c. Payment float is $40, since the check that you wrote has not yet cleared.

Questions d. The bank™s ledger balance is $940 + $100 = $1,040. The bank is aware of the check you

deposited but is not aware of the check you wrote.

e. Ledger balance plus payment float = $1,000 + $40 = $1,040, which equals the bank™s

ledger balance. Available balance + availability float = $940 + $100 = $1,040, also equal

to the bank™s ledger balance.

2 The current market value of Ford is $57 billion. The 2-day reduction in float is worth $800

million. This increases the value of Ford to $57.8 billion. The new stock price will be

57.8/1.14 = $50.70 per share. Ford should be willing to pay up to $800 million for the sys-

tem, since the present value of the savings is $800 million.

3 The benefit of the lock-box system, and the price the firm should be willing to pay for the

system, is higher when:

a. Payment size is higher (since interest is earned on more funds).

b. Payments per day are higher (since interest is earned on more funds).

c. The interest rate is higher (since the cost of float is higher).

7 See I. Ross, “The Race Is to the Slow Payer,” Fortune, April 1983, pp. 75“80.

Cash and Inventory Management 225

d. Mail time saved is higher (since more float is saved).

e. Processing time saved is higher (since more float is saved).

4 a.

Orders per Average Order Carrying Total

Order Size Year Inventory Costs Costs Costs

1,250,000 Order Size

Bricks per $90 per $.09 per Order Costs plus

Order Bricks per Order 2 Order Brick Carrying Costs

1,000,000 1.25 500,000 $ 113 $45,000 $45,113

500,000 2.50 250,000 225 22,500 22,725

200,000 6.25 100,000 563 9,000 9,563

100,000 12.50 50,000 1,125 4,500 5,625

60,000 20.83 30,000 1,875 2,700 4,575

50,000 25.00 25,000 2,250 2,250 4,500

20,000 62.50 10,000 5,625 900 6,525

10,000 125.00 5,000 11,250 450 11,700

b. The optimal order size decreases to 50,000 bricks:

2 — annual sales — costs per order

Economic order quantity =

carrying cost

2 — 1,250,000 — 90

= = 50,000

.09

Therefore, the average inventory level will fall to 25,000 bricks. The effect of the higher

carrying costs more than offsets the effect of the higher sales.

5 At an interest rate of 4 percent, the optimal initial cash balance is

2 — 1,260,000 — 20

= $35,496

.04

The average cash balance will be one-half this amount, or $17,748. The firm will need to

sell securities 1,260,000/35,496 = 35.5 times per year. Therefore, annual trading costs will

be 35.5 — $20 = $710 per year. Because the interest rate is lower, the firm is willing to hold

larger cash balances.

6 a. Higher interest rates will lead to lower cash balances.

b. Higher volatility will lead to higher cash balances.

c. Higher transaction costs will lead to higher cash balances.

CREDIT MANAGEMENT

AND COLLECTION

Terms of Sale

Credit Agreements

Credit Analysis

Financial Ratio Analysis

Numerical Credit Scoring

When to Stop Looking for Clues

The Credit Decision

Credit Decisions with Repeat Orders

Some General Principles

Collection Policy

Bankruptcy

Bankruptcy Procedures

The Choice between Liquidation and Reorganization

Summary

PepsiCo™s accounts show that it is owed $2,453 million by its customers.

How do companies decide on the amount of credit that they give their customers?

Courtesy of PepsiCo. Inc. © 1998

227

hen companies sell their products, they sometimes demand cash on de-

W livery, but in most cases they allow a delay in payment. The customers™

promises to pay for their purchases constitute a valuable asset; therefore,

the accountant enters these promises in the balance sheet as accounts re-

ceivable. If you turn back to the balance sheet in Table 2.1, you can see that accounts

receivable constitute on the average more than one-third of a firm™s current assets.

These receivables include both trade credit to other firms and consumer credit to retail

customers. The former is by far the larger and will therefore be the main focus of

this material.

Customers may be attracted by the opportunity to buy goods on credit, but there is a

cost to the seller who provides the credit. Take PepsiCo, for example. We saw that in

1998 PepsiCo had sales of $22,300 million, or about $61 million a day. Receivables dur-

ing the year averaged $2,300 million.1 Thus PepsiCo™s customers were taking an aver-

age of 2,300/61 = 37.7 days to pay their bills. Suppose that PepsiCo could collect this

cash 1 day earlier without affecting sales. In that case receivables would decline by $61

million, and PepsiCo would have an extra $61 million of cash in the bank, which it

could either hand back to shareholders or invest to earn interest.

Credit management involves the following steps, which we will discuss in turn.

First, you must establish the terms of sale on which you propose to sell your goods.

How long are you going to give customers to pay their bills? Are you prepared to offer

a cash discount for prompt payment?

Second, you must decide what evidence you need that the customer owes you money.

Do you just ask the buyer to sign a receipt, or do you insist on a more formal IOU?

Third, you must consider which customers are likely to pay their bills. This is called

credit analysis. Do you judge this from the customer™s past payment record or past fi-

nancial statements? Do you also rely on bank references?

Fourth, you must decide on credit policy. How much credit are you prepared to ex-

tend to each customer? Do you play safe by turning down any doubtful prospects? Or

do you accept the risk of a few bad debts as part of the cost of building up a large reg-

ular clientele?

Fifth, after you have granted credit, you have the problem of collecting the money

when it becomes due. This is called collection policy. How do you keep track of pay-

ments and pursue slow payers? If all goes well, this is the end of the matter. But some-

times you will find that the customer is bankrupt and cannot pay. In this case you need

to understand how bankruptcy works.

After studying this material you should be able to

Measure the implicit interest rate on credit.

Understand when it makes sense to ask the customer for a formal IOU.

1 This is an average of receivables at the start of the year and those at the end of the year.

228

Credit Management and Collection 229

Explain how firms can assess the probability that a customer will pay.

Decide whether it makes sense to grant credit to that customer.

Summarize the bankruptcy procedures when firms cannot pay their creditors.

Terms of Sale

TERMS OF SALE

Credit, discount, and

payment terms offered on a Whenever you sell goods, you need to set the terms of sale. For example, if you are

sale. supplying goods to a wide variety of irregular customers, you may require cash on de-

livery (COD). And if you are producing goods to the customer™s specification or incur-

ring heavy delivery costs, then it may be sensible to ask for cash before delivery (CBD).

Some contracts provide for progress payments as work is carried out. For example,

a large consulting contract might call for 30 percent payment after completion of field

research, 30 percent more on submission of a draft report, and the remaining 40 percent

when the project is finally completed.

In many other cases, payment is not made until after delivery, so the buyer receives

credit. Each industry seems to have its own typical credit arrangements. These arrange-

ments have a rough logic. For example, the seller will naturally demand earlier payment

if its customers are financially less secure, if their accounts are small, or if the goods

are perishable or quickly resold.

When you buy goods on credit, the supplier will state a final payment date. To en-

courage you to pay before the final date, it is common to offer a cash discount for

prompt settlement. For example, a manufacturer may require payment within 30 days

but offer a 5 percent discount to customers who pay within 10 days. These terms would

be referred to as 5/10, net 30:

5 10, net 30

‘ ‘ ‘

percent discount number of days that number of days

for early payment discount is available before payment is due

Similarly, if a firm sells goods on terms of 2/30, net 60, customers receive a 2 per-

cent discount for payment within 30 days or else must pay in full within 60 days. If the

terms are simply net 30, then customers must pay within 30 days of the invoice date,

and no discounts are offered for early payment.

Suppose that a firm sells goods on terms of 2/10, net 20. On May 1 you buy goods from

Self-Test 1

the company with an invoice value of $20,000. How much would you need to pay if you

took the cash discount? What is the latest date on which the cash discount is available?

By what date should you pay for your purchase if you decide not to take the cash dis-

count?

230 SECTION TWO

For many items that are bought regularly, it is inconvenient to require separate pay-

ment for each delivery. A common solution is to pretend that all sales during the month

in fact occur at the end of the month (EOM). Thus goods may be sold on terms of 8/10,

EOM, net 60. This allows the customer a cash discount of 8 percent if the bill is paid

within 10 days of the end of the month; otherwise the full payment is due within 60 days

of the invoice date.

When purchases are subject to seasonal fluctuations, manufacturers often encourage

customers to take early delivery by allowing them to delay payment until the usual order

season. This practice is known as season dating. For example, summer products might

have terms of 2/10, net 30, but the invoice might be dated May 1 even if the sale takes

place in February. The discount is then available until May 10, and the bill is not due

until May 30.

A firm that buys on credit is in effect borrowing from its supplier. It saves

cash today but will have to pay later. This, of course, is an implicit loan from

the supplier.

Of course, a free loan is always worth having. But if you pass up a cash discount,

then the loan may prove to be very expensive. For example, a customer who buys on

terms of 3/10, net 30 may decide to forgo the cash discount and pay on the thirtieth day.

The customer obtains an extra 20 days™ credit by deferring payment from 10 to 30 days

after the sale but pays about 3 percent more for the goods. This is equivalent to bor-

rowing money at a rate of 74.3 percent a year. To see why, consider an order of $100. If

the firm pays within 10 days, it gets a 3 percent discount and pays only $97. If it waits

the full 30 days, it pays $100. The extra 20 days of credit increase the payment by the

fraction 3/97 = .0309, or 3.09 percent. Therefore, the implicit interest charged to extend

the trade credit is 3.09 percent per 20 days. There are 365/20 = 18.25 twenty-day peri-

ods in a year, so the effective annual rate of interest on the loan is (1.0309)18.25 “ 1 =

.743, or 74.3 percent.

The general formula for calculating the implicit annual interest rate for customers

who do not take the cash discount is

( ) 365/extra days credit

discount

Effective annual rate = 1 + “1

discounted price

The discount divided by the discounted price is the percentage increase in price paid by

a customer who forgoes the discount. In our example, with terms of 3/10, net 30, the

percentage increase in price is 3/97 = .0309, or 3.09 percent. This is the per-period im-

plicit rate of interest. The period of the loan is the number of extra days of credit that

you can obtain by forgoing the discount. In our example, this is 20 days. To annualize

this rate, we compound the per-period rate by the number of periods in a year.

Of course any firm that delays payment beyond day 30 gains a cheaper loan but dam-

ages its reputation for creditworthiness.

Trade Credit Rates

EXAMPLE 1

What is the implied interest rate on the trade credit if the discount for early payment is

5/10, net 60?

The cash discount in this case is 5 percent and customers who choose not to take the

discount receive an extra 60 “ 10 = 50 days credit. So the effective annual interest is

Credit Management and Collection 231

( )

discount 365/extra days credit

Effective annual rate = 1 + “1

discounted price

( )

5 365/50

= 1+ “ 1 = .454, or 45.4%

95

In this case the customer who does not take the discount is effectively borrowing money

at an annual interest rate of 45.4 percent.

You might wonder why the effective interest rate on trade credit is typically so high.

Part of the rate should be viewed as compensation for the costs the firm anticipates in

collecting from slow payers. After all, at such steep effective rates, most purchasers will

choose to pay early and receive the discount. Therefore, you might interpret the choice

to stretch payables as a sign of financial difficulties. It follows that the interest rate you

charge to these firms should be high.

What would be the effective annual interest rate in Example 1 if the terms of sale were