Chapter 5

Accounts Receivable Management

Contents

Trade Credit and Shareholder ValueManaging the Credit FunctionEstablishing a Credit PolicyReceivables, Collections, and EDIFOCUSED CASE: Y GUESS JEANS

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Answers to Questions: 1.         Trade credit arises when goods are sold under delayed

payment terms.  When credit terms are offered, the seller is exchanging the title to the goods for the buyer's promise to pay at an agreed-upon later date.  Credit managers believe that the convenience of vendor financing may result in larger purchases.  They also believe that credit customers may be more stable and more likely to become repeat purchasers.

 2.         Trade credit does not have an explicit cost (the buyer is not

charged for the credit extension unless payment is made after the due date), but this does not mean it is “free.”  The implicit interest cost enters into the total cost which must be recovered by the seller, who either absorbs it in the form of a lower profit margin or “prices” for it to recover it.

 3.         The financial motive refers to sellers charging a higher price

when selling on credit, generating a greater present-value profit based on the implicit interest rate charged.  Under the operating motive, suppliers respond to variable and uncertain demand by the way in which they extend trade credit, instead of using more costly responses such as installing extra capacity, building or depleting inventories, or forcing customers to wait in line.  The argument that sales contracting costs between buyers and sellers are reduced for buyers because they can inspect the quantity and quality of goods prior to payment and reduce the payment if some goods are missing or defective is the contracting cost motive.  The pricing motive is attributed to a situation in which sellers in certain industries are unable to alter their prices, perhaps because they  are part of an oligopoly or due to governmental regulation; unpublished variations in credit policy allow these sellers to effectively charge varying amounts to their customers.

 4.   a. Cash application is the process of crediting an account for

the amount remitted (usually by check) by the customer. 

b.  Speedy application is desirable when a customer has used most or all of his credit limit, because crediting the account frees up that amount of the credit limit for additional orders from this customer.  As long as payments are received and applied on a timely basis the credit-granting process is a continuous flow of alternating orders and payments.

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c.  Not generally--unless the check deposit awaits A/R posting (which would be unwise).

 5.         Traditional approaches to setting the credit limit include

setting it equal to customer need, at 10% of customer net worth, at a percent of high credit reported by other suppliers or banks, or by judgment (gut feeling). Evidence suggests that judgment is used predominantly (53% of surveyed firms), with ratio analysis (21%), and agency ratings (7.5%) the next most frequent.  Beranek and Scherr surveyed practitioners and found that about 30% of them believe that the probability of payment decreases with the amount of credit granted for some or all buyers.  This suggests that credit granting and credit limit setting are simultaneously determined in many cases.  Although not asked in this question, it is interesting that four of five surveyed credit executives indicated use of credit limits. 

 6.         Character refers to moral uprightness, integrity,

trustworthiness, and quality of management.  It is important because, unlike the other "C's" of credit, it provides an indicator for willingness to pay.  The other "C's" refer to ability to pay.  Past payment records and insights from a customer's existing suppliers are often all the information the credit analyst has to base an assessment on.

 7.         Dun & Bradstreet provides valuable credit-related data in its

Business Information Reports.  It includes items such as: payments reported, which shows speed of payment, maximum amount of credit extended, and present balances owed; and banking, which provides average balances, present balances, or both, size of bank credit line or loans outstanding, whether borrowing is secured or unsecured, and how these amounts will be repaid.  D&B also provides a useful credit rating, and three years of balance sheet data.  The speed of payment (and Paydex score), present balances owed, and bank credit line or loans outstanding are probably the most valuable for ascertaining present and near-future trade credit repayment probability. It should be observed, however, that much D&B financial data on small businesses is self reported and unaudited and frequemtly subject to self-reporting bias.

 8.         In the chapter presentation (Exhibit 5-8) these categories of

ratios are shown.  The answer might also be based on thought concerning the "capital" dimension of the five C's of credit (and logical deductions related to loan repayment considerations).  Near-term repayment capabilities are closely linked to liquidity

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(current ratio, net working capital, quick ratio, cash flow to total debt, cash flow from operations, cash conversion cycle, net liquid balance, and defensive interval). Debt ratios include times interest earned, long-term debt to capital, and total liabilities to total assets (sometimes called the debt ratio).  In general, debt analysis focuses on coverage of financing-related obligations, and unused debt capacity.  The latter relates to existing debt utilization.  In bank credit and trade credit decisions these ratios are important because they measure the ability to repay ongoing and new debt, whether bank or trade obligations.

 9.         Credit scoring models weight variables depending on their

helpfulness in discriminating between good and bad applicants, based on past payment histories. These models are developed with the assistance of computerized statistical techniques such as multiple discriminant analysis. They save the company with many credit applicants the expense of individually and manually evaluating the applications.

 10.       Here are the expected directions of the default prediction

variables, where + increases predicted default risk and – decreases predicted default risk:time at present residence     - (longer is better)prior bankruptcy filing   Y = +  (N probably neutral but might be -)time in present job              - (longer is better)monthly income             - (larger is better)phone in name                    Y = - N = +prior repossession of credit purchase  Y = + (N probably neutral but might be -)type of residence (apart.rent, own house) A = +, RH = +, OH = - (debatable)

 11.       Two-thirds of the companies offered credit but no cash

discount. One-fourth of the companies offered credit terms with a cash discount. The type of industry had a major influence here, as 80% of wholesalers offered their customers cash discounts, whereas 36% of service firms offered cash discounts.  Utilization rates of offered cash discounts varied widely. Four or five companies charged a service fee for late payments, usually 15-20%, and usually beginning with the net date; 30% of the companies both offered a cash discount and charged a service fee for late payment.  Survey evidence pertaining strictly to cash discounts documents several practices:  (1) changes in the cash discount are linked to competitor changes, but not economic conditions [note:  this begs the issue of why the competitor

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initiated the change to begin with, however]; (2) the probability of competitive changes are not related to the existing (price - variable cost) margin, although logically they should be; (3) managers think demand is more responsive to a 2% cash discount than a 2% price cut; (4) penalty fees and credit policy reevaluation are not linked to the level of receivables held on the books, although logically both would be more cost-effective when the company has a higher level of receivables.  Finally, cash discounts provide information to the seller regarding buyer creditworthiness, longer terms are associated with longer buyer inventory conversion periods (DIH) and international transactions, and cash discounts are higher when the underlying product’s value is subject to rapid change.

 12.              Expert systems quickly assess the data a company or bank

has collected on prior and present credit applicants.  The computerized database supporting this system might include complete customer information as well as a model to determine the appropriate credit limit for each potential customer. Advantages of the application of expert systems include: increased productivity and lower costs of credit evaluation, higher quality of decisions by providing factual support without taking the decision out of the hands of the credit analyst, more consistent application of credit standards, reduced training costs when credit managers retire or leave the company, and use as a training tool to teach newly hired credit analysts how the company evaluates credit.  Disadvantages include the cost of development and questionable accuracy achieved by some models.

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Solutions to Problems: Chapter 5

1. Nast Stores - Consumer credit scoring model.Y = (a * EMPLOYMENT) + (b * HOMEOWNER) + (c * CARDS) where:a = parameter for EMPLOYMENT = 0.20 b = parameter for HOMEOWNER = 0.40 c = parameter for CARDS = 0.30

EMPLOYMENT = 1 if full-time, 0.5 part-time, 0 if unemployedHOMEOWNER = 1 if homeowner, 0 otherwiseCARDS = 1 if presently have 1-5 credit cards, 0 otherwiseMinimum score = 0.70

a.) Consumer credit scoring model.Value of Janice's variables:

EMPLOYMENT= 0.50 HOMEOWNER = 1.00 CARDS = 0.00

Y = (0.20)(0.50) + (.40)(1) + (.30)(0) = 0.50Y = 0.50 : reject credit application

b.) Consumer credit scoring model.Value of Janice's variables

EMPLOYMENT= 1.00 HOMEOWNER = 1.00 CARDS = 1.00

Y = (0.20)(1) + (0.40)(1) + (0.30)(1) = 0.90Y = 0.90 : accept credit application because she now meets the minimum cutoff score

c.) Adding a new variable to a consumer credit scoring model.

0 stands for less than one year, 0.5 stands for 1-2 years, 1 stands for > 2 years. (Answers may vary.)

d.) Suggesting other variables for a consumer credit scoring model.- How long employed in current job 0 for < one year, 0.5 for 1-5 years, 1 for > than 5 years.- Dollar amount annual income 0 < than $20,000, 0.5 for $20-$50,000, 1 > than $50,000. - Phone

number 0 for no phone number, 1 for phone number.

( There are many other possible answers.)

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2. Illustration of a business credit scoring model.Variable Applicant Standing Applicant ScoreCredit History Minor Delinquencies -10Unused Credit 30% Available 20Credit History of Bus. Satisfactory 15Industry Type C 35Avail. Liq. Assets-Bus. $11,500 20Net Worth-Principal $55,000 20

100 Score = -10 + 20 + 15 + 35 + 20 + 20 = 100

Since the credit applicant's score is equal to 100, grant credit. (The criterion was for the score to be at least 100. A score of 100 is therefore acceptable).

3. Certainty NPV and Uncertainty NPV for Credit Decision.(The solution assumes that all collection costs are incurred at the time of the credit sale collection.

a.) The certainty case.ASSUMPTIONS:Credit terms, CP 45 days i per day =Opportunity cost of funds, k 12.00% APR 0.0003288Dollar amount of invoice, S $30,000 Variable costs, VCR 65.00% of salesCredit administration and collection 1.00% of sales costs, EXP

ILLUSTRATION OF CASHFLOW TIMELINEDay 0 Day 45----|----------------------------------------------------------------|---------------------------

--> |

0.65 * $30,000 = $30,000 invoice$19,500.00 ($300) EXPPV of variable costs |

|$29,700 * 1 / (1 + (0.12 / 365) * 45)) |$29,267.01 |PV of collections |

$29,267.01 - $19,500=$9,767.01 = -(VCR * S) +S/(1+ iCP)) - (EXP * S)/(1+ iCP)

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= NPV of credit extension under certainty. Tricia should approve the order since NPV > 0.

b.) The uncertainty case.Payment Timing Probability< 45 days 0.50 45-60 days 0.30 60-90 days 0.15 > 90 days 0.05

1.00

The impact here is that the firm will spend the variable costs associated with the sale upfront, but will only receive the expected value of the invoice over time. So we need to find the expected present value of the invoice.

Additional NetExpected Collection- Collection-

Payment Collection Payment Costs FlowDate Period Probability (> $300) =S-(EXP*S)-(4) (1) (2) (3) (4) (5) < 45 22.5 0.50 $0 $29,700 45-60 52.5 0.30 $125 $29,575 60-90 75 0.15 $250 $29,450 > 90 120 0.05 $9,250 $9,950

* ** ****Note: 22.5 is 1/2 of 45, 52.5 is 1/2 of the 45-60 day range, 75 is 1/2 of the 60-

90day range, and the 120 is the best point estimate for the over 90 day range.

**Note: There are no collection costs for payment in 45 days or less; for 52.5 days, however, the additional collection costs (beyond the 1% * $30,000) are $125; for 75.5 days the additional collection costs (beyond the $300) double to $250; after 90 days, the additional collection costs cumulate to the $250 plus the 30% of the referred amount of $30,000 (= $9,000) for a total of $9,250 in additional charges beyond the original $300 !

***Note: the $9,950 = 0.65 * $30,000 (the percent of the referred amount collected by the agency = $19,500) less the agency's charge of 30% (=$9,000 !), less the $250 accrued additional collection costs, less the 1% EXP * S of $300.

Net NPV of ExpectedCollection- Credit PresentFlow PV Sale Value= S - (EXP*S) - (4) Factor =(5) * (6) - S * VCR = (7) * (3)

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(5) (6) (7) (8) $29,700 0.9927 $9,981.91 $4,990.96 $29,575 0.9830 $9,573.19 $2,871.96 $29,450 0.9759 $9,241.31 $1,386.20$9,950 0.9620 ($9,927.6) ($496.38)

Total NPV = $8,752.73

While not as large as the NPV for the certainty case ($9,767.01), the NPV of $8,752.73 from the credit sale from the risk analysis is positive, and so credit should be extended.

ILLUSTRATION OF CASH FLOW TIMELINE

Day 0 Day 22.5 Day 52.5 Day 75 Day 120---|----------------------------|-------------|------------------|---------------|-----------------

-> $29,700 $29,575 $29,450 $9,950

0.65 * $30,000 = | | | |($19,500.00) | | | |PV of variable costs | | | |

| | | |$29,481.91 | | | |=PV of Day 22.5 collections | | |probability = 50% | | |

| | |$29,073.19 | | |=PV of Day 52.5 collections | |probability = 30% | |

| |$28,741.31 | |=PV of Day 75 collections |probability = 15% |

|$9,572.35 |=PV of Day 120 collections = $9,950 * 1 / (1 + (0.12 /365 * 120)) for exampleprobability = 5%

$8,752.73 = Total NPV

Note: You must calculate the NPV for each day, weight that result, and then add them.

4. Collection float including invoicing float and the cash consequences.Order & Invoice Preparation:

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Order Entry and Shipping 5Invoice Preparation & Sending ("Invoicing Float") 3

Credit Period:Credit Terms 30Added Delay (customers payables) 2Payment Preparation 1Payment Collection & Application:Mail, Processing, Availability Delays 6Cash Application 0

Total Delay from Purchase Communication 47to Cash Application: days

a.) Calculate the total delay from purchase communication to cash application.Total delay = 5 + 3 + 30 + 2 + 1 + 6 + 0 = 47 days

b). From the seller’s perspective, what part of the total delay represents cash tied up?From the point of view of the seller, every moment past the point of “contract fulfillment” (the point where the customer now owes payment for goods or services provided) represents cash tied up. It could be argued that the “Order Entry” step takes place prior to contract fulfillment – that the customer doesn’t truly owe payment until goods are shipped or, depending on the circumstances, until they are received F.O.B. Other than that reservation, the entire time line represents cash not available for either investment or reduction in short-term borrowing.

c.) Why should the seller be concerned about the order and invoice preparation delays?Because, as we saw in part b, order and invoice preparation delays slow incoming cash from sales. It is also directly controllable by the seller.

d.) What fraction of the total delay in your answer to (a) is made up of the credit terms?Based on your answer, comment on the importance of managing all parts of the cash flow timeline.Credit Terms = 30 daysTotal Delay = 47 days

Therefore, 64% of the total delay is made up of credit terms.This leaves 36% of the delay to be managed, some of which is directly under the control of the seller.

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5. Calculating liquidity, debt, and performance ratios from financial statements. "Balance sheet only" ratios may be calculated for two years, the other ratios for one year. Notes: 1. See the AAA CRF file on disk which allows for automatic ratio calculation of some of these ratios; 2. These statements follow the Essentials of Cash Management presentation format, helping students who will eventually sit for the CCM exam.

ASSUMPTIONS Balance Sheets (in 000's)(current assets shaded) Current Year Prior YearCash & Equivalents $2,500.00 $1,000.00 Short-Term Investments $1,300.00 $1,500.00 Accounts Receivable $1,700.00 $1,300.00 Inventory $2,600.00 $2,100.00 Prepaid Expenses $900.00 $900.00Property, Plant & Equipment $7,500.00 $6,800.00 Total Assets $16,500.00 $13,600.00

(current liabilities shaded)Accounts Payable $1,600.00 $1,200.00 Notes Payable $1,800.00 $1,300.00 Accrued Operating Exp. $0.00 $0.00 Current maturities (CMLTD) $0.00 $0.00 Long-term Debt $3,900.00 $3,500.00 Common Stock at Par $200.00 $200.00 Paid-in Capital $3,600.00 $3,600.00 Retained Earnings $5,400.00 $3,800.00 Total Liabilities & Net Worth $16,500.00

$13,600.00

Income Statement (000's)Revenues $16,000 Divs. Paid $250 Cost of Goods Sold $9,200 Add to RE $1,600 Operating Expenses $4,000 EPS $8.00 Depreciation $200 (200,000 shares outstanding)Interest $300 Taxes $450 Net Income (Profit) $1,850

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Statement of Cash Flows (000's)Cash Flows from Operating ActivitiesNet Income $1,850 Adjustments to reconcile net income to net cashChange in Depreciation $200 Increase in Accounts Receivable ($400.00)Increase in Inventories ($500.00)Increase in Accounts Payable $400.00 Net Cash Provided (Used) by Operating Activities $1,550

Cash Flows from Investing ActivitiesCapital Expenditures $ (900)Decrease in Short-Term Investments $ 200Net Cash Provided (Used) in Investing Activities $ 700

Cash Flow from Financing ActivitiesNet Borrowing (Bank Line of Credit Agreement) $500Proceeds from Issuance of Long-Term Debt $400Dividends Paid ($250)Net Cash Provided (Used) by Financing Activities 650

Net Increase (Decrease) in CashCash – Beginning of Year $1,000Cash – End of Year $2,500Net Cash Increase (Decrease) $1,500

Calculating ratios with both a balance sheet numerator and denominator.Note: in Exhibit 5.8 and here, we use liquidity as popularly construed, but you may wish to point out for reinforcement that some are solvency, others are financial flexibility. Warn CCM exam-takers that Essentials of Cash Management calls all of them "liquidity" ratios.

Formula w/ current year Current PriorLiquidity Ratios: data for example Year Year (measure solvency)Current Ratio CA / CL = 9000 / 3400 2.65 2.72Net Working Cap. (000's) CA - CL = 9000 - 3400 $5,600 $4,300 Quick Ratio (CA-Inv)/CL = 6400 / 3400 1.88 1.88

Liquidity Ratios: (measure liquidity)Cash Flow to NI + D Depr. = 1850 + 200 0.36 NATotal Debt ST + LT Debt = 1800 + 3900

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Cash Flow from Taken from Statement $1,550 NAOperations (000's) of Cash Flows

Cash Cycle DIH + DSO - DPO 81.73 NA(Use PUR vs. COGs) 103.15 + 38.78 - 60.21PUR=(EI-BI)+COGS (see Chapter 2)

Cash Turnover 365 / Cash Cycle = 365 / 81.73 4.47 NANet Liquid Balance Cash + ST Investments 2.11 1.92

NP + CMLTD= (2500 + 1300) / (1800 + 0)

Defensive Interval Cash + ST Investments 105.08 NADaily Operating Expenses= (2500 + 1300) / ((9200 + 4000) / 365)

Debt Management & Coverage Ratios: Formula: Times Interest Earned EBIT / Interest = 2600 / 300 8.67 NA

Long-Term Debt Long-Term Debt = 3900 to Capital Long Term Debt + Equity 0.30 0.32

(3900 + 200 + 5600 + 3400)

Total Liabilities Total Liabilities = 1600 + 1800 + 3900to Total Assets Total Assets = 16500 0.44

0.44

Performance Ratios: Formula: Return on Equity Earnings Available 0.20 NA

to Shareholders = 1850Common Equity = 9200

Profit Margin on Sales Net Income / Revenue 11.56% NA= 1850 / 16000

Return on Total Assets Net Income / Total Assets 11.21% NA= 1850 / 16500

a.) The liquidity ratios (solvency measures here) that can be compared for two years offer some support for the applicant's "increased" creditworthiness claim (note NWC and NLB), but the debt ratios are essentially unchanged and offer almost no

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support for the claim. We would want to see two years of the other ratios to draw firmer conclusions.

b.) Slightly more "liquid," based on NWC and the "best" solvency measure, NLB. We would want to look at another year or two of income statements to calculate more trend ratios before firming up this conclusion. One should be cautious basing a conclusion solely on solvency, as opposed to liquidity and financial flexibility (see Chapter 2).