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A B C D E F G H I J K
1/13/2015
JAN
$100
FEB 200
JUN 100
Chapter 22. 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.
b. Assume that, on average, the brothers expect annual sales of 18,000 items at an average price of $100 per item. (use
a 365 day year.) What is the firm’s expected days sales outstanding (DSO)?
(2.) What is its expected average daily sales (ADS)?
(1) Receivables are a function of the average daily sales and the days sales outstanding. Exogenous economic
factors such as the state of the economy and competition within the industry affect average daily sales, but so does
the firm’s credit policy. The DSO depends mainly on credit policy, although poor economic conditions can lead to a
reduction in customers’ ability to make payments.
(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?
5. If loans have a cost of 12 percent, what is the annual dollar cost of carrying the receivables?
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?
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Looking at the DSO, it appears that customers are paying significantly faster in the second quarter than in the first.
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100
0-30
$210
84%
$70
64%
31-60
$40
16%
$40
36%
$250
100%
$110
100%
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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%
$110
90%
June
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A B C D E F G H I J K
Month (1)
Credit Sales
for Month (2)
Receivables
at End of
Month
ADS (4)
DSO (5)
January
$100
$70
Age of Account
(Days)
AR
%
AR
%
Monthly
Sales
Contribution
to AR
AR to Sales
Ratio
Quarter 1:
January
$100
$0
0%
Predicted
Sales
Predicted
Contribution
to AR
Predicted AR to
Sales Ratio
Quarter 1:
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?
See above in question (D) for average daily sales and DSO at the end of the quarter.
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
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
made earlier.
March
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March
$300
$250
$6.59
37.9
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To begin the analysis, describe the four variables which make up a firm’s credit policy, and explain how each of
The net expected result is for sales to increase to $1,100,000; for 60 percent of the paying customers to take the
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Finally, collection policy refers to the procedures that the firm follows to collect past-due accounts. These can
How the firm handles each element of credit policy will have an influence on sales, speed of collections, and bad
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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.
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Old (current) situation: BDL
= 0.02($1,000,000) = $20,000. New situation: BDL
= 0.01($1,100,000) = $11,000. Thus,
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The brothers are now considering a change in the firm’s credit policy. The change would entail (1) changing the
credit terms to 2/10, net 20, (2) employing stricter credit standards before granting credit, and (3) enforcing collections
with greater vigor than in the past. Thus, cash customers and those paying within 10 days would receive a 2 percent
discount, but all others would have to pay the full amount after only 20 days. The brothers believe that the discount
would both attract additional customers and encourage some existing customers to buy more from the firm–after all,
the discount amounts to a price reduction. Of course, these customers would take the discount and, hence, would
pay in only 10 days.
m. What is the firm’s current dollar cost of carrying receivables? What would it be after the proposed change?
Current situation: under the current, no discount policy, the cost of discounts is $0.
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?
l. What would be the firm’s expected dollar cost of granting discounts under the new policy?
k. What is the dollar amount of the firm’s current bad debt losses? What losses would be expected under the new
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.
The credit period is the length of time allowed to all “qualified” customers to pay for their purchases. In order to
qualify for credit in the first place, customers must meet the firm’s credit standards. These dictate the minimum
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ADS =
$ 2,739.73
ADS =
$ 3,013.70
DSO =
32
days
DSO =
15
days
AR=
$ 87,671.23
AR=
$45,205.48
Amt Financed
$ 65,753.42
Amt Financed
$33,904.11
Cost of financing
$ 7,890.41
Cost of
financing
$ 4,068.49
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net sales
1,086,932
1,000,000
86,932
profit before credit
11,932
(3,822)
(9,000)
profit before taxes
246,864
222,110
24,754
Taxes (40%)
98,745
88,844
Net income
148,118
133,266
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national policy. Note also that credit policy changes may not be announced in a “broadcast” sense so as to slow down
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Production costs
750,000
costs and taxes
238,120
Credit-related costs:
bad debt losses
10,000
profit before taxes
224,421
Under the old terms the net income was $133,266, so the policy change would result in a slight incremental gain of
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A B C D E F G H I J K
Current situation Proposed situation
Sales 1,000,000$ Sales
$1,100,000
New
Old
Difference
Gross sales 1,100,000 1,000,000
100,000
Less discounts
13,068
–
13,068
New
Gross sales
1,000,000
Less discounts
11,880
net sales
988,120
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
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,
so accounts receivable amount to 32($2,73973) = $87,671. However, only 75 percent of this total represents cash costs-
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Effective rate =
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4
Effective rate =
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Interest charge =
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Cash to be received =
98,000.00
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Interest rate =
Amount to borrow =
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Interest charge =
Comp. Balance =
Cash received =
Cash repaid at end of loan =
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Comp. Balance =
Cash received =
Cash repaid at end of loan =
90,000.00
Effective qtly rate of loan =
Effective annual rate =
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Interest rate =
8%
Comp. Balance =
10%
A B C D E F G H I J K
(1) Simple interest:
The effective rate of an annual loan:
If the loan is for 90 days and renewable:
Amount of loan to provide desired usable funds:
(2) Discount interest:
The effective rate of an annual loan:
If the loan is for 90 days and renewable:
Interest charge =
$2,000
Amount of loan to provide desired usable funds:
(3) discount interest with a 10 percent compensating balance.
compensating bal. % =
10%
The effective rate of an annual loan:
If the loan is for 90 days and renewable:
Interest charge =
$2,000
Amount of loan to provide desired usable funds:
Loan Amount =
100,000.00
In a discount interest loan, the bank deducts the interest in advance. Therefore, the borrower receives
less than the face value of the loan. From this, we can determine the actual cash received by the interest
charge, the borrower and the effective rate of such a loan.
Notice that this is less than if the loan is for an entire year. The reason it is less is that you don’t have to
pay as much interest up front if you borrow for 90 days and then roll the loan 4 times a year.
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?
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Interest rate
8%
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Monthly pmt =
$9,000.00
The loan face value amount divided by the numnber of payments.
15.45%
(1 + periodic rate) ^ number of payments – 1
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(4) Add-on interest on a 12-month installment loan.
Loan amount
$100,000
The effective rate of an annual loan:
Interest charge =
$8,000
The interest charge is simply the interest rate times the loan amount.
Amount of loan to provide desired usable funds:
The full proceeds are usable.
Amount required to get desired level of usable funds =
$100,000
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Loan Amount =
$121,951.22