Trade Credit Decisions

Trade Credit Decisions

Instructor Details

• Name: Jun Zhu

• Institution: Kelley School of Business

• Field: Finance

Learning Objectives

• Calculate trading credit decisions

• Understand Accounts Receivable (A/R)

• Monitoring and Control

Introduction to Credit and Receivables

• Credit Terms: When a firm sells goods and services, it can either demand cash on or before the delivery date or extend credit to customers, allowing for a payment delay.

• Reasons for Granting Credit:
    - To enhance sales by enabling customers who may not have immediate cash to purchase goods.

• Risks Associated with Granting Credit:
    - Potential for delayed payments or defaults.

• Creation of Accounts Receivable:
    - When credit is granted to customers, an Accounts Receivable is created.

• Definition of Trade Credit:
    - Trade credit is defined as credit granted to other firms, serving as a mechanism for financing operational needs between businesses.

Components of Credit Policy

1. Time: Refers to the total period customers have to settle their accounts after a sale.

2. Credit Sales: When a sale is made with an agreement for payment at a later date.
      

The Cash Flows of Granting Credit

• Flow:
    1. Customer mails a check to the firm.
    2. The firm then deposits the check into the bank.
    3. Cash collection is recorded in accounts receivable.
    4. The bank credits the firm’s account.

Trade Credit Policies Example

• Scenario: Penny Blossoms is offered trade credit terms of 2/10, net 30 by IU Supplier LLC for a $1,000 invoice.
    - Terms Explanation:
      - 2/10 means a 2% discount is available if paid within 10 days.
      - Net 30 means the full payment is due in 30 days.

• Borrowing Situation: Penny Blossoms currently has no cash available and needs to borrow funds.

• Annual Borrowing Cost: 5%.

Calculating Trade Credit Decisions

• Objective: Determine whether Penny Blossoms should accept the discount.

• Present Value (PV) Calculations:
    - PV Discount Calculation:
      $PV(disc) = rac{980}{1 + 0.05 imes rac{10}{365}} = -978.66$
    - PV Full Payment Calculation:
      $PV(full) = rac{1000}{1 + 0.05 imes rac{30}{365}} = -995.91$
    - Conclusion: Accepting the discount results in a lower present value amount, thus it is advisable to take the discount.

Float Neutral Calculation

• It represents a point where there’s indifference between taking a discount or not.

• Formulas:
    - $PV_{discount} = rac{P(1-D)}{1 + T imes OC/365}$
    - $PV_{full payment} = rac{P}{1 + N imes OC/365}$

• If both present values are equal, it represents a float neutral point.

• Further simplification yields:
    - $D = 1 - rac{1 + T imes OC/365}{1 + N imes OC/365}$

Practical Example for Penny Blossoms

• Scenario:
    - Penny Blossoms receives trade credit terms of 3/15, net 45 for a $5,000 invoice.
    - Annual Interest Rate for Borrowing: 8%.

• Effective Discount Rate Calculation:
    1. Identify cost of not taking discount and compare to opportunity cost.
    2. Total Interest Payment:
       - After not taking discount:
       - OC = rac{20}{980} imes rac{365}{20} = 37.23 ext{%}

• Conclusion: Given the opportunity cost exceeds borrowing rates, Penny Blossoms should take the discount.

Decision Factors When Forgoing Discounts

• Considerations for a buyer to forgo discounts include:
    - Inability to secure cash and costs of short-term borrowing exceed annualized discount rate.
    - Availability of cash but short-term investment rates surpass the annualized discount rate.

Case Study: Credit Policy at Howlett Industries

• Background:
    - Growth of Howlett Industries has stagnated; expansion in the economy could lead to increased sales.
    - Howlett's current policy is net 60 days; considering a discount for early payment.

• Investment Scenario:
    - Propose terms of 2/10 net 45 with a $200,000 average invoice and 8% cost of capital to evaluate profitability versus accepting cash after the net period.

Investment in Receivables

• Investment depends on credit sales and Days Sales Outstanding (DSO).

• Example Calculation:
    - Total sales of $310,000 over a 90-day period yielding a DSO of 82.74 days calculated as:
    - $DSO = rac{Outstanding A/R}{ ext{Avg. Daily Credit Sales}}$

• Further Analysis: Determine optimal credit terms versus current DSO and assess value of receivables based on historical sales data.

A/R Aging Schedule

• Composed of current and past-due receivables break into increments of 30 days.
    - Example:
      - Current: $1,750,000
      - 1-30 Days Past Due: $375,000
      - Total A/R: $2,500,000, providing a breakdown by percentage of total.

Example Practice Problem

• Given Penny Blossoms sells on terms of net 30 with accounts average 5 days past due, evaluate total accounts receivable resulting from $7.2 million annual credit sales.
    - $A/R ext{ Balance} = rac{ ext{Annual Credit Sales}}{365} imes ext{DSO}$

Summary and Wrap Up

• Review key concepts of credit policies, decision matrices involving discount acceptance, and fiscal responsibilities tied to accounts receivable management.

• Encourage analysis of cash flow impacts based on trade credit decisions to maximize business profitability.