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Chapter 21
Chapter 21
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Chapter 21

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    • 1. CHAPTER 21 Providing 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.
      • Cash discounts
      • Credit period
      • Credit standards
      • Collection policy
      • Size of credit line
      What five variables make up a firm’s credit policy? 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…)
    • 4. 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 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
    • 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 January $100 April $300 February 200 May 200 March 300 June 100 Terms of sale: Net 30 . Assume the following sales estimates: These data are from the Mini Case.
    • 11.
      • 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
    • 12.
      • 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
    • 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.
      • A/R $182,466 Notes payable $136,849
      • Retained 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 Case .
    • 15.
      • = 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
    • 16.
      • 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 which influence a firm’s receivables level?
    • 17.
      • 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?
    • 18. What would the receivables level be at the end of each month? Month Sales A/R Jan $100 $ 70 Feb 200 160 Mar 300 250 April 300 270 May 200 200 June 100 110 A/R = 0.7(Sales in that month) + 0.2(Sales in previous month).
    • 19. What is the firm’s 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. Avg. Daily Sales = . 1st Qtr: $600/91 = $6.59 . 2nd Qtr: $600/91 = $6.59 . Total sales # of days
    • 20. 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? You can also calculate the DSO monthly using yearly Average Daily Sales data. DSO = . A/R ADS
    • 21.
      • 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.
      What does the DSO indicate about customers’ payments?
    • 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.
      • 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 %
      Construct the uncollected balances schedules for the end of March and June.
    • 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.
      • 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? (More...)
    • 26.
      • 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.
    • 27.
      • 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 year’s 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
    • 31. 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.
      • Current: DSO 0 = 0.8(30) + 0.2(40) = 32 days
      • New: DSO N = 0.6(10) + 0.3(20) + 0.1(30) = 15 days
      What is the DSO under the current and the new credit policies?
    • 34.
      • Current: BDL 0 = 0.02($1,000,000) = $20,000 .
      • New: BDL N = 0.01($1,100,000) = $11,000 .
      What are bad debt losses under the current and the new credit policies?
    • 35.
      • Discount 0 = $0 .
      • Discount N = 0.6(0.02)(0.99)($1,100,000) = $13,068 .
      What are the expected dollar costs of discounts under the current and the new policies?
    • 36.
      • Costs of carrying receivables O =($1,000,000/365)(32)(0.75)(0.12) =$7,890 .
      • Costs of carrying receivables N =($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?
    • 37. 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 $100,000 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...)
    • 38. New Old Diff. Profit before credit costs and taxes $261,932 $250,000 $11,932 Credit-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 firm’s after-tax profitability?
    • 40.
      • A credit policy change may prompt the company’s 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 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 react .
    • 43. 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.
    • 45. 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. Finance 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, r Nom = EAR. r EAR Nom     , $100,000 . 8 000 0.08 8.0%
    • 47. Finance 402 Simple Interest, Paid Monthly Monthly interest = (0.08/12)($100,000) = $666.67 . -100,000.00 -666.67 100,000 0 1 12 -666.67 N I/YR PV PMT FV 12 100000 -666.67 -100000 0.66667 (More…) ...
    • 48. Finance 402 r Nom = (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 08 4 1 8. 24% . 4 . EAR           1 0 08 12 1 8.30%. 12 . = Or: With an HP calculator only
    • 49. Finance 402 8% Discount Interest, 1 Year Interest deductible = 0.08($100,000) = $8,000 . Usable funds = $100,000 - $8,000 = $92,000 . 1 92 0 -100 8.6957% = EAR 0 1 i = ? 92,000 -100,000 N I/YR PV PMT FV
    • 50. Discount Interest (Continued) Amount borrowed = = = $108,696 . Amount needed 1 - Nominal rate (decimal) $100,000 0.92 Thus, to obtain the use of $100,000, you have to borrow $108,696.
    • 51. Need $100,000. Offered Loan With Terms of 8% Discount Interest, 10% Compensating Balance. (More...) = = = $121,951 . Amount needed 1 - Nominal rate - CB $100,000 1 - 0.08 - 0.1 Face amount of loan
    • 52. Finance 402 Interest = 0.08 ($121,951) = $9,756. EAR correct only if amount is borrowed for 1 year. (More...) EAR   $9 , $100,000 756 9. 756% .
    • 53. Finance 402 8% Discount Interest With 10% Compensating Balance (Continued) This procedure can handle variations. N I/YR PV PMT FV 1 100000 -109756 9.756% = EAR 0 0 1 i = ? 121,951 Loan -121,951 + 12,195 -109,756 -9,756 Prepaid Interest -12,195 Compensating Balance 100,000 Usable Funds
    • 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...)
    • 55. Finance 402 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: -9,000 100,000 0 1 12 i = ? -9,000 -9,000 Months 2 ...
    • 56. Finance 402 12 100000 -9000 1.2043% = rate per month 0 r Nom = 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. N I/YR PV PMT FV
    • 57. 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 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.
    • 60. Conclusion
      • Receivables Management
        • Days Sales Outstanding
        • Aging Schedule
        • Payments Pattern Approach
      • Interest Costs
        • Annual Percentage Rate
        • Effective Annual Rate

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