A B C D E F G H I

1 Tool Kit Chapter 27 11/23/2018

2 Providing and Obtaining Credit
3
4
In Chapter 16, we addressed the topic of working capital management with a brief discussion of trade credit. In this chapter, we extend those analyses to
5 several more advanced issues, including monitoring the receivables position and the cost of short term bank loans.
6
7
8
9 27-3Analyzing Proposed Changes in Credit Policy
10
11
12 Tax rate = 25%
13
14 TABLE 27-4
15 Monroe Manufacturing Company: Analysis of Changing Credit Policy (Millions of Dollars)
16
17
18 Projected
19 Projected 2020 2020 Net
Net Income Effect of Income
20 under Current Credit Policy under New
21 Credit Policy Change Credit Policy
22 (1) (2) (3)
23 Gross sales $400.0 $130.0 $530.0
24 Less discounts 2.0 4.0 6.0
25   Net sales $398.0 $126.0 $524.0
26 Production costs, including overhead 280.0 91.0 371.0
27   Profit before credit costs and taxes $118.0 $35.0 $153.0
28 Credit-related costs
29   Cost of carrying receivables 3.0 2.0 5.0
30   Credit analysis and collection expenses 5.0 -3.0 2.0
31   Bad-debt losses 10.0 22.0 32.0
32 Profit before taxes $100.0 $14.0 $114.0
33   State-plus-federal taxes (25%) 25.0 4.0 29.0 Note: rounded to zero decimals for clarity of presentation.
34 Net income $75.0 $10.0 $85.0
35 Note: The table reports only those cash flows that are related to the credit policy decision. Also, taxes
36 are rounded for clarity of presentation.
37
38 Analysis of Current Situation
39
40 Current
41 Discount: 1%
42 Free days 10
43 Net days 30
44
45 Days after sale: 10 30 40
46 Precent paying 50% 40% 10%
47
48
49 Days sales outstanding (DSO) 21.0
50
51 Total discounts $2.0 million
52
53
54 Variable costs / sales 70%
55 Cost of capital for receivables 20%
56 Days in year 365
57
58 Cost of carrying receivables = $3.22 million
59
60 Cost of carrying receivables ≈ $3.0 million
61
62 Cost of credit analysis and collection of bad debts 5
63 Percent of debt never collected = 2.50%
64
65 Bad debt losses = $10.0 million
66
67
68 Analysis of Proposed Situation
69
70
71 Proposed
72 Discount: 2%
73 Free days 10
74 Net days 40
75
76 Days after sale: 10 40 50
77 Precent paying 60% 20% 20%
78
79
80 Days sales outstanding (DSO) 24.0
81
82 Total discounts = $6.36 million
83
84 Total discounts ≈ $6.0 million
85
86 Variable costs / sales 70%
87 Cost of capital for receivables 20%
88 Days in year 365
 A B C D E F G H I
89
90 Cost of carrying receivables = $4.88 million
91
92 Cost of carrying receivables ≈ $5.0 million
93
94 Cost of credit analysis and collection of bad debts 2
95 Percent of debt never collected = 6.00%
96
97 Bad debt losses = $31.80 million
98
99 Bad debt losses ≈ $32.0 million
100
101
102 27-4Analyzing Proposed Changes in Credit Policy: Incremental Analysis
103
104 In an incremental analysis, we attempt to determine the increase or decrease in both sales and costs associated with a given easing
105 or tightening of credit policy. The difference between incremental sales and incremental costs would be incremental profit.
106
107 Total Inventory Costs
Slope
(TIC)
= SalesTotal
Rate
TotalOrdering
Carrying
= 500 Shirts
Costs
Costs(TOC)
per
(TCC)
Week
 A B TotalCInventory Costs
D
Slope
(TIC) E Ordering
= SalesTotal
Rate
Total Carrying F G H I
108 27-6 Monitoring Receivables with the Uncollected Balances Schedule = 500 Shirts
Costs
Costs(TOC)
per
(TCC)
109 Week
110 Table 27-1
111 Hanover Company: Receivables Data for 2019 (Thousands of Dollars)
112
Based on Quarterly
113 Sales Data Based on Year-to-Date Sales Data

114 Credit Sales for Receivables at

Month (1) Month (2) End of Month ADS (4) DSO (5) ADS (6) DSO (7)
115 January $60 $54
116 February $60 $90
117 March $60 $102 $1.98 52 $1.98 52
118 April $60 $102
119 May $90 $129
120 June $120 $174 $2.97 59 $2.47 70
121 July $120 $198
122 August $90 $177
123 September $60 $132 $2.97 44 $2.64 50
124 October $60 $108
125 November $60 $102
126 December $60 $102 $1.98 52 $2.47 41
127
128
129 Table 27-2
130 Hanover Company: Quarterly Aging Schedules for 2019 (Thousands of Dollars)
131
132 Age of Accounts Value and Percentage of Total Accounts Receivable at the End of Each Quarter
133 (Days) 31-Mar 30-Jun 30-Sep 31-Dec
134 0-30 $54 53% $108 62% $54 41% $54 53%
135 31-60 $36 35% $54 31% $54 41% $36 35%
136 61-90 $12 12% $12 7% $24 18% $12 12%
137 $102 100% $174 100% $132 100% $102 100%
138
139
140 Table 27-3
141 Hanover Company: Quarterly Uncollected Balances Schedules for 2019 (Thousands of Dollars)
142
143 Remaining
144 Receivables
Remaining as Percent of
145 Receivables at Month's
146 End of Sales at End
147 Quarter Monthly Sales Quarter of Quarter
148
149 Quarter 1:
150 January $60 $12 20%
151 February $60 $36 60%
152 March $60 $54 90%
153 $102 170%
154 Quarter 2:
155 April $60 $12 20%
156 May $90 $54 60%
157 June $120 $108 90%
158 $174 170%
159 Quarter 3:
160 July $120 $24 20%
161 August $90 $54 60%
162 September $60 $54 90%
163 $132 170%
164 Quarter 4:
165 October $60 $12 20%
166 November $60 $36 60%
167 December $60 $54 90%
168 $102 170%
169
170
171 27-7 Analyzing Proposed Changes in Credit Policy
172
173
174
175 Monroe Manufacturing Company's current credit terms are 1/10, net 30. Monroe is considering changing its terms to 2/10, net 40, relaxing its
176 credit standards, and putting less pressure on slow-paying customers. It has annual sales of $400 million. Under its current policy, 50% of
177 customers who pay do so on Day 10 and take the discount, 40% pay on Day 30, and 10% pay late on Day 40.
178
179 Current New
Policy Policy
180 Annual sales (in millions) = $400 $530
181 Discount = 1% 2%
182 % customers who take discount = 50% 60%
183 % customers who pay on day 10 = 50% 60%
184 % customers who pay on day 30 = 40% 0%
185 % customers who pay on day 40 = 10% 20%
186 % customers who pay on day 50 = 0% 20%
187 Variable cost ratio = 70% 70%
188 Cost of funds = 20% 20%
189 Bad debt percent = 2.5% 6.0%
190 Credit analysis and collections expenses = $5 $2
191
192 Current DSO = 21 24
 A B C D E F G H I
193 Current discounts (in millions) = $2 $6
194 Cost of carrying (in millions) = (DSO)(Sales per day)(VC ratio)(Cost of funds)
195 Cost of carrying (in millions) = $3.2 $4.9
196 Bad debt losses = $10.0 $31.8
197
198
199 Table 27-4
200
Monroe Manufacturing Company: Analysis of Changing Credit Policy (Millions of Dollars)
201
202
203 Projected
204 2020 Net
205 Income
206 Under Effect of
Current Credit Projected 2020 Net
207 Credit Policy Policy Income Under New
208 (1) Change (2) Credit Policy (3)
209 Gross sales $400 $130 $530
210 Less discounts $2 $4 $6
211 Net sales $398 $126 $524
212 Production costs, including OH $280 $91 $371
213 Profit before credit costs and taxes $118 $35 $153
214 Credit related costs: $0
215 Cost of carrying receivables $3 $2 $5
216 Credit analysis and collection expenses $5 -$3 $2
217 Bad debt losses $10 $22 $32
218 Profit before taxes $100 $14 $114
219 State-plus-federal taxes (50%) $50 $7 $57
220 Net Income $50 $7 $57
221
222
223 27-8 Analyzing Proposed Changes in Credit Policy: Incremental Analysis
224
225 Sometimes it is preferrable to do an incremental analysis based on a particular division or product.
226
227 S0 = Current gross sales.
228 SN = New gross sales, after the change in credit policy. Note that S N can be greater or less than S0.
229 SN - S0 = Incremental, or change in, gross sales.
230 V= Variable costs as a percentage of gross sales.
231 1-V = Contribution margin, sometimes called gross margin.
232 r= Cost of financing investments in receivables.
233 DSO0 = Days sales outstanding before change in policy.
234 DSON = New days sales outstanding after the change in policy.
235 B0 = Average bad debt loss under current policy as a percent of current gross sales.
236 BN = Average bad debt loss under new policy as a percent of new gross sales.
237 P0 = % of current gross sales that are at the discount.
238 PN = % of new gross sales that are at the discount.
239 D0 = Current discount percent.
240 DN = New discount percent.
241
242
ΔI is the incremental change in the level of the firm's investment in receivables. The formula for ΔI is different for changes in policies that
243 increase sales and those that decrease sales.
244
245
246 If sales increase:

[Increased investment in [Increased investment in

247 ΔI = receivables associated with the + receivables associated with
original sales] incremental sales]

[Change in days [(DSON)(Incremental

[Old sales per
248 ΔI = sales
day]
+ V
sales per day)]
outstanding]

249 ΔI = [DSON - DSO0] [S0 / 365] + V [(DSON) (SN - S0)/365]

250
251
 A B C D E F G H I
252 If sales decrease:
[Decreased investment in [Decreased investment in
253 ΔI = receivables associated with + receivables associated with
remaining original customers] customers who left]

[Change in days [(DSO0)(Incremental

Remaining
254 ΔI = sales sales per day] + V
sales per day)]
outstanding]
255 ΔI = [DSON - DSO0] [SN / 365] + V [(DSO0) (SN - S0)/365]
256
257
258 ΔP is the incremental change in pre-tax profitability.

[Change in [Change in [Change in

[Change in gross cost of
259 ΔP = profit] - carrying bad debt cost of
losses] - discounts]
receivables] -

[DNSNPN -
260 ΔP = [(SN -S0)(1-V)]- [r(DI)] - [BNSN -B0S0] -
D0S0P0]

261
262 Example: Lengthening the Credit Period
263
264 S0 = $100,000
265 SN = $150,000
266 SN - S0 = $50,000
267 V= 60%
268 1-V = 40%
269 r= 10%
270 DSO0 = 0
271 DSON = 30
272 B0 = 0%
273 BN = 2%
274 P0 = 0%
275 PN = 0%
276 D0 = 0%
277 DN = 0%
278
279 ΔI = [DSON - DSO0] [S0 / 365] + V [(DSON) (SN - S0)/365]

280 ΔI = 30 $273.97 + 60% $4,109.59

281 ΔI = $8,219.00 + $2,466.00
282 ΔI = $10,685
283
284 ΔP = $20,000 -$1,069 -$3,000 $0
285 ΔP = $15,931
286
287
288 Example: Shortening the Credit Period
289
290 S0 = $150,000
291 SN = $130,000
292 SN - S0 = -$20,000
293 V= 60%
294 1-V = 40%
295 r= 10%
296 DSO0 = 30
297 DSON = 20
298 B0 = 2%
299 BN = 2%
300 P0 = 0%
301 PN = 0%
302 D0 = 0%
303 DN = 0%
304

305 ΔI = [DSON - DSO0] [SN / 365] + V [(DSO0) (SN - S0)/365]

306 ΔI = -10 $356.16 + 60% -$1,644

307 ΔI = -$3,562 + -$986
308 ΔI = -$4,548
309
310 ΔP = -$8,000 $455 $400 $0
311 ΔP = -$7,145