# ACCOUNTS RECEIVABLE ANALYSIS AND THE ASSESSMENT OF CREDIT POLICY CHANGES

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3 compute those amounts to better evaluate the costs and benefits associated with the proposed credit policy change. Table 1 Agriserve, Inc. Income Statement (Projected) (Credit Policy Analysis Table) (1) Current Policy Projected 1992 Income (\$ million) (2) Impact of Policy Change (3) New Policy Projected 1992 Income (\$ million) (\$ million) a. Gross Sales b. - Discounts c. Net Sales d. Prod. Expense/Overhead (60%) Credit Related Costs: e. Cost of Carrying Receivables f. Credit Analysis/Collection g. Bad Debt h. Profit Before Taxes i. Taxes (40%) j. Net Income Additional Opportunity Cost Table 2 Credit Policy Alternatives Current (1/10, net 30) New (2/10, net 40) - \$5 million cost of collection - \$2 million cost of collection - \$300 million in annual sales - \$400 million in annual sales - Firm s cost of funds = 15% - Firm s cost of funds = 15% - 50% of customers who pay, do so on day 10 with discount - 60% of customers who pay do so on day 10 with discount - 40% of customers who pay do so on day 30 - half of remaining customers who pay do so on day 40-10% of customers who pay do so on day 40 - remaining other half of customers who pay, do so on day % of sales are never collected - 6.0% of sales are never collected - cash collections are reduced by discounts taken - cash collections are reduced by discounts taken Adjusted Computation Management must first compute the average collection period (ACP) under both policies. Under the current policy, half (50%) of the customers paying do so on day 10, 40% pay on day 30 and 10% are ACP = = 21days. Under the delinquent but pay on day 40. Therefore, C ( )( ) ( )( ) ( )( ) new policy ACP = (.60)( 10 ) + (.20)( 40 ) + (.20)( 60) = 26 days. N While Agriserve expects to spend \$5 million in credit analysis and collection efforts under the current policy, 2.5 % of sales will never be collected. Bad debt losses, therefore amount to (.025)(\$300 million) = \$7.5 million. Under the proposed new policy, credit analysis and collection costs would be reduced to \$2 3

4 million, but as a result of those reduced efforts, bad debts would rise to 6% of sales or (.60)(\$400 million) = \$24 million. Note that Agriserve's net income is reduced by the amount of discounts taken. Under the current policy, 97.5% of all customers do pay, and of those 50% take the 1% cash discount by paying within 10 days. Under the current policy, discounts can be calculated as (\$300 million)(.975)(.01)(.50) = \$1.46 million. If those customers who pay under the new policy (94%), 60% of those pay within 10 days and enjoy the larger (2%) discount. Hence, new policy discounts are (\$400 million)(.94)(.02)(.60) = \$4.51 million. Under both policies, variable production expenses are expected to average 60% of gross sales, i.e. if a customer buys goods worth \$100, Agriserve will have to invest \$60 in labor and materials. Under current and new policies, this calculates to \$180 million and \$240 million, respectively. When products are sold but not yet paid for, Agriserve must, therefore, finance 60% of their sales value (sometimes called the variable cost ratio). Agriserve's annual cost of carrying receivables, in turn, equals the average amount of receivables time the variable cost percentage times the cost of money used to finance those receivables, e.g.: Average Amt Variable Cost Cost of Cost of Carrying of Receivables = Ratio Funds Receivables The average amount of receivables for Agriserve is equal to the average collection period (ACP) times sales per day. Therefore, their cost of carrying receivables is: Sales Variable Cost ACP per Cost of = Cost of Carrying Receivables Day Ratio Funds OR \$300,000, (.60)(.15) = \$1.575 million for the current policy \$400,000, (.60)(.15) = \$2.600 million for the new policy Finally, it should be noted that the new credit policy results in a longer ACP. Hence, Agriserve will have to wait longer (26 vs. 21 days) to actually receive the profits on the products it sells. Agriserve, therefore, will incur an opportunity cost due to not having this cash from profits available for investment. This additional opportunity cost" is equal to the sales per day (current policy) times the change in ACP, times the contribution margin (1) minus the (variable cost ratio) times the cost of funds invested in receivables (k), or: Added Opportunity Cost = (Sales, Old Policy/)( ACP)(1-V)(k) = \$300,000,000/ = \$250,000 ( )( )( )( ) Computatorial Summary As shown in Table 1, the combined effect of the new credit policy on Agriserve's operations is a \$13.45 million increase in net income. Of course this is just an estimate as there always exists some uncertainty regarding the numerous assumptions incorporated into the illustrative example. However, the procedure alone provides management with a valuable tool for evaluating the benefits/costs associated with a contemplated change in credit policy. Without such a tool, management is left with no means for evaluating the interrelationships between credit policies and cash flow decisions. 4

6 Our computations show that: N.I. = ( 1-.4 ) PBT, where: ( ) ( Prod. Exp./Over + Cost of Car. Rec. + Cred. Ap./Col. + \$ Bad Debt) PBT = A - \$ Discounts A = \$400,000,000 \$ Discounts = A( 1 - B.D. ) (.02)(.60) Prod. Exp/Over =.6 A A Cost of Car. Rec. = Cred. An/Col. = \$2,000,000 \$ Bad Debt = (B.D.) A ( ) ( ) 400,000,000 \$62,679,000 =.6 400,000, ,000,000( 1 BD..)(.02)(.6).6( 400,000,000) 26 (.6)(.15) 2,000, ,000,000B.D. } Solving for B.D. =.1167 or 11.67% Conclusions For most agribusiness firms, the creation of a credit policy and the granting of credit to their customers have become commonplace activities. Management recognizes that a credit policy can often be used to stimulate sales. Management also recognizes that sales on credit generate added costs in the form of uncollected accounts and collection fees, along with the firm's need to finance those sales generated on credit. The first challenge, therefore, is for management to accurately evaluate the costs and benefits associated with credit transaction. The second quest is for management to correctly evaluate the economic/financial impacts of changing credit policies. The final goal, therefore, is to accurately measure the trade-offs between bad debt losses emerging from a credit policy alteration and the benefits of added sales stimulated in large part by the credit policy adjustment. This paper has attempted to address each of the goals or challenges posed above. It reviews a means of computing the costs and benefits of a hypothetical credit policy change. It demonstrates the computational procedures used to test the impact of such a credit policy change in the firm's net income. And finally, it outlines a breakeven procedure by which bad debt costs and sales increases can be equated. Ken D. Duft Extension Economist 6

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