20.1-20.2 Credit Policy and Terms of Sale
When a firm grants credit, it creates an account receivable, which is an investment in its customers. The decision involves a trade-off between the benefit of increased sales and the costs of granting credit (potential defaults and the cost of carrying receivables).
Components of Credit Policy
- Terms of Sale: Establishes how the firm sells its goods. Key elements include the credit period, cash discount, and type of credit instrument. An example is "2/10, net 30," which means a 2% discount if paid in 10 days, otherwise the full amount is due in 30 days.
- Credit Analysis: The process of distinguishing between customers who are likely to pay and those who are not.
- Collection Policy: The procedures for collecting cash after credit has been granted.
The Cost of Not Taking a Discount
The implicit interest rate for not taking a cash discount can be extremely high. For terms of 2/10, net 30, the customer is effectively borrowing for an additional 20 days. The interest rate for this period is 2/98 ≈ 2.04%. The Effective Annual Rate (EAR) is $(1.0204)^{365/20} - 1$, which is over 44%!
20.3-20.4 Analyzing and Optimizing Credit Policy
The decision to grant credit should be analyzed like any other investment: it should be done only if the NPV is positive. The analysis involves comparing the incremental cash flows from increased sales against the costs of the switch.
NPV of Switching Credit Policies
The NPV of switching from a cash-only policy to a credit policy can be calculated as:
NPV = -[Initial Investment] + [PV of Future Incremental Cash Flows]
NPV Formula Components:
- Initial Investment: The upfront cost. This includes the revenue from current sales that is now delayed ($P \times Q$) plus the variable cost of producing the new units sold on credit ($v \times (Q' - Q)$).
- PV of Future Incremental Cash Flows: The present value of the additional profit generated. This is the incremental gross profit ($(P-v) \times (Q' - Q)$) treated as a perpetuity.
- $P$: Price per unit.
- $Q$: Current quantity sold per period (cash only).
- $Q'$: New quantity sold per period (with credit).
- $v$: Variable cost per unit.
The optimal credit policy is found at the point that minimizes the total credit cost, which is the sum of carrying costs (bad debts, cost of managing credit) and opportunity costs (lost sales from a restrictive policy).
20.5-20.6 Credit Analysis and Collection
Credit analysis is the process of deciding whether to grant credit to a specific customer. A key insight is that for a new customer, the firm only risks its variable cost (v), whereas for a returning customer, it risks the full sales price (P). The possibility of repeat business makes it worthwhile to extend credit even with a high probability of default on the initial sale.
The Five Cs of Credit
A traditional framework for credit analysis involves evaluating the five Cs:
- Character: Willingness to pay.
- Capacity: Ability to pay from operating cash flow.
- Capital: Financial reserves.
- Collateral: Assets pledged in case of default.
- Conditions: Relevant economic conditions.
Collection Policy
This involves monitoring receivables using tools like the Average Collection Period (ACP) and the aging schedule, which classifies accounts by how long they have been outstanding. Collection efforts typically follow a sequence from delinquency letters to legal action.
20.7-20.8 Inventory Management and Techniques
Inventory management involves a trade-off between carrying costs (storage, insurance, cost of capital) and shortage costs (restocking costs, lost sales). The goal is to minimize the sum of these two costs.
The EOQ Model
The Economic Order Quantity (EOQ) model is a technique for finding the optimal inventory level. It identifies the restocking quantity (Q*) that minimizes total inventory costs.
The minimum cost occurs where carrying costs equal restocking costs. The formula is:
$Q^* = \sqrt{\frac{2T \times F}{CC}}$
EOQ Formula Components:
- $Q^*$: The optimal order quantity (the EOQ).
- $T$: Total unit sales per year.
- $F$: Fixed cost per order (restocking cost).
- $CC$: Carrying cost per unit per year.
Other Inventory Techniques
ABC Approach: Classifies inventory into groups (A, B, C) based on value. High-value 'A' items are monitored closely, while low-value 'C' items are kept in larger quantities.
Just-in-Time (JIT): A system to minimize inventory by having materials arrive exactly when they are needed in the production process. This maximizes inventory turnover but requires a high degree of supplier coordination.
Chapter Review and Critical Thinking Questions
Solution:
a. Sight draft: A commercial draft requiring immediate payment.
b. Time draft: A draft that is payable at a future specified date.
c. Banker's acceptance: A time draft that has been accepted by a bank, meaning the bank guarantees payment. It is actively traded.
d. Promissory note: A basic IOU signed by the customer.
e. Trade acceptance: A time draft that has been accepted by the buyer, who promises to pay it in the future.
Solution: Trade credit is most commonly offered on "open account." The only formal credit instrument is the invoice that accompanies the shipment of goods.
Solution: The costs of carrying receivables include the required return on the funds tied up in receivables, losses from bad debts, and the costs of managing credit and collections. The cost of not granting credit is the opportunity cost of lost sales. The sum of these costs is the total credit cost.
Solution: The five Cs are Character (willingness to pay), Capacity (ability to pay), Capital (financial reserves), Collateral (assets pledged), and Conditions (economic climate). Each provides a different dimension of the customer's creditworthiness, helping the lender assess the overall risk of default.
Solution: Factors include the perishability of the goods, consumer demand, cost and profitability, credit risk of the buyer, account size, and competition. If the credit period exceeds the buyer's operating cycle, the seller is financing more than just the buyer's inventory and receivables; they are effectively providing general financing for the buyer's business, which increases risk.
Solution:
a. Firm A (cure): Shorter period. Higher demand product.
b. Firm A (landlords): Longer period. Landlords are often slower to pay.
c. Firm A (10x turnover): Longer period. Its customers have a longer operating cycle.
d. Firm B (canned fruit): Longer period. Less perishable than fresh fruit.
e. Firm A (carpeting): Longer period. Installation makes it a higher-ticket, less standardized item compared to a rug.
Solution: The main types for a manufacturer are raw materials, work-in-progress, and finished goods. They differ in their liquidity and role in the production process. Raw materials and work-in-progress have dependent demand because the need for them depends on the production schedule for finished goods. The demand for finished goods is independent because it is based on external customer demand.
Solution: A JIT system reduces inventory levels.
Inventory turnover (COGS/Inventory) will increase.
Total asset turnover (Sales/Total Assets) will increase because total assets will decrease.
Return on Equity (ROE) will increase. According to the DuPont identity (ROE = PM * TAT * EM), an increase in Total Asset Turnover (TAT) will increase ROE, all else being equal.
Solution: The firm keeps too little inventory on hand. In the optimal EOQ model, carrying costs should equal restocking (order) costs. Because the firm's order costs (\$8M) are higher than its carrying costs (\$5M), it is ordering too frequently in small quantities. It should increase its order size, which would increase average inventory and carrying costs, but decrease the number of orders and the total order costs, moving toward the optimal point where the two costs are equal.
Solution: In the PC industry, component prices fall very rapidly. A short inventory period is a huge advantage for Dell because it means the components it uses are, on average, cheaper than those used by competitors who hold inventory for longer. This leads to lower costs and higher profit margins. Other manufacturers struggle to replicate this because it requires a complete re-engineering of the supply chain and a high degree of coordination with suppliers, which is difficult and expensive to achieve.