This is the chapter core slideshow. ... Providing and

1
CHAPTER 21Providing and Obtaining Credit

• Receivables 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)

2
What five variables make up a firms credit
policy?

• Cash discounts
• Credit period
• Credit standards
• Collection policy
• Size of credit line

Covered also in Chapter 20 of your text.
3
Elements of Credit Policy

• 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.

(More)
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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

5

• 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

6
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

7
Sources of Credit Information

• The Sellers Prior Experience
• Credit Associations
• Credit Interchange
• Credit Rating Agencies
• Dun Bradstreet
• Equifax
• Trans Union
• Experian
• Consumer Information
• Fair Isaac (FICO) Score
• Analysis of Customers Financial Statements
• Customer Visit

8
Monitoring the Receivables Position

• Should signal a deviation from expectations when
  one has occurred
• Should be easy to implement and understand
• Should not signal a deviation when none has
  occurred
• Think of the warning lights on the automobile
  as a possible comparison.

9
Techniques of Monitoring Receivables

• Average Collection Period (ACP) or Days Sales
  Outstanding (DSO)
• Aging Schedule
• Payments Pattern Approach
• Uncollected Balances Schedule
• Receivables-to-Sales Ratio

10
Receivables Monitoring
Assume the following sales estimates
January 100 April 300 February
200 May 200 March 300 June 100
Terms of sale Net 30.
These data are from the Mini Case.
11
Expected Collections

• 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 _at_ 100/unit.
• 365-day year.

12
What is the firms expected DSO and average daily
sales (ADS)?

• DSO 0.30(10) 0.50(40) 0.20(70)
• 37 days.
• How does this compare with the firms credit
  period?

18,000(100) 365
ADS 4,931.51 per day.
13
What is the expected average accounts receivable
level? How much of this amount must be financed
if the profit margin is 25?
A/R (DSO)(ADS) 37(4,931.51) 182,466.
Need to Finance 0.75(182,466) 136,849.
14
If notes payable are used to finance the A/R
investment, what does the firms balance sheet
look like?

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

From the Mini Case.
15
If bank loans cost 12 percent, what is the annual
dollar cost of carrying the receivables?
Cost of carrying receivables

• 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.

16
What are some factors which influence a firms
receivables level?

• Receivables are a function of average daily sales
  (ADS) and days sales outstanding (DSO).
• State of the economy, competition within the
  industry, and the firms credit policy all
  influence a firms receivables level.

17
What are some factors which influence the dollar
cost of carrying receivables?

• 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.

18
What would the receivables level be at the end of
each month?
A/R 0.7(Sales in that month) 0.2(Sales in
previous month).
Month Sales A/R Jan 100 70 Feb 200
160 Mar 300 250 April 300 270 May 200
200 June 100 110
19
What is the firms forecasted average daily sales
(ADS) for the first 3 months? For the entire
half-year? (assuming 91-day quarters)
Many firms calculate the average daily sales
using the annual credit sales and divide that
number by 365 days.
20
What DSO is expected at the end of March? At the
end of June?
1st Qtr 250/6.59 37.9 days. 2nd
Qtr 110/6.59 16.7 days.
You can also calculate the DSO monthly using
yearly Average Daily Sales data.
21
What does the DSO indicate about customers
payments?

• It appears that customers are paying
  significantly faster in the second quarter than
  in the first.
• However, the receivables balances were created
  assuming a constant payment pattern, so the DSO
  is giving a false measure of payment performance.
• Underlying cause seasonal variation. With
  increasing sales, the DSO looks bad. With
  decreasing sales, the DSO appears good.Yet,
  nothing has happened!
• The underlying cause is seasonal variation.

22
Construct an aging schedule for the end 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 36 61-90
0 0 0 0 250
100 110 100
Do aging schedules tell the truth?
23
Construct the uncollected balances schedules for
the end of March and June.

• Contrib. A/R
• Mos. Sales to A/R to Sales
• Jan 100 0 0
• Feb 200 40 20
• Mar 300 210 70
• End of Qtr. A/R 250 90

24
Contrib. A/R Mos. Sales to A/R to
Sales Apr 300 0 0 May 200
40 20 June 100 70 70 End of
Qtr. A/R 110 90
25
Do the uncollected balances schedules properly
measure customers payment patterns?

• 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.)
  

(More...)
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• The uncollected balances schedule gives a true
  picture of customers payment patterns, even when
  sales fluctuate.
• Any increase in the A/R-to-sales ratio from one
  month in one quarter to the corresponding month
  in the next quarter indicates a slowdown in
  payment.
• The bottom line gives a summary of the changes
  in payment patterns.

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• This technique is not sales-level dependent and
  is not affected by fluctuations in sales. It can
  be used to monitor collection performance.
• The Payments Pattern Approach and uncollected
  balances schedule disaggregates the data. The DSO
  and Aging Schedule aggregates the sales data and
  can give a wrong indication. However, both the
  DSO and Aging Schedule methods are widely used.

28

• Assume it is now July and you are developing pro
  forma financial statements for the following
  year. (You can use the Uncollected Balance
  Schedule method to forecast or project your
  Accounts Receivables and cash flows.)
• Furthermore, sales and collections in the first
  half-year matched predicted levels. Using Year 2
  sales forecasts, what are next years pro forma
  receivables levels for the end of March and June?

29
March 31
Predicted Predicted Predicted
A/R-to- Contribution Mos. Sales Sales
Ratio to A/R Jan 150 0 0 Feb
300 20 60 Mar 500 70
350 Projected March 31 A/R balance 410 As
stated in the previous slide, this method can be
used for planning purposes.
30
June 30
Predicted Predicted Predicted A/R to
Contrib. Mos. Sales Sales Ratio
to A/R Apr 400 0 0 May
300 20 60 June 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.

32
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.

33
What is the DSO under the current and the new
credit policies?

• CurrentDSO0 0.8(30) 0.2(40) 32 days
• NewDSON 0.6(10) 0.3(20) 0.1(30) 15
  days

34
What are bad debt losses under the current and
the new credit policies?

• CurrentBDL0 0.02(1,000,000) 20,000.
• NewBDLN 0.01(1,100,000) 11,000.

35
What are the expected dollar costs of discounts
under the current and the new policies?

• Discount0 0.
• DiscountN 0.6(0.02)(0.99)(1,100,000)
  13,068.

36
What are the dollar costs of carrying receivables
under the current and the new policies?

• 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.

37
What is the incremental after-tax profit
associated with the change in credit terms?
New Old
Diff. Gross sales 1,100,000 1,0
00,000 100,000 Less Disc. 13,068
0 13,068 Net sales 1,086,932 1,000
,000 86,932 Prod. costs 825,000
750,000 75,000 Profit before credit costs
and taxes 261,932 250,000 11,932
(More...)
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New Old
Diff. Profit before credit
costs and taxes 261,932 250,000 11,932 Credi
t-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
24,754 Taxes (40) 98,745 88,844
9,902 Net income 148,118 133,266 14,852
Should the company make the change?
39
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 firms after-tax
profitability?
40

• A credit policy change may prompt the companys
  competitors to change their own credit terms,
  which might offset the expected increase in
  sales.
• Conclusion Not a clear-cut decision not an
  obviously good or bad move. Many times, decisions
  are not clear-cut, and then you have to made a
  judgmental decision.

41

• Gross sales 1,000,000
• Less discounts 11,880
• Net sales 988,120
• Production costs 750,000
• Profit before credit
• costs and taxes 238,120
• Credit costs
• Carrying costs 3,699
• Bad debt losses 10,000
• Profit before taxes 224,421
• Taxes 89,769
• Net Income 134,653

42

• Before the new policy change, the firms 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 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.

44
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.

46
Simple Annual Interest, 1-year Loan
Simple interest means not a discount or add-on
loan. Interest 0.08(100,000) 8,000.
8 000
,
r
EAR
?
?
?
.
0.08
?
8.0
Nom
100,000
On a simple interest loan of one year, rNom EAR.
47
Simple Interest, Paid Monthly
Monthly interest (0.08/12)(100,000)
666.67.
0
1
12
...
-666.67
100,000
-666.67
-100,000.00
12
100000
-666.67
-100000
N
I/YR
PV
PMT
FV
0.66667
(More)
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rNom (Monthly rate)(12) 0.66667(12) 8.00.
12
0
08
.
?
?
8.30.
EAR
?
?
?
?
?
1
1

?
?
12
Or With an HP calculator only
8 NOM, 12 P/YR, EFF 8.30.
Note If interest were paid quarterly, then

4
0
08
.
?
?
EAR
?
?
?
?
?
1
1
8.
24.
?
?
4
Daily, EAR 8.33.
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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.
0
1
i ?
92,000
-100,000
1
92
0
-100
8.6957 EAR
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Discount Interest (Continued)
Amount borrowed
Amount needed 1 - Nominal rate
(decimal)
108,696.
100,000 0.92
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.
Face amount of loan
Amount needed 1 - Nominal rate - CB
121,951.
100,000 1 - 0.08 - 0.1
(More...)
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Interest 0.08 (121,951) 9,756.
9
,
756
EAR
?
?
9.
756.
100,000
EAR correct only if amount is borrowed for 1 year.
(More...)
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8 Discount Interest With 10 Compensating
Balance (Continued)
0
1
i ?
121,951 Loan
-121,951 12,195 -109,756
-9,756 Prepaid Interest
-12,195 Compensating Balance
100,000 Usable Funds
1
100000
-109756
0
N
I/YR
PV
PMT
FV
9.756 EAR
This procedure can handle variations.
54
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 loan outstanding
(More...)
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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
Months
0
1
12
2
...
i ?
-9,000
100,000
-9,000
-9,000
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12
100000
-9000
0
1.2043 rate per month
rNom APR (1.2043)(12) 14.45. EAR
(1.012043)12 - 1 15.45.
14.45 NOM enters nominal rate 12
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.

58
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

59
Current Money Market RatesJune 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