Finance 402 1

CHAPTER 21Providing and Obtaining

CreditReceivables Management

Credit Policy Days Sales Outstanding (DSO) Aging Schedules Payments Pattern Approach

Cost of bank loans Interest costs

Annual Percentage Rate (APR) Effective Annual Rate (EAR)

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Cash discountsCash discounts Credit periodCredit period Credit standardsCredit standards Collection policyCollection policy Size of credit lineSize of credit line

What five variables make up a firm’s credit policy?

Covered also in Chapter 20 of your text.Covered also in Chapter 20 of your text.

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Cash Discounts: Lowers price. Attracts new customers and reduces DSO.

Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.

Elements of Credit Policy

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Credit Terms Discounts

For example, 2/10... Credit Period

For example, n/30; or n/30 EOM Seasonal Dating, for example n/30, June 1st

Promotes Sales Reduces Inventory Smoothes Production Transfers Risk of Obsolescence Might offer Anticipation Discount

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Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO.

Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

Credit Line: Size of the credit line can be increased with positive experience

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Credit Standards Might use Dun & Bradstreet ratings:

1 = excellent 2 = good 3 = fair 4 = limited

Credit Scoring Systems Multiple Discriminant Analysis (MDA)

Judgmental Scoring Systems

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Sources of Credit Information

The Seller’s Prior Experience Credit Associations

Credit Interchange Credit Rating Agencies

Dun & Bradstreet Equifax Trans Union Experian

Consumer Information Fair Isaac (FICO) Score

Analysis of Customer’s Financial Statements Customer Visit

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Monitoring the Receivables Position

Should signal a deviation from Should signal a deviation from expectations when one has occurredexpectations when one has occurred

Should be easy to implement and Should be easy to implement and understandunderstand

Should not signal a deviation when Should not signal a deviation when none has occurrednone has occurred

Think of the “warning lights” on the Think of the “warning lights” on the automobile as a possible comparison.automobile as a possible comparison.

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Techniques of Monitoring Receivables

Average Collection Period (ACP) or Average Collection Period (ACP) or Days Sales Outstanding (DSO)Days Sales Outstanding (DSO)

Aging Schedule Aging Schedule Payments Pattern ApproachPayments Pattern Approach

Uncollected Balances Schedule Receivables-to-Sales Ratio

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January $100 April $300

February 200 May 200

March 300 June 100

Terms of sale: Terms of sale: Net 30Net 30..

Receivables Monitoring

Assume the following sales estimates:Assume the following sales estimates:

These data are from the Mini Case.These data are from the Mini Case.

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30% pay on Day 10 (month of sale).

50% pay on Day 40 (month after sale).

20% pay on Day 70 (2 months after sale).

Annual sales = 18,000 units @ $100/unit.

365-day year.

Expected Collections

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DSO = 0.30(10) + 0.50(40) + 0.20(70)

= 37 days.How does this compare with the firm’s credit period?

What is the firm’s expected DSO and average daily sales (ADS)?

ADS=

= $4,931.51 per day.

18,000($100)365

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What is the expected average accounts receivable level? How much

of this amount must be financed ifthe profit margin is 25%?

A/R = (DSO)(ADS) = 37($4,931.51)= $182,466.

Need to Finance: 0.75($182,466) = $136,849.

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A/R $182,466 Notes payable $136,849Retained earnings 45,617

$182,466

If notes payable are used to finance the A/R investment, what does the

firm’s balance sheet look like?

From the Mini CaseFrom the Mini Case.

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= 0.12($136,849)

= $16,422.

In addition, there is an opportunity cost of not having the use of the profit component of the receivables. One must examine the Economic Value Added (EVA) by the sale.

If bank loans cost 12 percent,what is the annual dollar cost of

carrying the receivables?

Cost of carrying receivables

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Receivables are a function of average daily sales (ADS) and days sales outstanding (DSO).

State of the economy, competition within the industry, and the firm’s credit policy all influence a firm’s receivables level.

What are some factors whichinfluence a firm’s receivables level?

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The lower the profit margin, the higher the cost of carrying receivables, because a greater portion of each sales dollar must be financed.

The higher the cost of financing, the higher the dollar cost of carrying the receivables.

What are some factors which influence the dollar cost of

carrying receivables?

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What would the receivables level be at the end of each month?

Month Sales A/R Jan $100 $ 70Feb 200 160Mar 300 250April 300 270May 200 200June 100 110

A/R = 0.7(Sales in that month) + 0.2(Sales in previous month).

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What is the firm’s forecasted average daily sales (ADS) for the first 3

months? For the entire half-year? (assuming 91-day quarters)

Avg. Daily Sales = .

1st Qtr: $600/91 = $6.59.2nd Qtr: $600/91 = $6.59.

Total sales # of days

Many firms calculate the average daily sales using the annual credit sales and divide that number by 365 days.

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1st Qtr: $250/$6.59 = 37.9 days.2nd Qtr: $110/$6.59 = 16.7 days.

What DSO is expected at the end of March? At the end of June?

DSO = . A/R ADS

You can also calculate the DSO monthly using yearly Average Daily Sales data.

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It appears that customers are paying significantly It appears that customers are paying significantly faster in the second quarter than in the first. faster in the second quarter than in the first.

However, the receivables balances were created However, the receivables balances were created assuming a constant payment pattern, so the DSO is assuming a constant payment pattern, so the DSO is giving a giving a falsefalse measure of payment performance. measure of payment performance.

Underlying cause = seasonal variation. With Underlying cause = seasonal variation. With increasing sales, the DSO looks increasing sales, the DSO looks “bad.”“bad.” With With decreasing sales, the DSO appears “decreasing sales, the DSO appears “goodgood.”Yet, .”Yet, nothingnothing has happened!has happened!

The underlying cause is seasonal variation.The underlying cause is seasonal variation.

What does the DSO indicateabout customers’ payments?

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Construct an aging schedule for theend of March and the end of June.

Age of Account March June(Days) A/R % A/R % 0 - 30 $210 84% $ 70 64%31-60 40 16 40 3661-90 0 0 0 0

$250 100% $110 100%

Do aging schedules tell the truth?

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Contrib. A/R Mos. Sales to A/R to Sales

Jan $100 $ 0 0%Feb 200 40 20Mar 300 210 70End of Qtr. A/R $250 90%

Construct the uncollected balances schedules for the end of March and

June.

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Contrib. A/R Mos. Sales to A/R to Sales

Apr $300 $ 0 0%May 200 40 20June 100 70 70End of Qtr. A/R $110 90%

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The focal point of the uncollected balances schedule is the receivables-to-sales ratio.

There is no difference in this ratio between March and June, which tells us that there has been no change in payment pattern. (You can analyze the data on a month-to-month basis also.)

Do the uncollected balances schedules properly measure

customers’ payment patterns?

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The uncollected balances schedule gives The uncollected balances schedule gives a a truetrue picture of customers’ payment picture of customers’ payment patterns, even when sales fluctuate.patterns, even when sales fluctuate.

Any increase in the A/R-to-sales ratio Any increase in the A/R-to-sales ratio from one month in one quarter to the from one month in one quarter to the corresponding month in the next quarter corresponding month in the next quarter indicates a slowdown in payment.indicates a slowdown in payment.

The “bottom line” gives a summary of The “bottom line” gives a summary of the changes in payment patterns.the changes in payment patterns.

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This technique is not sales-level This technique is not sales-level dependent and is not affected by dependent and is not affected by fluctuations in sales. It can be used to fluctuations in sales. It can be used to monitor collection performance.monitor collection performance.

The Payments Pattern Approach and The Payments Pattern Approach and uncollected balances schedule uncollected balances schedule disaggregates the data. The DSO and disaggregates the data. The DSO and Aging Schedule aggregates the sales Aging Schedule aggregates the sales data and can give a data and can give a wrongwrong indication. indication. However, both the DSO and Aging However, both the DSO and Aging Schedule methods are widely used.Schedule methods are widely used.

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Assume it is now July and you are Assume it is now July and you are developing pro forma financial developing pro forma financial statements for the following year. (You statements for the following year. (You can use the Uncollected Balance can use the Uncollected Balance Schedule method to forecast or project Schedule method to forecast or project your Accounts Receivables and cash your Accounts Receivables and cash flows.) flows.)

Furthermore, sales and collections in the Furthermore, sales and collections in the first half-year matched predicted levels. first half-year matched predicted levels. Using Year 2 sales forecasts, what are Using Year 2 sales forecasts, what are next year’s pro forma receivables levelsnext year’s pro forma receivables levels for the end of March and June?for the end of March and June?

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March 31:

Predicted PredictedPredicted A/R-to- Contribution

Mos. Sales Sales Ratio to A/RJan $ 150 0% $ 0Feb 300 20 60Mar 500 70 350

Projected March 31 A/R balance $410

As stated in the previous slide, this methodcan be used for planning purposes.

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June 30

Predicted PredictedPredicted A/R to Contrib.

Mos. Sales Sales Ratio to A/R

Apr $400 0% $ 0May 300 20 60June 200 70 140

Projected June 30 A/R balance $200

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Disregard any previous assumptions.

Current credit policy: Credit terms = Net 30. Gross sales = $1,000,000. 80% (of paying customers) pay on Day

30. 20% pay on Day 40. Bad debt losses = 2% of gross sales.

Operating cost ratio = 75%. Cost of carrying receivables = 12%.

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The firm is considering a change in credit policy.

New credit policy: Credit terms = 2/10, net 20. Gross sales = $1,100,000. 60% (of paying customers) pay on Day

10. 30% pay on Day 20. 10% pay on Day 30. Bad debt losses = 1% of gross sales.

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Current:DSO0 = 0.8(30) + 0.2(40)

= 32 days New:

DSON = 0.6(10) + 0.3(20) + 0.1(30)

= 15 days

What is the DSO under the currentand the new credit policies?

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Current:BDL0 = 0.02($1,000,000)

= $20,000. New:

BDLN = 0.01($1,100,000)= $11,000.

What are bad debt losses under the current and the new credit policies?

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DiscountDiscount0 0 = = $0$0..

DiscountDiscountN N = 0.6(0.02)(0.99)($1,100,000)= 0.6(0.02)(0.99)($1,100,000) = = $13,068$13,068..

What are the expected dollar costs of discounts under the current and the

new policies?

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Costs of carrying receivablesO =($1,000,000/365)(32)(0.75)(0.12)=$7,890.

Costs of carrying receivablesN

=($1,100,000/365)(15)(0.75)(0.12)=$4,068.

What are the dollar costs of carrying receivables under the current and the

new policies?

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What is the incremental after-tax profit associated with the change in credit

terms?

New Old Diff.

Gross sales $1,100,000 $1,000,000 $100,000Less: Disc. 13,068 0 13,068 Net sales $1,086,932 $1,000,000 $ 86,932Prod. costs 825,000 750,000 75,000Profit before credit costs and taxes $ 261,932 $ 250,000 $ 11,932

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New Old Diff. Profit before credit costs and taxes $261,932 $250,000 $11,932Credit-related costs:Carrying costs 4,068 7,890 (3,822)Bad debts 11,000 20,000 (9,000)Profit before taxes $246,864 $222,110 $24,754Taxes (40%) 98,745 88,844 9,902 Net income $148,118 $133,266 $14,852

Should the company make the change?

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Assume the firm makes the policy change, but its competitors react by making similar changes. As a result,

gross sales remain at $1,000,000. How does this impact the firm’s after-tax

profitability?

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A credit policy change may prompt A credit policy change may prompt the company’s competitors to the company’s competitors to change their own credit terms, change their own credit terms, which might offset the expected which might offset the expected increase in sales.increase in sales.

Conclusion: Not a clear-cut Conclusion: Not a clear-cut decision; not an obviously good or decision; not an obviously good or bad move. Many times, decisions bad move. Many times, decisions are not clear-cut, and then you have are not clear-cut, and then you have to made a judgmental decision.to made a judgmental decision.

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Gross sales $1,000,000Less: discounts 11,880

Net sales $ 988,120Production costs 750,000Profit before credit

costs and taxes $ 238,120Credit costs:

Carrying costs 3,699Bad debt losses 10,000

Profit before taxes $ 224,421Taxes 89,769

Net Income $ 134,653

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Before the new policy change, the firm’s net income totaled $133,266.

The change would result in a slight gain of $134,653 - $133,266 = $1,387.

A firm can lose income if other firms reactA firm can lose income if other firms react..

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Analyzing Proposed Changes in Credit Policy: Incremental

Analysis In an incremental analysis, we determine

the increase or decrease in both sales and costs associated with a given easing or tightening of credit policy

The difference between incremental sales and incremental costs is defined as incremental profit.

Use formulas from pages 754 and 755 of your text. Please do not memorize them.

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A Bank Is Willing to Lend TIGER PAWS $100,000 for 1

Year at an 8 Percent Nominal Rate. What Is the EAR Under

the Following Five Loans?1. Simple annual interest, 1 year.2. Simple interest, paid monthly.3. Discount interest.4. Discount interest with 10 percent

compensating balance.5. Installment loan, add-on, 12 months.

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Why Must We Use Effective Annual Rates (EARs) to

Evaluate the Loans? In our examples, the nominal

(quoted) rate is 8% in all cases. We want to compare loan cost

rates and choose the alternative with the lowest cost.

Because the loans have different terms, we must make the comparison on the basis of EARs.

46Finance 402

Simple Annual Interest, 1-year Loan

“Simple interest” means not a discount or add-on loan.

Interest = 0.08($100,000) = $8,000.

On a simple interest loan of one year,rNom = EAR.

r EARNom ,

$100,000.

8 0000.08 8.0%

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Simple Interest, Paid Monthly

Monthly interest = (0.08/12)($100,000) = $666.67.

-100,000.00-666.67100,000

0 1 12

-666.67

N I/YR PV PMT FV12 100000 -666.67 -100000

0.66667

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48Finance 402

rNom = (Monthly rate)(12)= 0.66667%(12) = 8.00%.

8 NOM%, 12 P/YR, EFF% = 8.30%.

Note: If interest were paid quarterly, then:

Daily, EAR = 8.33%.

EAR

1

0 084

1 8.24%.4.

EAR

1

0 0812

1 8.30%.12.

=

Or: With an HP calculator only

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8% Discount Interest, 1 Year

Interest deductible = 0.08($100,000) = $8,000.Usable funds = $100,000 - $8,000 = $92,000.

N I/YR PV PMT FV

1 92 0 -100

8.6957% = EAR

0 1i = ?

92,000 -100,000

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Discount Interest (Continued)

Amountborrowed =

= = $108,696.

Amount needed 1 - Nominal rate (decimal)

$100,0000.92

Thus, to obtain the use of $100,000, you have to borrow $108,696.

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Need $100,000. Offered Loan With Terms of 8% Discount Interest, 10% Compensating Balance.

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=

= = $121,951.

Amount needed 1 - Nominal rate - CB

$100,000 1 - 0.08 - 0.1

Face amount of loan

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Interest = 0.08 ($121,951) = $9,756.

.received Amount

paid InterestCost

EAR correct only if amount is borrowedfor 1 year.

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EAR $9,

$100,000

7569.756%.

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This procedure can handle variations.

N I/YR PV PMT FV1 100000 -109756

9.756% = EAR

0

0 1i = ?

121,951 Loan -121,951+ 12,195-109,756

-9,756 Prepaid Interest-12,195 Compensating Balance100,000 Usable Funds

8% Discount Interest With 10% Compensating Balance (Continued)

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1-year Installment Loan, 8% “Add-on”

Interest = 0.08($100,000) = $8,000.

Face amount = $100,000 + $8,000 = $108,000.

Monthly payment = $108,000/12 = $9,000.

= $100,000/2 = $50,000.

( I strongly prefer that you do not use the approximate cost formula in your text.)

Average loanoutstanding

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Installment Loan

To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below:

-9,000100,000

0 1 12i = ?

-9,000 -9,000

Months2

...

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N I/YR PV PMT FV

12 100000 -9000

1.2043% = rate per month

0

rNom = APR = (1.2043%)(12) = 14.45%.EAR = (1.012043)12 - 1 = 15.45%.

14.45 NOM% enters nominal rate12 P/YR enters 12 pmts/yr EFF% = 15.4489 = 15.45%.

1 P/YR to reset HP calculator.

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Interest Rate Calculations - Annual Percentage Rates Vs.

Effective Annual Rates

Simple Interest Discount Interest Installment Loans - Add-on

Interest You should know how each method

works. We will also work examples on the blackboard in class.

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Choosing a Bank(Negotiated Source of Funds)

Willingness to assume risks Advise and counsel Loyalty to customers Maximum loan size Specialization Merchant Banking capabilities Other Services

Technology and telecommunications

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Current Money Market Rates

June 3, 2005 LIBOR – 3.7025% (one year) Prime Rate – 6.00%, effective 5/03/05 Placed Directly Commercial Paper –

3.15% for GE Capital for 60 to 89 days Dealer Commercial Paper – 3.19% for 60

days Federal Funds Rate – 3.00% Effective

Rate Treasury Bills – 3.080% for 26 weeks

Source: Wall Street Journal, page C13.

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Conclusion

Receivables Management Days Sales Outstanding Aging Schedule Payments Pattern

Approach Interest Costs

Annual Percentage Rate

Effective Annual Rate