Exercise 6.4: "The Real" Cost of Trade Credit
Having studied "Strategic Debtor Management" from either core text, you will recall the following contributory factors for a historical build-up of debtors, which then requires a corresponding increase in working capital investment to maintain production, in sophisticated market economies.
- Creditor firms often offer large discounts to induce early payment from all their clientele, including high risk customers with excessive opportunity cost of capital (borrowing) rates. Although this means the receipt of less money, it should arrive earlier and hopefully the reduction in price is more than compensated for, by an increase in demand and hence profit.
- High risk customers, however, typically suffer from liquidity problems. So, if taking the discount by the end of the discount period is not viable, they must opt for the end of credit period. Better still, if suppliers' debt collection procedures are lax, they will actually remit payment well beyond this date to compensate for the loss of a significant discount.
Empirical studies outlined in the core texts also explain the build-up of debtors and working capital by exploding the myth that customers who do not take cash discounts, or pay late, are always poor credit risks. On the contrary, some are maximizing their own profitability by easing cash flow at the expense of the creditor firm.
Unscrupulous (unethical but rational) customers without liquidity problems often forego the discount period and offset the resultant cost (or even where discounts are not offered, increase the benefit of trade credit) by unilaterally extending the payment period.
It is also common for debtors (irrespective of their risk profile) to still take the discount when they eventually remit payment!
To illustrate the cost of ineffectual and sub-optimal credit policies from a creditor firm's perspective, rather than the benefit to debtors, let us return to Chapter Five and the data for the Pixie Company (Exercise 5). The development of the question should also deepen your comprehension of working capital management from a financial rather than an accounting perspective.
You will recall that despite increased turnover and a history of Balance Sheet solvency, the Pixie Company is beset by liquidity problems. To summarize its financial position:
- Current assets far exceed current liabilities.
- The working capital ratio has risen from one year to the next
- The conversion of raw materials to the eventual receipt of cash from debtors (the operating cycle) far exceeds the credit period granted by suppliers (the financing cycle).
We concluded our analysis by suggesting that the difference between the periods of credit taken compared to that granted is the root cause of the company's current liquidity crisis. Over a two year period, customers are taking 73 and 87 days to pay (compared with creditor turnover ratios of 61 and 55 days) respectively,
To illustrate Pixie's dilemma, let us now introduce a new piece of information.
The company offers its clientele "standard" industry terms of (3% / 7: 45).
1. Evaluate why adopting terms of sale that conform to the industry "norm" may have created the company's liquidity crisis.
2. Given the assumption that the availability of credit is a necessary pre-condition for trade, suggest how companies such as Pixie can improve their liquidity without increasing the cash price for goods and services, or raising external finance to support future production.
An Indicative Outline Solution
A company's terms of sale (c/t: T) need not conform to traditional industry standards. Chapter Eight "Working Capital and Strategic Debtor Management" and Chapter Four "Strategic Debtor Management and the Terms of Sale" (2013) illustrate why variations in the cash discount (c), discount period (t) and credit period (T) all represent dynamic marketing tools that can restructure "effective" discount and credit prices (P" and P') relative to an original (constant) cash price (P).
By manipulating the time value of money and opportunity cost concepts for both the buyer and seller:
"Ideal" credit terms should create "purchasing power" for customers who need to delay payment. Such terms not only increase demand for the creditor firm, but also maximize the net cash profit from their associated cost - revenue function, which may be unique.
1. The Liquidity Crisis
The key to understanding the problem that confronts the Pixie Company is defined by the familiar relationship between a creditor firm's annual cost of trade credit [k = 365c/(T-t)] and their customers' annual opportunity cost of borrowing, (r).
Customers will logically take the discount if:
r < k = 365c/(T-t)
The following simple interest calculations illustrate the enormous financial burden (k) of not taking the discount that Pixie's terms of trade have imposed on all its customers, irrespective of "realistic" borrowing opportunities.
Annual Costs of Trade Credit (3 3/4/7: 45)
Most debtors have obviously abandoned their agreed terms of sale (3% /7: 45) altogether, resulting in deteriorating average debtor turnover ratios revealed by Pixie's annual accounts.
Many are foregoing the cash discount and unilaterally extending their repayment period, not only beyond the legal maximum of 45 days but also well beyond 87 days this year (remember this is an average) simply to bring the annual cost of trade credit closer to their own opportunity cost of borrowing. Explained simply, given today's term structure of interest rates, no company need borrow funds at even 17.1 per cent.
2. Improving Liquidity
Although the advantage of trade credit for debtors represents an explicit cost-free source of finance, without increasing price or borrowing to survive, the Pixie Company must consider revising its credit terms and tightening its collection procedures as a matter of urgency.
Generous discount terms are being offered to attract trade. But credit control procedures (perhaps including vetting) are weak.
The discount policy confers unnecessary benefits on cash customers. They also force customers who do not take a discount to remit full payment well beyond the standard credit period.
To solve its liquidity problems, without compromising future demand and cash profitability:
- The company should initially reconfigure its credit period to entice low "effective" price (high opportunity rate) buyers.
- Within this context, the cash discount should be utilized to provide a lower cash price for customers with low opportunity rates.
- All debtor levels (discount or credit) should then be monitored continuously, using an age analysis to forewarn of any subsequent "bad debt" loss.
Summary and Conclusions
This Chapter's Exercises subscribe to the normative, over-arching objective of financial management explained throughout my bookboon series, which creates wealth through an optimum combination of investment and financing decisions that generates maximum net cash inflows at minimum cost.
Within this context, optimum terms of sale are the determinant of an optimum working capital structure. In other words, optimum investments in inventory, debtors, cash and creditors are determined by a company's optimum terms of trade (and not vice versa).
Using the time value money and present value (PV) analysis, we have demonstrated how credit policy variables (discount policy and the credit period) elicit a price reduction associated with either the discount price P (1-c), or the credit price (P). These define their corresponding "effective" prices (P" and P', respectively).
The previous Exercises (supplemented by your reading of the companion bookboon texts referenced at the end of this Chapter) confirm that if credit terms are a precondition of trade, then contrary to the balance of academic literature and practice on the subject:
o Terms of sale need not conform to industry "norms". They may be "unique" to a creditor firm, depending on its own structure of revenue and costs and the risk-return profile of their customer portfolio.
o Companies must first review their credit related demand function and derive optimum terms of sale within the context of an optimum credit period.
o The optimum credit period should be set for a high opportunity rate clientele that cannot benefit from ineffectual debt collection procedures.
o Discount policy should be designed to attract low opportunity rate customers.
o Rather than offer an expensive discount for all, the creditor company should provide a selective price reduction, which creates a positive contribution to net cash inflow and corporate wealth (through shorter operating cycles and lower financing costs).
o Debtor levels for all class of customer (high or low risk) should then be monitored continuously, using an age analysis to pre-empt any subsequent "bad debt" loss.
Finally, remember that the whole process is dynamic. With changing economic conditions, revised terms of sale may become suboptimal and require speedy revision.
Working Capital and Strategic Debtor Management, 2013.
Working Capital Management: Theory and Strategy, 2013. Strategic Debtor Management and the Terms of Sale, 2013.