Read and summarize chapter 20 of your Financial Management Text in at least 400 words.
-What is trade credit?
-Is it beneficial to a business to offer trade credit? why or why not?
-How is credit worthiness determined?
-Research the term “after pay.” In your opinion, who does it help more, the customer or the business? Explain your answer.
-What is inventory?
-What is JIT?
-How is inventory monitored?
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 CAPITALnotes, 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
= Contribution margin × Change in sales
(20-1)
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 653■ 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
= Discount percentage × Credit sales using discount
(20-2)
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% 0.20
Contribution margin = – = 20.408%(1 – 0.02)
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
