Three: Strategic Debtor Investment
The Effective Credit Price and Decision to Discount
For your convenience let us begin with a resume.
Part One presented a detailed explanation of the over-arching definition of the normative objective of strategic financial management, namely the maximization of expected net cash inflows at minimum cost (the ENPV decision rule) from a working capital perspective.
Part Two, then provided a series of Exercises, focusing on differences between the dynamic wealth maximizing implications for internal working capital management and an external interpretation of a firm's static working capital position, revealed by its published accounts.
Part Three now develops another critique within this context, underpinned by my bookboon series on working capital. This relates to the pivotal role of a creditor company's "terms of sale" as a determinant of its overall working capital efficiency. It also departs from accounting convention, based on the intricacies of recording transactions and the details of financial reporting, by introducing the need for mathematical modeling.
If you require guidance on the following sequence of Exercises, I recommend that before embarking on Part Three, you refer to either:
Chapter Six or Chapter Two of the appropriate texts with which you are familiar: "Working Capital and Strategic Debtor Management" or "Strategic Debtor Management and Terms of Sale" respectively.
There you will discover that the efficient working capital management is not only determined by an optimum investment in current assets and current liabilities, which rejects traditional solvency and liquidity ratios of 2:1 and 1:1.But, given the extent to which most firms sell on credit to increase their turnover:
Many practicing financial managers not only fail to model the dynamics of their company's overall working capital structure satisfactorily. They also misinterpret the functional inter-relationships between its components.
Contrary to the balance of academic literature on the subject (which focuses on cash management and inventory control as the key to success):
o The prime determinant of working capital efficiency should relate to accounts receivable (debtor) policy, which is a function of a company's optimum terms of sale to discounting and non-discounting customers. This might also be unique and need not conform to industry "norms".
o Variations in the cash discount, discount period and credit period all represent dynamic marketing tools.
o Based upon the time value of money and opportunity cost concepts, the terms of sale create purchasing power for customers, which should enhance demand for the creditor firm, increase turnover and hopefully net profits from revenues.
Optimum terms of sale not only determine a company's optimum investment in debtors but as a consequence its optimum investments in inventory, cash and creditors, which in total define the structure of current assets and liabilities and therefore overall working capital requirements.
Exercise 6.1: Terms of Sale: A Theoretical Overview
We have assumed that companies wishing to maximize shareholder wealth using ENPV techniques within the context of project appraisal should:
o Maximize current liabilities and minimize current assets compatible with their debt paying ability, based upon future cash profitability determined by its terms of sale,
o Optimize terms of sale to determine optimum working capital balances for inventory, debtors, cash and creditors.
However, this presupposes that management can initially model the differential impact of their credit terms on future costs, revenues and hence profits when formulating an optimum debtor policy.
So, let us begin our analysis based on your reading of either Chapter from the bookboon companion texts referenced earlier, or Exercise 1 contained in Chapter One of this study:
Summarize how the "terms of sale" mathematics (represented by cash discount, discount period and credit period variables) underpin the demand for a firm's goods and services within a framework of effective prices.
An Indicative Outline Solution
Using the common Equation numbering from whichever bookboon reference you have sourced, the following mathematical framework can be derived to determine optimal credit policies.
The incremental gains and losses associated with a creditor firm's terms of sale are evaluated within a framework of "effective" prices based on the time value of money. These define the customers' credit price (P') and discount price (P") associated with "effective" price reductions arising from delaying payment over the credit or discount period, respectively.
Where buyers of a firm's product at a cash price (P) are offered terms of (c/t:T) such as (2/10:30):
(c) = the cash discount (2%)
(t) = the discount period (10 days)
(T) = the credit period (30 days)
Because (P') differs from (P") it is then possible to analyze how the introduction of any cash discount into a firm's period of credit influences the demand for its product and working capital requirements. When formulating credit policy, management must therefore consider the division of sales between discounting and non-discounting customers.
For any combination of credit policy variables, the buyer's decision to discount depends upon the cost of not taking it exceeding the benefit.
The annual benefit of trade credit is defined by the customer's annual opportunity cost of capital rate (r). Because non-discounting customers delay payment by (T-t) days and forego a percentage (c), their annual cost of trade credit (k) can be represented by:
Thus, if purchases are financed by borrowing at an opportunity rate (r) that is less than the annual cost of trade credit (k) so that:
The buyer will logically take the discount.
From the seller's perspective, we can now confirm that:
To increase the demand for its products, a firm should design its credit periods to entice low effective price (high opportunity rate) buyers, whereas the cash discounts should be utilized to provide a lower cash price for those customers with low opportunity rates.
To summarize: with a COD price (P) on terms (c/t: T) and a customer opportunity rate (r), the effective price framework and discount decision can be expressed mathematically as follows:
In an ideal world all firms would prefer to hold no inventory, sell everything for cash and not leave the balance lying idle. Conversely, they would prefer to purchase all stocks on credit. As a consequence, they would hold no current assets but finance their reinvestment activities by maximizing current liabilities, subject to no loss of goodwill.
In the real world these options are obviously the exception rather than the rule, given the extent to which most firms buy and sell on credit and "manufacture" their products. An increase in the creditor payment period offered to suppliers may cause them to cease trading with the company, thereby interrupting the whole production process. Likewise, a reduction in the period of credit granted to customers may cause the company's clientele to look elsewhere, thereby reducing future sales.
Nevertheless, whilst these "barriers to trade" may prohibit an ideal relationship between the two, companies should still strive to minimize current assets and maximize current liabilities. As a consequence, within the context of normative wealth maximization, we can still define the efficient objectives of working capital management as follows.
o The determination of optimum (minimum) inventory, debtor and cash investments.
o The acquisition of an optimum (maximum) level of creditor finance, subject to a firm's future profitability and debt-paying ability.
Assuming no loss of customer or supplier goodwill, the inflow of cash will then be maximized at minimum cost, satisfying the overall NPV criteria of financial management.