but not certain." In any event, Stanley doesn't expect any widespread reaction and believes that in the worst case there will be no change in predicted sales.

QUESTIONS

1. Evaluate Roberts's assertion that "it's clear you need to stiffen credit standards since your bad debt percentage seems (quite) high for a firm in your line of business." (You may assume for the sake of argument that SP's bad debt percentage is in fact quite high.)
2. (a) Assuming no change in its receivables or payables policies and no dividends are paid, use the percent-of-sales method to estimate SP's external financing requirements, EFR, for year t + 1. Use:

EFR = N( S) - bmS₁+ 1

where

N = A/S - LIS and L refer to spontaneous liabilities.

S= change in annual sales

b = retained earnings ratio

m = net profit margin = NI/Sales

St+₁ = sales in year t + 1

(b). Estimate the maximum yearly sales growth, g, that SP can internally finance. Continue to assume no change in its receivables or payables policies and no dividends are paid. Use:

(c). If Stanley chooses to limit growth to the amount that can be internally financed, predict SP's annual sales over the next three years.

3. (a). Estimate SP's days sales outstanding, that is, its average collection period (ACP), assuming the proposed credit changes are made.

(b). Complete Exhibit 3

(c). Complete Exhibit 4

EXHIBIT I Stanley Products Present 1996 (t = 0) Income Statement and Balance Sheet ($000s) Income Statement Sales $987.0 Bad debt expense 12.sa Net sales 974.2 Variable cost 740.3 Fixed cost 176.7 Earnings before taxes 57.2 Taxes (40%) 22.9 Net income $34.3 "Includes collection costs Balance Sheet A.1.lets Liabilities and Equity Cash $29.6 Debt due $9.9 Inventory 123.4 Accounts payable 45.6 Receivables 109.7 Accruals 39.7 Currents assets 262.7 Current liabilities 95.2 Net fixed assets 98.7 Long-term debt 65.4 Total assets $361.4 Equity 200.8 Total liabilities and equity $361.4EXHIBIT 2 Projected Annual Sales ($0005) Year t =0 t+ 1 t + 2 t+ 3 1996 1997 1998 1999 $987.0 $1,400.2 $1,778.3 $2.294.1 These forecasts assume no change in SP's credit policy. EXHIBIT 3 Worksheet to Calculate Incremental Asset Requirements and Capital Cost of Credit Changes for 1997 (Year t+ 1) ($000s) Nu Credit With Changes Changes Dyferevwe lnvesbnent in $116.7 receivables Inventory needed 175.1 Total 291.8 Capital cost 35.0 EXHIBIT 4 Worksheet to Evaluate the Credit Changes for 1997 (Year 13+ 1) ($000s) Nu Credit With Changes Changes Difference Sales $1,400.2 Bad debt expense 18.2 Discounts taken _ 0_ Net sales 1.3820 Variable cost 1,050.2 Fixed cost 252.0 Earnings before taxes 79.8 Taxes (40%) _11 Net income 47.9 Capital Cost 72.19 Gain (loss) $12.9