The Credit Related Fund System

How a firm actually chooses the best combination of credit policy variables once a range of customer opportunity rates are established is also a managerial decision where the net benefits are difficult to quantify.

By creating a unique level of demand, a change in either the credit period or cash discount policy results in a unique structure of costs and revenues, associated with sales turnover.

The Structure and Flow of Working Capital

Figure 7.1: The Structure and Flow of Working Capital

On the operational side, if you refer back to Figure 2.2 (reproduced in Figure 7.1) and the commentary in Chapter Two, you will recall that longer credit periods increase finished goods outflows to sustain demand. These increase production in previous periods (work in progress) that earlier still determines the raw material purchases, financed by creditors to support that production. In current and future periods there are also increased investments in debtors. Consequently, more cash is committed to production and the inflow of cash is delayed longer.

Cash inflows are further offset by the additional ongoing costs of credit investigation, billing and collection. In the presence of collection risk, there is also the possibility of unauthorized delays in payment and bad debt losses. These inject uncertainty into the timing and amount of the firm's cash inflows, which leads to a need for precautionary cash balances at the anticipated time of collection.

On the financing side, the firm will need to support increased demand by borrowing. This also entails a cost that is inextricably tied to the volume, structure and duration of the cash outflows outlined above. As credit-related demand increases, finance must be acquired to support increased production, the costs of credit extension and precautionary cash balances. The longer credit period means more finance for longer, for each unit sold but carried on credit. Hence, their impact on the inter-relationship between the operating and financing cycles, summarized by the net operating cycle, which we worked through in Chapter Four (Figure 4.1) reproduced in Figure 7.2.

The Working Capital Cycles

Figure 7.2: The Working Capital Cycles

Within the context of the credit period, cash discount policies also exert their influence on a firm's investment and financing structure. For the seller they provide less money but earlier, to the extent that buyers take the discount. On the other hand, this reduction in cash inflow is offset by shorter operating cycles, which in turn result in lower financing costs. Consequently:

A creditor firm's investment in current assets and other cash outflows related to its operating cycle, as well as the borrowing and associated cost required to sustain it, (the financing cycle) are a function of the credit terms that provided the demand in that cycle.

Each will have its own asset and financing requirements. This, in turn, will determine the firm's total investment and borrowing commitments, as well as their associated costs over some future period. We can view multi-product firms as consisting of many sets of operating cycles in operation at a given point in time, each with its own financing cycle. Optimal sets of credit terms determine the firm's total working capital needs and hence the availability and associated cost of such requirements.

The Development of Theory

Given the severe limitations of an external accounting interpretation of working capital (using ratio analysis explained in previous Chapters) compared to the complexities of its internal financial management outlined above, it may surprise you to learn that:

The credit related funds system (first discussed in Chapter Five) and the pivotal role of credit terms are frequently overlooked on taught academic and professional courses world wide.

Yet, like much else in finance, the underlying theories and how to model them have a long history, which can be traced back to the "golden era" of American research and literature in the 1960s and 1970s.

As far back as 1969, Wrightsman derived optimum credit terms for a company's "accounts receivable" (i.e. debtors). He explained how a creditor firm can use a framework of effective prices to simplify the inter-relationships between the credit period and cash discount policy as separate variables (explained in Chapter Six).

Subsequent research, as far later as that by Gallinger and Ifflander (1986), suggested the use of sensitivity analysis (also explained in Chapter Six) to experiment with different credit policies, given a range of customer opportunity cost of capital rates.

The decision to take the discount for each buyer, or class of buyers, can be determined for different values of T, c and t. The terms of the following inequality derived from Equation (13) are simply rearranged to solve for the appropriate variable (where k equals the annual cost of trade credit).

On the financing side, Tavis (1970) formulated the availability of short-term funds into a linear programming model. The optimal balances represented those sources of finance that result in the minimum cost of borrowing. The coefficients of the objective function are those which minimise the cost of short-term borrowing from each source. The coefficients in the constraint matrix relate the borrowing capacity to each fund's source and reflect the requirement that sources of funds must equal uses throughout the planning period.

Prior to this, C.C. Greer (1967) developed a profit maximisation model, based upon the quality of debtors, determined by the number of credit applications accepted by the creditor firm. Functional relationships were derived by linking the number of customers accepted to their credit rating. By differentiating the profit function with respect to the number of customers accepted and setting the expression equal to zero, he solved for the number of applicants that maximise profits.

Going back even further, Cyert, Davidson and Thompson (1962) had already applied Markov Chains to estimate the probability of a bad debt loss for a debtor at various future dates. Subsequently, Mao and Sarndal (1974) also examined the predictive accuracy of expected bad debt ratios for customers under varying degrees of correlation between default losses for such customers.

Picking up on these theoretical American studies, the first major survey of UK credit policies (independently mailed to both the Financial and Marketing Directors of 250 of the FT-SE top 1000 companies) compiled by the author of this text, revealed that the dynamics of a company's terms of sale should also have "marketing" significance.

In order 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 (Hill 1979).

Subsequent UK academic research confirmed this view. For example, Emery and Finnerty (1991) also observed that given the extent to which most firms sell on credit, the terms of sale should occupy a pivotal position in working capital management.

- A company's credit operations should be seen as more than the financing of current assets, which are held by the seller. Trade credit also finances a firm's markets in terms of goods and services sold and in the possession of the buyer.

- Credit management is the means whereby uncertain potential demand can be converted into actual demand.

- As such, it should not be the sole the responsibility of a firm's finance function.

Certainly, the view taken here is that:

The credit function should involve the marketing process, which determines a firm's sales turnover and hence production, investment in inventories and the need for cash balances.

The availability of trade credit is a means to an end designed to satisfy a firm's normative profit maximising objective. It should be a policy for which all executive financial management, irrespective of their functional divide, should be ultimately responsible.

Summary and Conclusions

To conclude our discussion, the true significance of the relationship between the modern credit function and traditional working capital analysis only emerges when placed in a historic theoretical context. Unfortunately, very little seems to have percolated into practice.

As we shall see later, a significant body of more recent empirical evidence continues to suggest that the role of trade credit as a fundamental determinant of working capital management has neither progressed as far as it might, nor been that successful.

Debtor policy should involve sales ledger personnel, production departments, budget teams, computer analysts, legal advisors and in particular sales and marketing. Yet, it has long been a financial matter (see Pike, Cheng and Chadwick, 1998). Only in a minority of cases does it even stand alone and command status. In fact, in many smaller companies it appears to be the part-time responsibility of a single individual. Not surprisingly, therefore, that many of the problems relating to credit management have long been a reflection of a separation of authority from responsibility, or alternatively accountability from management.

Even in many larger organizations, where there is a greater tendency for the sales and credit functions to be horizontally integrated, this is also a common dilemma. Here, aggressive marketing techniques may override financial credit considerations. The reverse rarely holds, (due to the lower esteem traditionally accorded to accounting, relative to sales and marketing).

As a result, increased turnover and the accompanying investment in debtors may be followed by bad debt loss, or reduced profitability. Antagonism may develop between management, even at executive level. Treated with indifference by the highest authority, it can then become an area where over-arching organizational objectives conflict and sub-optimization inevitably follows.

The two functions, credit and sales, find themselves pulling in opposite directions, which provides a significant explanation for the financial disparity between liquidity and profitability (covered in previous Chapters) that the external users of published accounts subsequently find so difficult to unscramble.

Selected References

1. Wrightsman, D., "Optimal Credit Terms for Accounts Receivable", Quarterly Review of Economics and Business, Summer 1969.

2. Gallinger, G.W. and Ifflander, A.J., "Monitoring Accounts Receivable Using Variance Analysis", Financial Management, No 15, Winter 1986.

3. Tavis, L.A., "Finding the Best Credit Policy", Business Horizons, October 1970.

4. Greer, C.C., "The Optimal Credit Acceptance Policy", Journal of Financial and Quantitative Analysis, December 1967.

5. Cyert, R.M., Davidson, H.J., and Thompson, G.L., "Estimation of the Allowance for Doubtful Accounts by Markov Chains", Management Science, April 1962.

6. Mao, J.C.T. and Sarndal, C.E., "Controlling Risks in Accounts Receivable Management", Journal of Business Finance and Accounting, Autumn 1974.

7. Hill, R.A., "Terms of Sale Theory and Practice", European Journal of Marketing, Vol13, No. 8, 1979.

8. Emery, D.R. and Finnerty, J.D., Principles of Finance, (Chapters 25 and 26), Western Publishing Company, Germany 1991.

9. Pike, R., Cheng, N.S. and Chadwick, l., "Managing Trade Credit for Competitive Advantage", CIMA Research Report, May 1998.

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