terms of sale decisions

May 1, 20231

Fatima;

Terms of Sale Decisions

Working Capital ManagementFIN 6407

Terms of Sale DecisionChapter 5

Text: Modern Working Capital ManagementText and Cases

Frederick C. Scherr

May 1, 2023 2Fatima;


Main Focus:

Provides an introduction to the management of accounts receivable

Discusses decision methodologies with respect to the what terms of sale should the firm use



Creation of Accounts Receivable-Two Ways

a. Making advance payments to suppliers of inventories to ensure timely supply

b. Selling a firm’s outputs on credit to the “sundry debtors”

In an average, it constitutes 20%-30% of the total assets of the manufacturing firms



Why we grant credit?

The granting of credit from one business to another for the purchase of goods or services –trade credit

Trade credit is a major means of obtaining debt financing by businesses, more than commercial borrowings

Accounts receivable-arises from granting trade credit-conceived one-fourth of total assets



Why we grant credit? Apart from the basic attributes of the products,

trade-credit itself influences the distributor’s preferences to push the products of a particular manufacturer

For customers, trade-credit effectively reduces the price of the product because of time value of money

For the manufacturer, motives for extending trade credit are operating, marketing and financial



Trade credit performs useful economic functions, like-

Can provide the opportunity for financial arbitrage

Help to overcome an information problem in the sale of goods

May make the payment for goods less difficult

Trade-off between marketing and finance strategies

• A company having investments in manufacturing assets of Rs. 20,000 produces 360 units a year at a cost of Rs. 100 per unit. Market price of the product is Rs. 150 per unit. The company can sell its entire output to distributors at a 10 percent trade discount on the listed price with a credit period of two-months.


a. Should the company go for direct marketing with a capital investment of Rs.4000 in marketing assets? In addition to that marketing department’s overheads will claim Rs.3000 per year. But holding of receivables will come down to one month.


b. If working with external distribution channel, the company is currently expending an amount of Rs.1800 per annum for continuous market research and credit information through external agencies which will be reduced to Rs. 300 per annum under Option II, then what will be the new decision?


Maximum length of trade credit

Example: Basic price of the product is $10,000; cost of capital is 24% per annum, cost of sales is $8000, determine the maximum trade credit period ranging from 3 months to 12 months.


Limit the maximum length of credit period that a firm can allow on its receivables

Determination of maximum rate of cash discount

• Trade-off between the cost of giving up some part of invoice price and the benefits of quickening of cash inflows, increase in sales, reduction in outstanding receivables and a possible bad-debt losses

• Example: Present annual sales of a firm is Rs.1000 crore. Sales made on credit net 60 days, 50 percent of the receivables pay within 60 days, and the rest pay on 120 days. It is currently considering offering a cash discount of 2 percent (2/10, net 60). It is expected that who are paying within 60 days they would pay on their previous pattern. Cost of capital is 20 percent. Determine if to alter the cash discount policy or not?


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Fatima;


Possibility of Financial Arbitrage Granting credit is equivalent to granting a

loan from the seller to the buyer The seller bears the cost of this

loan….how? Cost of trade credit is same as selling at a discount.

Buyer may not be able to borrow at economical rate, sellers can borrow from the capital market and lend it to the buyer through trade credit



Buyer’s Imperfect Knowledge Regarding the Quality of the Products Purchased

If payment for purchases is not made instantly, the buyer has the option to reduce the price and return products for defective qualities

A large number of staffs are engaged in the transaction process, there is chance of theft and fraud in cash sales



Costs, Revenues and Credit Decisions

Firm’s terms of sales and credit-granting decisions affect it’s sales volume

Also affects the level and timing of certain costs

Policy evaluation procedures have to compare these sales and costs effect



It is expected to influence: Collections on Sales would increase Investment in Inventory due to increase or

decrease in inventory Cost of Sales would be influenced as several

types of costs like direct labor, direct material, etc.

Discounts and Bad Debt Expenses are the deductions from the expected level of cash inflows

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It is expected to influence: Collection costs of accounts receivable

are costly Credit policies can influence timing and

amount of future capital expenditures Changes in credit policy may also affect

the firm’s tax payments Salvage and Recovery Values of

accounts receivable, inventory and capital assets

May 1, 202318

Fatima;


Terms of Sale Decisions: Standard Approach

Terms of sale must in almost all cases, be same for all the firm’s customers, although the selling firm may require some specific buyers to pay cash because of the high costs of granting credit to them

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Terms of Sale involves three parameters

The cash discountThe cash discount periodOptimum terms of sales that ensures

highest possible Net Present Values

Analyze the effects of changes of terms, the positive changes will make move toward the optimum terms of sale

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A firm is changing it’s terms of sales from net 30 days to net 60 days (it does not offer a cash discount ), the change in terms will not affect the collection expenses or bad debt expenses. The firm’s current sales are $ 50 million per year, and it is estimated that the new policy would increase the sales to $ 53 mil. The out-of-pocket costs of materials are 80 percent of sales and the required rate of return is 12 percent. Should the firm take the change?


Credit-Granting Decision


Management’s decision-making about which of the selling firm’s credit applicants will be allowed to purchase goods and services on credit, and which will be required to pay cash. Also called as credit standard policy.




A selling-firm can either follow the same rule for every customer. Again it can analyze each customer separately to grant credit.

Either a standard set of rules for all customers

Or customized on the basis of each customer’s profile

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Terms of Sales Vs. Credit-Granting Decision

The firm’s terms of sale policy is in aggregate across customers, the level of analysis for credit-granting policy can be at the level of individual customers.

Terms of sale decision are made infrequently (when required), while credit-granting decision occurs constantly as when a new customer comes and old customers are reviewed.



Credit-Granting Decision Policy Questions

How much information should the firm collect on each credit applicant?

What method of analysis should the seller use to determine which applicants should be granted credit?



Credit-Granting Decision Policy Questions

How many periods should be considered in evaluating the expected cash flows from selling to an applicant?

How should the credit granting parameters of credit applicants be estimated?



Information Costs and Credit-Granting Decision

The selling firm evaluates the cash flows that would result from granting credit to a credit applicant versus those that would result if credit were not granted to that applicant.

These cash flows result from the cost and revenue effects of the decision.



Changes in sales and collections, cost of productions, bad debt expenses, etc. that are related with granting or not granting credit.

These sources vary in their costs and their type of information they provide.

Several sources of information are:



The seller’s prior experience with the customer

Credit agency ratings and reports Personal contract with applicant’s bank

and other creditors Analysis of the applicant’s financial

statements Customer visit

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An applicant has placed an order with the seller for $75,000 worth of goods and services which actually costs $60,000 to provide. If the applicant pays, it is expected that payment will be received in 60 days. If the applicant defaults, a 10 percent recovery is expected, and it is expected that the courts will take two years to liquidate the firm and disburse the proceeds. The estimated probability of default is 25 percent and the required return is 10 percent per year. Should the credit be granted?

• A seller facing a tax-rate of 33 percent has received an order for $100,000, the cost of materials for serving this order will be $ 85,000; the estimated probability of default is 10 percent and the estimated recovery rate is 20 percent. If the applicant does not default, the payment is expected within 75 days; if the applicant does default, the disbursement from the court will be received in three years. The required rate of return is 13 percent per year. What is the expected net present value of the credit?

Thank You

terms of sale decisions

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