The Strategic Impact of Alternative Credit Policies on Working Capital and Company Profitability

Introduction

If the creditor firm is to achieve its normative wealth maximising objectives, we must view working capital management generally and credit terms in particular as major profit-producing functions, rather than institutionalized or supportive areas of business finance. This, in turn, implies a model into which the firm's objectives have been incorporated.

The purpose of this Chapter is to reveal the dynamics of how management should choose an optimum combination of credit period and discount policy for each product, which ensures that their overall objectives are satisfied.

Effective Prices and the Creditor Firm

We can evaluate the incremental gains and losses associated with a creditor firm's terms of sale by using a framework of "effective" prices, which modifies the series of equations presented in Chapter Six. These began with the customers' credit price and discount price respectively:

Activity 1

Reconsider the data for Activity 2 in Chapter Six, where a firm offers goods for sale at a price (P) of $100 with credit terms (2/10:30). Assume that its opportunity cost of capital (r) is identical to that of its customers, namely 18%. But let us now assume that the profit margin on turnover is $20. In other words, the cost of sales (C) is $80).

Using all the above data, evaluate the effective credit and discount prices for the creditor firm. You may use 360 days in the formulae to simplify the calculations.

First, we must define the cost of trade credit, which represents an investment in cost of sales (C) over the credit period:

We then deduct this opportunity loss from the amount that is paid to the firm at the end of the period to yield the present value (PV) of that amount:

Using 360 days for simplicity, the effective credit price:

With regard to discount policy, we first define the investment in inventory associated with the discount period:

If we now deduct this from the discount price P (1 - c) to yield the effective discount price:

Again, using 360 days:

It is now clear that to offer a 30 day credit period and then provide a 2 per cent cash discount for payment within 10 days represents an additional price concession by the seller. Conversely, perhaps you recall from Chapter Six that this is precisely why the availability of the discount is too attractive to sacrifice for all buyers with similar financing costs.

Of course, in our original example, customers actually pay either effective credit or discount prices of $98.50 and $97.51 respectively. The different effective prices facing each party to the transaction of goods and services arise because we have substituted an inventory figure into Equations (23) and (25) for price in Equations (9) and (11). The cost of goods sold represents the seller's investment in working capital at the time the sale occurs. So, it is clearly the more appropriate measure for the creditor firm. Further adjustments could be made to the right-hand side of Equations (23) and (25), relating to the firm's investment in debtors between the date of sale and the eventual receipt of cash (but more of this later).

Of more immediate interest is the fact that the seller's decision to offer various discounts can also be analysed by modifying Equations (12) to (16) in Chapter Six (which defined the customer's annual cost of trade credit). For example, reformulating Equation (12) where (k) now equals the annual cost of offering (rather than receiving) discount terms, we can define:

Reversing the logic of Chapter Six (a customer's perception of the benefit of discount policy) we now observe that the creditor firm loses the discount (c) by allowing customers to advance payment by (T - t) days.

If sales to non-discounting customers can be financed at a lower rate (r) than the annual cost of the discount represented by:

The discount policy should not be implemented, unless it can profitably increase sales.

Returning to our Activity (using 360 days), Equation (27) confirms this view, which also corresponds to the range of effective prices calculated earlier and summarized in Table 8.1:

Table 8.1: The Impact of Credit Terms on Sales Price ($)