Exercise 7.5: Terms of Sale: A Review
The preparation of a cash budget in our previous Exercise reveals how a creditor firm's investment in current assets and other cash outflows relating to its operating cycle, as well as the borrowing and associated costs required to sustain it, (the financing cycle) are primarily a function of the terms of sale.
So, to conclude our analysis, let us re-examine how a change in either the credit period or cash discount policy results in a unique structure of costs and revenues associated with a company's sales turnover by creating a unique level of demand, which determines its working capital commitments.
Despite the use of net present value (NPV) techniques to vet all new capital investments, Goldfrapp plc is experiencing continual liquidity problems. The Board believes that somehow, the terms of sale are the root cause and has employed financial consultants to review the company's working capital function.
The consultancy's first observations are that with standard industry terms of 2.5/10:40 offered to all its customers, liquidity is indeed a problem, if only because Goldfrapp's actual debtor turnover ratio revealed by its latest annual accounts is 85 days.
A detailed analysis of the company's credit-related demand function prepared by the consulting team confirms that a move to uniform terms of 1/15:45 should not only improve cash flow, but also increase sales without compromising future profitability.
Applying the available Goldfrapp data to what you have learned from this study's Exercises and companion texts:
1. Explain why the company's current working capital position is at variance with an optimum investment in current assets and current liabilities, which maximizes the inflow of cash at minimum cost.
2. Derive the customers "decision to discount" using three annual "cost of trade credit" calculations based on:
o Current terms of sale (2.5/10:40)
o Current discount policy with a debtor turnover of 85 days (2.5/10:85)
o Revised terms of sale (1/15:45)
3. Comment on your results.
4. Explain how the previous "decision to discount" calculations can be reformulated within a theoretical framework of "effective" prices
5. Examine the "effective" price benefits of revising the company's credit terms from 2.5/10:40 to 1/15:45 using all the available information.
An Indicative Outline Solution
Your answer requires an analysis of working capital efficiency that compares alterative costs of trade credit and effective prices, relative to those based on Goldfrapp's current terms of sale.
1. Efficient Working Capital Management
As far back as Chapter One, we defined working capital as an investment in current assets irrespective of its financing source and rejected the accounting convention that firms need to maintain 2:1 and 1:1 working capital and liquidity ratios revealed by a published Balance Sheet. Such policies are invariably sub-optimal, relative to the normative wealth maximization criteria of financial management.
Management's objective should be to minimize current assets and maximize current liabilities compatible with their debt paying ability, based upon future cash profitability.
These points were illustrated in Chapter Three by reference to the "ideal" relationship between a firm's short-term operating and financing cycles, where raw materials are purchased and finished goods are sold on credit, subject to the proviso that:
Operating cycles (conversion of raw material to cash) < Financing cycles (creditor turnover)
Although we are not aware of the company's overall working capital position (current assets relative to current liabilities), Goldfrapp plc has a particular problem. Based on available data, its average debtor turnover of 85 days far exceeds the legitimate credit period of 40 days.
2. The Annual Cost of Trade Credit
The decision to discount is based on the creditor firm's annual cost of trade credit exceeding a customer's assumed annual opportunity cost of capital rate (r). Using the familiar Equation (13) from our previous studies:
r < k = 365c / (T-t) (Take the discount)
Three annual costs of trade credit (k) can be derived from the company data:
Credit Terms (2.5/10:40) (2.5/10:85) (1/15:45)
Cost of Trade Credit (k) 30.4% (current) 12.2% (default) 12.2% (revised)
3. A Commentary
The simple interest calculations, using the right-hand side of Equation (13) illustrate the enormous financial burden (k) of not taking the discount that Goldfrapp's terms have imposed on all its customers, irrespective of their borrowing opportunities (r). Explained simply:
I Given today's term structure of interest rates, no company borrows funds at 30.4 per cent. I
Consequently, most debtors have obviously abandoned their agreed terms of sale (2.5 /10: 40) altogether, resulting in the average 85 day debtor turnover ratio.
Many are foregoing the cash discount and unilaterally extending their repayment period, not only beyond the legal maximum of 40 days but also well beyond 85 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.
4. The Effective Price Framework
Throughout this study (and its companions) we have noted that corporate terms of sale need not conform to industry norms.
Variations in the cash discount, discount period and credit period all represent dynamic marketing tools, which are a form of price competition. Based upon the time value of money and opportunity cost concepts, they create purchasing power for discounting and non-discounting customers by offering lower effective prices, all of which should increase demand for the creditor firm and hopefully net profits from revenues.
A firm should design its credit periods to ensure low effective price, high risk customers (with high opportunity rates) who forego the cash discount pay on time. Discount policy should be utilized to provide a lower effective cash price for low risk customers (with low opportunity rates) as an incentive for early payment.
With a COD price (P) on terms (c/t: T) and a customer opportunity rate (r), the generic decision to discount, based on the annual cost of trade credit [k = (365c/T-t)] can be reformulated using a framework of effective discount and credit prices and compared as follows.
5. Revising the Company's Credit Terms
Finally, given the previous general theoretical formulations, let us illustrate the Board's dilemma by applying the limited information for Goldfrapp plc to a specific class of customer.
Decisions to discount for any class of customer with a given opportunity rate (r) based on the formula [k = (365c/T-t)] can be confirmed by an effective price framework (at one extreme C.O.D., at the other the credit period and in between the discount period) even without price information.
For example, if Goldfrapp moves from the current terms of sale (2.5/10:40) to those recommended by their management consultants (1/15:45):
The whole range of effective prices, denoted algebraically by an initial cash price (P) for those customers with an annual opportunity rate (r) of 10% can be defined as follows:
Where the price subscripts (O and R) relate to original and revised terms, respectively.
Because the only unknown in the series of equations is the uniform cash price (P) those variables for which we have data combine to provide a valid arithmetic comparison (the figures in brackets) of the range of effective prices. These calculations confirm the company's dilemma illustrated by our previous cost of trade credit data.
The series of inequalities reveal that the original credit period offered by Goldfrapp plc is too harsh and the original discount policy is an expensive concession for all (think about it).
The Annual Cost of Credit (k) 30.4% (current terms) 12.2% (revised terms)