Alternative Credit Policies, Working Capital Investment and Corporate

Profitability

For the purpose of exposition, the preceding analysis was kept deliberately simple. Although informative, it was static and only related to a single transaction. It revealed nothing concerning the dynamic impact of the terms of sale on overall demand and hence turnover, working capital and incremental profitability for a creditor firm. So, let us introduce these variables.

Consider a company that is motivated by the conviction that its long-term growth and profitability appear unlimited. In the short term it is only constrained by a predetermined output capacity beyond which prohibitive production costs arise. We shall also assume (not unreasonably) that in the short term, it has still not achieved full capacity working. The company's objective is to increase sales for its product to a point of maximum profit by introducing trade credit. Finally, let us assume that the physical volume of credit sales is a positive function of the terms of credit, and that its competitors will not react to any changes in the firm's credit policy.

Armed with knowledge of how prospective credit terms might influence demand, short term investments and the means of financing those investments; let us introduce a series of financial variables which the firm wishes to model:

The potential impact of trade credit is measured by determining that credit policy, which provides the highest post-tax profit (P) requiring the following estimates:

- Cash revenue (R) that includes collections from debtors ("accounts receivable") to use American parlance) plus cash sales obtained by the firm from alternative credit policies.

- Cash expenses (V)

- Investment (I) for each credit policy.

Given these estimates, plus the firm's own cost of capital (r) and the tax rate (b), we can establish the following objective function:

(28) Max P = [(1 - b) (R - V)] - r (I)

Suppose we now compare existing cash sales (A) with four feasible credit periods (B increasing through E) over a particular planning period.

To evaluate each policy and ascertain the net revenues from anticipated sales volume, the impact on debtors, revenues and expenses first needs to be established. Table 8.2 summarizes assumed values for these variables, with supplementary notes on their derivation.

Credit Policy

Debtors

R

Sales

V

Acquisition

Cost of

Inventory

V

Bad Debt Loss

V

Operating cost

Net Revenues

Net

Revenues after tax

A

0

120

84

0

24

12.0

6.0

B

10

240

168

0

42

30.0

15.0

C

25

300

210

0.6

50

39.4

19.7

D

42

340

238

2.6

57

42.4

21.2

E

60

360

252

5.0

60

43.0

21.5

Notes: Net revenues = (R - SV)

Acquisition cost of inventory = 70 per cent of selling price

Tax rate b = 50 per cent

Net revenues after tax = (1 - b) x Net revenues

Table 8.2: The Impact of Alternative Credit Policies on Revenue and Cost (£million)

We can see that each credit period results in a unique structure of costs and revenues. As the credit period lengthens, the firm produces additional sales because the effective price for each potential customer falls. Quantity demanded continues to increase as new customers are attracted in and existing ones buy more. Only when full capacity working is achieved does an incremental increase in the credit period fail to increase turnover.

Set against this benefit are the increasing costs of sales associated with extending the credit period. These are represented by production outflows required to acquire stocks, as well as operating costs. They include the holding and ordering costs of inventory, plus other expenses incurred both directly and indirectly in selling the firm's product.

For each credit period, the short term investments in each operating cycle over the planning period represent the optimal balances, given the anticipated demand in that cycle. So, in an "ideal world" if the supply of raw materials were perfectly elastic the firm would not plan to hold stocks. Similarly, as soon as cash was expected to be received from sales it would not be held idle, but committed to the expansion of production outlays, utilized to repay any borrowings, or even distributed to the owners provided the firm's precautionary needs were satisfied.

Table 8.3 illustrates the investment (I) required for each policy. Optimal cash investment in debtors is assumed to be 80 per cent of the corresponding debtor figure in Table 8.2. The 20 per cent difference is the profit that the investment produces. It is also assumed that the firm maintains 60 days of sales in inventory, i.e. increasing sales necessitates an increase in stocks.

Credit Policy

Cash Investment for

debtors

Inventory Investment

Total Investment

A

0

14.0

14.0

B

8.0

28.0

36.0

C

20.0

35.0

55.0

D

33.6

39.6

73.2

E

48.0

42.0

90.0

Notes: Cash investment in debtors = 80 per cent of debtors, (from column 1, Table 8.2). Investment in inventory = 60 days sales, I.e. the acquisition cost of inventory x 60/360 (from column 3, Table 8.2).

Table 8.3: Investment for Alternative Credit Policies (£ million)

Returning to our creditor firm's objective profit function represented by:

(28) Max P = [(1 - b) (R - V)] - r (I)

The remaining factor to consider is the creditor firm's cost of capital (r) which calibrates its opportunity cost of capital rate. Estimated correctly (r) represents the borrowing undertaken to finance the firm's optimal balances flowing from that combination of fund sources that minimise the total cost of borrowing over the planning period.

You should also note that subject to there being no loss of goodwill:

Management should limit the outflow of cash to its own creditors to the extent that its marginal cost of capital at the time of repayment is expected to exceed that of the original fund source to be repaid.

Applying the logic of our previous framework of trade credit equations (bearing in mind that our firm is also a "customer") it should not take the discount but always opt for the credit period, if its suppliers offered credit terms of (c / t: T) whenever:

Returning to our analysis, if we now assume that the firm's opportunity cost of capital rate (r) remains constant at 18 per cent, the net profit (P) associated with each credit policy can be calculated using Equation (28).

Net Profit for Alternative Credit Policies (£million)

Table 8.4: Net Profit for Alternative Credit Policies (£million)

As Table 8.4 reveals:

- A maximum net profit (P) of £9.8 million is achieved by adopting credit policy C.

- By definition this is the optimum policy, relative to those under consideration.

Summary and Conclusions

The preceding analysis provides a theoretical insight into how credit policy should underpin efficient "real world" working capital investment and hence overall cash profitability. Actual company's operations may be more sophisticated than the single product model presented here. But as we shall discover, academics have long maintained that there is no contention about its utility or applicability when placed in a wider context. The fundamental problem relates to the reluctance of creditor firms to depart from convention (notably standard industry terms and the conventional interpretation of financial accounts by external users) to improve their trading position.

With information on how sales vary with price (the demand function) multi-product firms can evaluate different combinations of credit periods and cash discount policies, by measuring their net benefit to each potential buyer in terms of an effective price reduction associated with their opportunity cost of capital.

The incorporation of cash discounts into the analysis present few problems. Management should model different discount terms within the context of different credit periods to attract the potential buyer whose effective price is relatively high due to a low opportunity rate.

To summarise our position:

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 utilised to provide a lower cash price for those customers with low opportunity rates.

This would mean the receipt of less money but sooner. But set against this would be shorter operating cycles, and lower financing costs.

Under the conditions stated, optimal credit terms would be that combination of credit period and discount policy, which maximized profits.

 
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