(AR) = (DSO)(ADS) =
Accounts Receivable
the higher the dollar cost of carrying receivables.
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A B C D E F G H I J
12/10/2012
JAN $100
FEB 200
MAR 300
APR 300
MAY 200
JUN 100
AVERAGE DAILY SALES = ADS = 18,000 (100)/365 = 4,931.51$ per day
cost = 12% x 136,849.32 = 16,421.92
(2.) What is its expected average daily sales (ADS)?
(4.) Assume that the firm’s profit margin is 25 percent. How much of the receivables balance must be financed? What
would the firm’s balance sheet figures for accounts receivable, notes payable, and retained earnings be at the end of one
year if notes payable are used to finance the investment in receivables? Assume that the cost of carrying receivables
had been deducted when the 25 percent profit margin was calculated.
(3.) What is its expected average accounts receivable (AR) level?
Since 25% of the sales price is profit, only 75% of the AR must be financed:
c. What are some factors which influence (1) a firm’s receivables level and (2) the dollar cost of carrying receivables?
Also there is the opportunity cost of not having use of the profit component of the receivables.
Chapter 27. Mini Case for Providing and Obtaining Credit
Rich Jackson, a recent finance graduate, is planning to go into the wholesale building supply business with his brother,
Jim, who majored in building construction. The firm would sell primarily to general contractors, and it would start
operating next January. Sales would be slow during the cold months, rise during the spring, and then fall off again in the
summer, when new construction in the area slows. Sales estimates for the first 6 months are as follows (in thousands of
dollars):
The terms of sale are net 30, but because of special incentives, the brothers expect 30 percent of the customers (by
dollar value) to pay on the 10th day following the sale, 50 percent to pay on the 40th day, and the remaining 20 percent to
pay on the 70th day. No bad debt losses are expected, because Jim, the building construction expert, knows which
contractors are having financial problems.
a. Discuss, in general, what it means for the brothers to set a collections policy. Answer: See Ch. 27 Mini Case Show.
DSO = 0.3(10) + 0.5(40) + 0.2(70) = 37 DAYS
Compared to a 30-day credit period, this isn’t too bad since one would expect some customers to pay slowly.
measure of customers’ payment performance. The underlying cause of the problem with the DSO is the seasonal
variability in sales. If there were no seasonal pattern, and hence sales were a constant $200 each month, then the DSO
would be 27 days in both march and June, indicating that customers’ payment patterns had remained steady.
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February $200 $40 20%
March $300 $210 70%
Quarter 2:
April $300 $0 0%
May $200 $40 20%
June $100 $70 70%
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A B C D E F G H I J
Month (1)
Credit Sales
for Month (2)
Receivables
at End of
Month
ADS (4) DSO (5)
Age of Account
(Days) AR %AR %
0-30 $210 84% $70 64%
Monthly
Sales
Contribution
to AR
AR to Sales
Ratio
Quarter 1:
January $100 $0 0%
d. Assuming that the monthly sales forecasts given previously are accurate, and that customers pay exactly as was
predicted, what would the receivables level be at the end of each month? To reduce calculations, assume that 30
percent of the firm’s customers pay in the month of sale, 50 percent pay in the second month following the sale, and
the remaining 20 percent pay in the second month following the sale. Note that this is a different assumption than was
g. Construct the uncollected balances schedules for the end of March and the end of June. Do these schedules
properly measure customers’ payment patterns?
March
June
March
Note that the end of June ageing schedule suggests that customers are paying more slowly than in the earlier quarter.
However we know that the payment pattern has remained constant, so the firm’s customers’ payment performance has
not changed. The apparent change is due to the seasonal fluctuations.
h. Assume that it is now July of Year 1, and the brothers are developing pro forma financial statements for the
following year. Further, assume that sales and collections in the first half-year matched the predicted levels. Using
the year 2 sales forecasts as shown next, what are next year’s pro forma receivables levels for the end of march and for
f. Construct aging schedules for the end of March and the end of June. Do these schedules properly measure
customers‘ payment patterns? If not, why not?
AR = 0.7(SALES IN THAT MONTH) + 0.2(SALES IN PREVIOUS MONTH).
Quarterly Statement
e. What is the firm’s forecasted average daily sales for the first 3 months? For the entire half-year? The days sales
outstanding is commonly used to measure receivables performance. What DSO is expected at the end of March? At
the end of June? What does the DSO indicate about customers’ payments? Is DSO a good management tool in this
situation? If not, why not?
Looking at the DSO, it appears that customers are paying significantly faster in the second quarter than in the first.
See above in question (D) for average daily sales and DSO at the end of the quarter.
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The four variables which make up a firm’s credit policy are (1) the discount offered, including the amount and period;
(2) the credit period; (3) the credit standards used when determining who shall receive credit, and how much credit;
To begin the analysis, describe the four variables which make up a firm’s credit policy, and explain how each of
them affects sales and collections. Then use the information given in part h to answer parts i through n.
depending on the customer’s financial strength as judged by the credit department.
Finally, collection policy refers to the procedures that the firm follows to collect past-due accounts. These can
range from a simple letter or phone call to turning the account over to a collection agency.
How the firm handles each element of credit policy will have an influence on sales, speed of collections, and bad
debt losses. The object is to be tough enough to get timely payments and to minimize bad debt losses, yet not to
new policy is expected to cut bad debt losses sharply.
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A B C D E F G H I J
Predicted
Sales
Predicted
Contribution
to AR
Predicted AR to
Sales Ratio
Quarter 1:
k. What is the dollar amount of the firm’s current bad debt losses? What losses would be expected under the new
March
i. Assume now that it is several years later. The brothers are concerned about the firm’s current credit terms, which
are now net 30, which means that contractors buying building products from the firm are not offered a discount, and
they are supposed to pay the full amount in 30 days. Gross sales are now running $1,000,000 a year, and 80 percent
(by dollar volume) of the firms paying customers generally pay the full amount on day 30, while the other 20 percent
pay, on average, on day 40. Two percent of the firm’s gross sales end up as bad debt losses.
Cash discounts generally produce two benefits: (1) they attract both new customers and expanded sales from
current customers, because people view discounts as a price reduction, and (2) discounts cause a reduction in the
days sales outstanding, since both new customers and some established customers will pay more promptly in order to
get the discount. Of course, these benefits are offset to some degree by the dollar cost of the discounts themselves.
and (4) the collection policy.
create ill will and thus lose customers.
j. Under the current credit policy, what is the firm’s days sales outstanding (DSO)? What would the expected DSO be
if the credit policy change were made?
Old (current) situation: DSO0 = 0.8(30) + 0.2(40) = 32 days. New situation: DSOn = 0.6(10) + 0.3(20) + 0.1(30) = 15 days.
Thus, the new credit policy is expected to cut the DSO in half.
The brothers are now considering a change in the firm’s credit policy. The change would entail (1) changing the
The net expected result is for sales to increase to $1,100,000; for 60 percent of the paying customers to take the
discount and pay on the 10th day; for 30 percent to pay the full amount on day 20; for 10 percent to pay late on day 30;
and for bad debt losses to fall from 2 percent to 1 percent of gross sales. The firm’s operating cost ratio will remain
unchanged at 75 percent, and its cost of carrying receivables will remain unchanged at 12 percent.
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January $150 $0 0%
February $300 $60 20%
March $500 $350 70%
Quarter 2:
April $400 $0 0%
May $300 $60 20%
June $200 $140 70%
net sales 1,086,932 1,000,000 86,932
Production costs 825,000 750,000 75,000
costs and taxes 261,932 250,000 11,932
carrying costs 4,068 7,890 (3,822)
bad debt losses 11,000 20,000 (9,000)
profit before taxes 246,864 222,110 24,754
Taxes (40%) 98,745 88,844 9,902
Net income 148,118 133,266 14,852
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A B C D E F G H I J
Current situation Proposed situation
Sales 1,000,000$ Sales
$ 1,100,000
New
Old Difference
Gross sales 1,100,000 1,000,000
100,000
Less discounts 13,068 – 13,068
New
However, the new policy is not riskless. If the firm’s customers do not react as predicted, then the firm’s profits could
actually decrease as a result of the change. The amount of risk involved in the decision depends on the uncertainty
inherent in the estimates, especially the sales estimate. Typically, it is very difficult to predict customers‘ responses to
competitors’ reactions.)
n. What is the incremental after-tax profit associated with the change in credit terms? Should the company make the
change? (assume a tax rate of 40 percent.)
o. Suppose the firm makes the change, but its competitors react by making similar changes to their own credit terms,
with the net result being that gross sales remain at the current $1,000,000 level. What would the impact be on the
firm’s post-tax profitability?
Thus, if expectations are met, the credit policy change would increase the firm’s annual after-tax profit by $14,852.
Since there are no non-cash expenses involved here, the $14,852 is also the incremental cash flow expected under the
new policy.
Current situation: the firm’s average daily sales currently amount to $1,000,000/365 = $2,739.73. The DSO is 32 days,
($1,100,000/365)(15)(0.75)(0.12) = $4,068.
= $13,068.
l. What would be the firm’s expected dollar cost of granting discounts under the new policy?
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The effective rate of an annual loan:
If the loan is for 90 days and renewable:
Amount of loan to provide desired usable funds:
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If the loan is for 90 days and renewable:
Amount of loan to provide desired usable funds:
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A B C D E F G H I J
Gross sales 1,000,000
Less discounts 11,880
net sales 988,120
Desired loan amount = $100,000
Quoted interest rate = 8%
(1) Simple interest:
(2) Discount interest:
The effective rate of an annual loan:
Interest charge = $8,000
Cash to be received = 92,000.00
Effective rate of loan = 8.70%
(3) discount interest with a 10 percent compensating balance.
compensating bal. % = 10%
The effective rate of an annual loan:
p. The brothers need $100,000 and are considering a 1-year bank loan with a quoted annual rate of 8%. The bank is
offering the following alternatives: (1) simple interest, (2) discount interest, (3) discount interest with a 10%
compensating balance, and (4) add-on interest on a 12-month installment loan. What is the effective annual cost rate
for each alternative? For the first three of these assumptions, what is the effective rate if the loan is for 90 days, but
renewable? How large must the face value of the loan amount actually be in each of the 4 alternatives to provide
$100,000 in usable funds at the time the loan is originated?
Production costs 750,000
profit before credit
Credit-related costs:
carrying costs 3,699
bad debt losses 10,000
profit before taxes 224,421
Taxes (40%) 89,769
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Interest charge = $8,000 The interest charge is simply the interest rate times the loan amount.
Amount of loan to provide desired usable funds:
If the loan is for 90 days and renewable:
Interest charge = $2,000
Comp. Balance = 10,000.00
Cash received = 88,000.00
Cash repaid at end of loan = 90,000.00
Effective qtly rate of loan = 2.2727%
Effective annual rate = 9.41%
Amount of loan to provide desired usable funds:
(4) Add-on interest on a 12-month installment loan.
Loan amount $100,000
Payments 12
Interest rate 8%
The effective rate of an annual loan:
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Interest charge = $8,000
Comp. Balance = 10,000.00
Cash received = 82,000.00