RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
date, it creates accounts receivable. By allowing customers to pay some time after they receive the goods or services, you are granting credit, which we refer to as trade credit. Trade credit, also referred to as mer- chandise credit or dealer credit, is an informal credit arrangement. Unlike other forms of credit, trade credit is not usually evidenced by
MANAGING WORKING CAPITAL
notes, but rather is generated spontaneously: Trade credit is granted when a customer buys goods or services.
Reasons for Extending Credit Firms extend credit to customers to help stimulate sales. Suppose you
offer a product for sale at $20, demanding cash at the time of the sale. And suppose your competitor offers the same product for sale, but allows customers 30 days to pay. Who’s going to sell the product? If the product and its price are the same, your competitor, of course. So the benefit from extending credit is the profit from the increased sales.
Extending credit is both a financial and a marketing decision. When
a firm extends credit to its customers, it does so to encourage sales of its goods and services. The most direct benefit is the profit on the increased sales. If the firm has a variable cost margin (that is, variable cost/sales) of 80%, then increasing sales by $100,000 increases the firm’s profit before taxes by $20,000. Another way of stating this is that the contri- bution margin (funds available to cover fixed costs) is 20%: For every $1 of sales, 20 cents is available after variable costs.
The benefit from extending credit is: Benefit from extending credit
(20-1) = Contribution margin × Change in sales If a firm liberalizes its credit it grants to customers, increasing sales
by $5 million and if its contribution margin is 25%, the benefit from liberalizing credit is 25% of $5 million, or $1.25 million.
Costs of Credit But like any credit, it has a cost. The firm granting the credit is forgoing
the use of the funds for a period—so there is an opportunity cost associ- ated with giving credit. In addition, there are costs of administering the accounts receivable—keeping track of what is owed. And, there is a chance that the customer may not pay what is due when it is due.
The Cost of Discounts Do firms grant credit at no cost to the customer? No, because as we just
explained, a firm has costs in granting credit. So they generally give credit with an implicit or hidden cost:
■ The customer that pays cash on delivery or within a specified time thereafter—called a discount period—gets a discount from the invoice price.
Management of Receivables and Inventory
■ The customer that pays after this discount period pays the full invoice price.
Paying after the discount period is really borrowing. The customer pays the difference between the discounted price and the full invoice price. How much has been borrowed? A customer paying in cash within the discount period pays the discounted price. So what is effectively bor- rowed is the cash price.
In analyses of credit terms, the dollar cost to granting a discount is: Cost of discount
(20-2) = Discount percentage × Credit sales using discount If a discount is 5% and there are $20 million credit sales using the dis-
count, the cost of the discount is 5% of $20 million, or $1 million. But wait. Is this the only effect of granting a discount? Only if you assume that when the firm establishes the discount it does not adjust the full invoice price of their goods. But is this reasonable? Probably not. If the firm decides to alter its credit policy to institute a discount, most likely it will increase the full invoice sufficiently to be compensated for the time value of money and the risk borne when extending credit.
The difference between the cash price and the invoice price is a cost to the customer—and, effectively, a return to the firm for this trade credit. Consider a customer that purchases an item for $100, on terms of 2/10, net 30. This means if they pay within 10 days, they receive a 2% discount, paying only $98 (the cash price). If they pay on day 11, they pay $100. Is the seller losing $2 if the customer pays on day 10? Yes and no. We have to assume that the seller would not establish a dis- count as a means of cutting price. Rather, a firm establishes the full invoice price to reflect the profit from selling the item and a return from extending credit. 1
Suppose the Discount Warehouse revises its credit terms, which had been payment in full in 30 days, and introduces a discount of 2% for accounts paid within 10 days. And suppose Discount’s contribution margin is 20%. To analyze the effect of these changes, we have to project the increase in Discount’s future sales and how soon Discount’s customers will pay.
1 If the customer pays within the discount period, there is a cost to the firm—the op- portunity cost of not getting the cash at the exact date of the sale but rather some
time later. With the terms 2/10 net 30, if the customer pays on the tenth day, the sell- er has just given a 10-day interest-free loan to the customer. This is part of the car- rying cost of accounts receivable, which we will discuss in a moment.
MANAGING WORKING CAPITAL
Let’s first assume that Discount does not change its sales prices. And let’s assume that Discount’s sales will increase by $100,000 to $1,100,000, with 30% paying within ten days and the rest paying within thirty days. The benefit from this discount is the increased contribution toward before tax profit of $100,000 × 20% = $20,000. The cost of the discount is the forgone profit of 2% on 30% of the $1.1 million sales, or $6,600.
Now let’s assume that Discount changes its sales prices when it institutes the discount so that the profit margin (available to cover the firm’s fixed costs) after the discount is still 20%:
Contribution margin 1 0.02 ( – ) = 20%
Contribution margin = 20.408%
= -------------------------
If sales increase to $1.1 million, the benefit is the difference is the profit, Before the discount = 20% of $1,000,000
= $200,000 After the discount = 20.408% of $1,100,000 = $224,488
so the incremental benefit is $24,488. And the cost, in terms of the dis- counts taken is 2% of 30% of $1,100,000, or $6,600.
While we haven’t taken into consideration the other costs involved (such as the carrying cost of the accounts and bad debts), we see that we get a different picture of the benefits and costs of discounts depending on what the firm does to the price of its goods and services when the discount is instituted. So what appears to be the “cost” from the discounts doesn’t give us the whole picture, because the firm most likely changes its contri- bution margin at the same time to include compensation for granting credit. In that way, it increases the benefit from the change in the policy.
Other Costs There are a number of costs of credit in addition to the cost of the dis- count. These costs include:
■ The carrying cost of tying-up funds in accounts receivable instead of investing them elsewhere. ■ The cost of administering and collecting the accounts. ■ The risk of bad debts.
The carrying cost is similar to the holding cost that we looked at for cash balances: the product of the opportunity cost of investing in accounts receivable and the investment in the accounts. The opportunity
Management of Receivables and Inventory
cost is the return the firm could have earned on its next best opportu- nity. The investment is the amount the firm has invested to generate sales. For example, if a product is sold for $100, and its contribution margin is 25%, the firm has invested $75 in the sold item (in raw mate- rials, labor, and other variable costs).
Suppose a firm liberalizes its credit policy, resulting in an increase in accounts receivable of $1 million. And suppose that this firm’s contribu- tion margin is 40% (which means its variable cost ratio is 60%). The firm’s increased investment in accounts receivable is 60% of $1 million, or $600,000. If the firm’s opportunity cost is 5%, the carrying cost of accounts receivable is:
Carrying cost of accounts receivable = 5% of $600,000 = $30,000 We can state the carrying cost more formally as:
Carrying cost of accounts receivable = ( Opportunity cost ) Variable cost ratio ( )
(20-3) ( Change in accounts receivable )
In addition to the carrying cost, there are costs of administering and collecting accounts. Extending credit involves recordkeeping. Moreover, costs are incurred in personnel and paperwork to keep track of which cus- tomers owe what amount. In addition to simply recording these accounts, there are expenses in collecting accounts that are past due. Whether the firm collects its own accounts or hires a collection agency to collect these accounts, there are costs involved in making sure that customers pay.
Still another cost of trade credit is unpaid accounts—bad debts. If the firm demanded cash for each sale, there would be no unpaid accounts. By allowing customers to pay after the sale, the firm is taking on risk that the customer will not pay as promised. And by liberalizing its credit terms (for example, allowing longer to pay) or to whom it extend credit, the firm may attract customers who are less able to pay their obligations when promised.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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