Question

Power Play Inc. has seen profits drop acutely because of the economic downturn. To enhance profitability and to preserve cash, Power Play is considering shortening its credit period and eliminating its cash discount. Terms are currently 3/10, net 60 and would be changed to net 30. Currently, 60 percent of customers, on average, pay at the end of the credit period (60 days); the other 40 percent pay, on average, in 10 days and receive the discount. It is anticipated that under the new policy customers will pay, on average, in 30 days. At present, average monthly sales are $450,000, but they are expected to fall to $400,000 with the tightening of credit. Variable production costs are 78 percent, and bank financing is currently floating at 11 percent. Bad debt losses at 2 percent of sales are expected to drop to 1.75 percent of sales.

a.Should Power Play's credit policy be tightened?Yes No

b.What is the average accounts receivable balance under both policies?(Use 365 days in a year. Round the final answers to nearest whole dollar.)

Present policy$

New policy$

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MANAGEMENT OF ACCOUNTS RECEIVABLE

LO4

Despite the expansion of credit via bank credit cards and the creation of finance subsidiaries, a substantial portion of the investment in assets by industrial companies continues to be in accounts receivable. This granting of credit by companies as an alternative to the banks or the capital markets occurs because trade credit facilitates sales. Credit is a part of the complete marketing package presented to a potential customer. It does, however, require careful monitoring and analysis by the financial manager.

Of course the accounts receivable of one firm is an account payable at another firm. The smaller firm, in fact, may lack access to the capital markets or to bank financing. Banks may be unwilling to lend to the small firm because the security it can offer is insufficient or the risks are too high and the profit margins too low. Larger firms with higher profit margins on their product, by extendingtrade credit, in effect provide access for the smaller firm to these financing sources. Remember, the large firm likely supports its accounts receivable position with short-term financing through the banks or the capital markets. ExamineFigure 8-1to see the extent of trade credit financing in Canada.

Trade credit is readily available and convenient. According to Statistics Canada, accounts receivable as a percentage of total assets for nonfinancial corporations in Canada have remained between 10 and 15 percent since 1962. In absolute terms, accounts receivable have risen from $7 billion from the 1960s to over $405 billion by 2014.

ACCOUNTS RECEIVABLE AS AN INVESTMENT

As is true of other current assets, accounts receivable should be thought of as an investment. The level of accounts receivable should not be adjudged too high or too low based on historical standards of industry norms, but rather, the test should be whether the level of return we are able to earn from this asset equals or exceeds the potential gain from other commitments. For example, if we allow our customers 10 extra days to clear their accounts, our accounts receivable balance increasesdraining funds from marketable securities and perhaps drawing down the inventory level. We must ask whether we are optimizing our return in light of appropriate risk and liquidity considerations.

Suppose a company's annual sales are $10.95 million and the company sells on terms of net 30, meaning customers are expected to pay their bills 30 days after purchase. Therefore,

d

If annual credit sales remain at $10.95 million and customers pay in 30 days, on average, the daily accounts receivable balance is $900,000. This is the company's investment as a result of its credit policy.

Notice that if the customers pay 10 days later,

This is an increased investment of $300,000, on average, every day of the year. That investment could have been in marketable securities as an alternative. If those securities offered a return of 6 percent, the annual opportunity cost of allowing customers to pay 10 days later would be $18,000 ($300,000 6%).

An example of a buildup in accounts receivable is presented inFigure 7-4, with supportive financing provided through reducing lower/higher-yielding assets and/or increasing lower-cost liabilities. If accounts receivable are increased for an expected return, they must be supported by bank loans or perhaps a less-significant position in marketable securities. Both have a cost to the firm offset by the return on receivables.

d

Figure 7-4

Financing growth in accounts receivable

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CREDIT POLICY ADMINISTRATION

In the extension of credit, three primary policy variables to consider in conjunction with our profit objective are

1. Credit standards
2. Terms of credit
3. Collection policy

Credit StandardsA firm must decide on the degree of credit risk it is prepared to accept. We have seen that large sums of "potential" cash can be invested in accounts receivable. Any receivable that becomes uncollectible affects the firm's success. Accounts receivable are self-liquidating assets. This depends on the ability of a firm's customers to sell their product so the firm granting credit can be paid. The degree of acceptable credit risk is influenced by several factors. These factors include whether the firm is attempting to establish a market, whether the firm is responding to competitive pressures, and the degree of utilization of plant capacity. Auto companies regularly offer credit direct to the ultimate customer to deal with oversupply of cars and to more fully utilize plant capacity.

To establish the degree of credit risk of a potential customer, a firm should develop a credit profile. This profile establishes the customer's strengths and weaknesses. Most importantly, it questions if customers are able to pay and if they can buy enough. Companies that analyze credit risk tend to develop a system in some way related to thefour Cs of credit.

Character:An analyst attempts to determine the customer's willingness to pay. If things get rough, does the customer go into hiding or attempt to work things out? Clues as to the strength of corporate character come from information on fraudulent activities, legal disputes, union problems, dealings with other suppliers, and even the willingness to supply credit information.

Capacity:The ability to pay is perhaps the most important C. Capacity is built on marketing abilities, experience in the business, the management team, and overall, the ability to generate profits. To judge a customer's ability to generate profits is a difficult process. Financial ratio analysis can be of considerable assistance, however, as is an investigation of the customer's abilities based on past experience.

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Capital:This is a look at assets and net worth. Strong net worth is evidence of past success and a commitment by shareholders to the firm. Growing assets demonstrate an ongoing successful business. In difficult economic times, when its ability to generate profits is diminished, a strong net worth helps a company survive.

Conditions:This is the state of the economy and the industry in general. One's experience and knowledge best help an analyst in getting a fix on conditions. One tries to foresee how existing conditions affect the potential credit customer. How the customer adapts to changing conditions in the marketplace is also a consideration.

The preceding is a very sketchy outline of the four Cs of credit. An analyst examines information and attempts to determine the potential customer's degree of credit risk. Regardless of the amount of information and analysis, judgments must be made because credit analysis is not an exact science. Firms must strike a balance in their credit policy to ensure that the firm is not exposed to undue risk; however, a credit policy which is too stringent could restrict the firm's capacity to grow and compete. Once the degree of credit risk is established, it must be measured against company policy to determine whether granting credit is acceptable.

The assessment of credit risk and the setting of reasonable credit standards that allow marketing and finance to set objectives together are based on the ability to get information and analyze it. An extensive network of credit information has been developed by credit agencies throughout the country. The most prominent source isD&B Canada(formerly Dun and Bradstreet), which provides computer access to information contained in its database of more than 1.3 million Canadian businesses. Information is given on a firm's line of business, financial situation, payment history, and creditworthiness.

D&B Canada

dnb.ca

D&B has created a statistical model to analyze the risk of a bad debt. Some of the more important variables they put into their model are the age of the company in years, negative public records, total number of employees, facility owned, financial statement data, payment index, percent of satisfactory payment experiences, and the percent of slow or negative payment experiences. The model is able to predict payment problems and bankruptcy with a high probability 12 months before they occur.

Given that the world is doing more and more business on a global scale, the fact that you can track companies around the world on a database that lists 140 million companies is helpful. The companies on the database can be accessed through a D-U-N-S number, which is accepted by the United Nations as a global business identification standard. TheData Universal Number System (D-U-N-S)is a unique nine-digit code assigned by D&B Canada to each business in its information base. It can be used to track a whole family of companies that are related through ownership. Subsidiaries, divisions, and branches can be tracked to their ultimate parent company at the top of the family pyramid. For example, this tracking ability helps to determine who would ultimately be responsible for a bad debt that occurred in a subsidiary.

Certain industries have also developed their own special credit reporting agencies. Even more important are the local credit bureaus that keep close tabs on day-to-day transactions in a given community.

In addition, information can be gathered from

• Sales reports and visits to the potential customer's place of business
• Customer's financial statements
• Financial institutions
• Other suppliers and industry contacts
• Other credit reporting agencies such as Equifax

Terms of TradeTerms of traderefers to the length of time credit is granted and whether a discount is allowed for early payment. The credit period is often set in response to what the competition is doing. Furthermore, significant customers with financial clout may require and receive credit terms that meet their needs.

Equifax

equifax.com

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A company may set a different credit period to increase sales or perhaps to make up for product deficiencies. Discounts are usually offered to encourage early payment to address cash flow concerns, rather than to stimulate sales. We have already seen how the length of the credit period allowed (not necessarily the stated term) can have a dramatic impact on the level of investment in accounts receivable. Offering thecredit terms"2/10, net 30" enables the customer to deduct 2 percent from the face amount of the bill when paying within the first 10 days, but if the discount is not taken, the customer must remit the full amount within 30 days. As later demonstrated inChapter 8, the annualized cost of not taking a cash discount may be substantial. It is important to recognize that in 2012 only 44.7% of companies in Canada made payments within the agreed payment terms. Keeping this statistic in mind companies must plan their terms of trade adequately to ensure necessary liquidity.⁴

Collection PolicyA third area for consideration under credit policy administration is the collection function. A company must establish collection procedures that get after delinquent accounts in a timely and regular manner. The procedures should be applied consistently with the goal not only of collecting the debt, but also of maintaining the customer. A number of quantitative measures may be applied to the credit department of the firm.

1. Average collection period(Seeformula 3-4binChapter 3.) As was discussed inChapter 6, the average collection period is part of the cash conversion period. An increasing collection period will have implications for financial planning, as it will take longer to turn the accounts receivable investment into cash. When applying this formula, a company must be careful if sales vary throughout the year, as it can give distorted signals. A trend toward a longer collection period could be the result of a predetermined plan to extend credit terms or the consequence of poor credit administration. Management should monitor this measure closely as compared to the collection department's credit terms and industry averages. If the collection period extends beyond these standards, management should seek corrective action, as it is likely that increasing amounts of capital are being tied up unproductively in accounts receivable.
2. Ratio of bad debts to credit sales. An increasing ratio may indicate too many weak accounts or an aggressive market expansion policy. On the other hand, too low a ratio may indicate an overly restrictive credit policy that is limiting sales. The standard for this ratio should be past experience and industry averages.
3. Aging of accounts receivables. We may wish to determine the amounts of time the various accounts have been on our books. The likelihood of accounts becoming uncollectible increases dramatically the further the account extends beyond its credit terms. Furthermore, older receivables represent less profitable investments. If there is a buildup in receivables beyond our normal credit terms, we may wish to take remedial action. Such a buildup is shown in the following table.
4. d

If our normal credit terms are 30 days, we may be doing a poor job of collecting our accounts, with particular attention required on the over-90-day accounts. It is important to examine the nature of the accounts receivable because their characteristics can change quickly due to their rapid turnover.

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AN ACTUAL CREDIT DECISION

We bring together the various elements of accounts receivable management in a decision about a potential change or implementation of a credit policy. This is done to, hopefully, improve company performance by comparing the firm's financial situation under the present credit policy with what it would be under the proposed credit policy. Only those financial variables that change are relevant for analysis. Our analysis and decision are good if we improve the wealth of the shareholders. Generally, credit policy changes affect the level of sales by changing credit standards or by changing the length of the credit period. Often, changes are a response to competitive pressures.

For example, let us assume a firm is considering a credit decision to sell to a group of customers that will result in sales increasing from $100,000 to $110,000, an increase of $10,000 in new annual sales. The cost of producing the product is 67 percent of sales, and selling expenses are expected to be 10 percent of sales. Additionally, collection costs are projected at 5 percent of sales, and because the new customers are risky, we forecast 10 percent of the new sales to be uncollectible. Although this is a very high rate of nonpayment, the critical question is, what is the potential contribution of these incremental sales to profitability? These incremental revenues and expenses are fairly easy to identify with the traditional income statement approach.

d

However, other costs may be more elusive, in particular the opportunity costs that will arise if the firm commits to the new credit policy. A major consideration is the increased investment in accounts receivable and the opportunity cost on the firm's funds tied up in this asset. This cost is often taken from the rate on short-term demand loans, which are sometimes used to finance accounts receivable. If bank financing is used for the incremental investment, this cost would be described fully by an income statement approach. However, the cost of an increased investment in accounts receivable is not always easily identified by such a direct cost. Sometimes, the increased investment is provided by an increased equity contribution, and expected return to the shareholders does not show up on the income statement. The use of an opportunity cost in the analysis captures the broader possibilities for financing the accounts receivable position.

Additionally, our analysis might consider possible investments in inventories or plant or equipment that may result from increased sales. We do not, however, consider them in this example.

In our example, our firm expects its receivables to turn over six times a year, and we assume that the opportunity cost is 15 percent. The analysis, set out below, proceeds on the basis of the incremental revenues and costs that we have identified from selling to the new group of customers, and includes the opportunity cost on the increased investment in accounts receivable. Incremental analysis isolates and identifies only the relevant changes that result from a shift in credit policy.

Accounts receivable only arise on credit sales, and it is the average credit period (when customers actually pay) not the stated credit terms that determine the size of the receivables.

d

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Our decision would be to proceed with the new credit policy. Not only have the increased profits and costs been considered in the analysis, but most important from an investor or shareholder perspective, consideration also has been given to the opportunity cost of having funds tied up or invested in accounts receivable. This opportunity cost of funds in our example is a before-tax cost.

This analysis is basically for one time period and assumes that the incremental changes are perpetual. It may neglect considerations such as the time value of money, changes to product life, earlier capital expenditure requirements as increasing sales wear out machinery sooner, and tax changes due to the previously noted considerations.

ANOTHER EXAMPLE OF A CREDIT DECISION

Assume that the firm currently has annual sales of $121,667 and collection occurs in 30 days. It is expected that sales will increase to $146,000 if 45 days of credit are extended to customers. Additionally, administration costs are projected to increase by $1,000. Another cost is the expected increase in bad debt expense from 1 to 1.5 percent of sales. The firm has an opportunity cost of capital of 12 percent and its variable costs are 80 percent of sales.

d

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Decision:Implement new credit terms.

On an incremental basis, with consideration given to the investment in accounts receivable, there is positive value added to the firm from changing the credit policy.