Summary and Conclusions
Empirical Evidence and Theoretical Review
Looking back over forty years at the pivotal role of credit terms policy within the theory and practice of working capital management, the purpose of this Chapter is to produce a selective overview of empirical work conducted by academics, analysts and professional bodies.
To provide a sequential analysis within a defined macro-economic framework, most of the material is based on the UK literature with reference to the European Union (EU). Hopefully, on completion of this text, you will then pursue comparative research from your own country as a guide to further study.
Part One of our text (like all others in the author's bookboon series) introduced the time-honored normative objective of finance theory as a convenient benchmark for subsequent analysis and critique. Namely, that a company should maximise shareholder wealth using an NPV investment model that incorporates optimum financing, a combination of which maximises the net cash inflow of all its projects at minimum cost.
Within this overall strategy:
Management's working capital objective should be to maximise current liabilities and minimise current assets compatible with their company's debt paying ability, based upon future cash profitability dictated by their optimum terms of sale.
Part Two defined working capital as an investment in current assets irrespective of their financing source. This definition questioned the accounting conventions of solvency and liquidity revealed by traditional Balance Sheet analyses.
We observed that if firms strive to maintain a 2:1 working capital ratio of current assets to current liabilities, supported by a "quick" asset ratio of 1:1, these policies are likely to be sub-optimal relative to normative wealth maximisation criteria.
The point was proven by reference to the interrelationship between a firm's short-term operating and financing cycles in an ideal world, whereby:
Inventory is purchased on credit using "just in time" (JIT) inventory control techniques. Finished goods are sold for cash on delivery (COD).
Cash surpluses do not lie idle, but are reinvested or distributed as a dividend. So that:
The operating cycle (conversion of raw material to cash and its reinvestment or distribution) is shorter than the financing cycle (creditor turnover).
Part Three also departed company from conventional external Balance Sheet ratio analyses of a firm's operating and financing cycles to reveal why:
Optimum terms of sale determine an overall working capital structure, which comprises optimum investments in inventory, debtors, cash and creditors.
The incremental gains and losses associated with a creditor firm's terms of sale were evaluated within a framework of "effective" prices using the following equations from Chapter Six. These define the customers' credit price (P') and discount price (P") 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") we analysed 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 can be represented 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 then confirmed 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 utilised to provide a lower cash price for those customers with low opportunity rates.
To summarise: 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: