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Self-Test posited.
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

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

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.
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 Procedures
The Choice between Liquidation and Reorganization


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

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.

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
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-

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
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
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%
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


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