A Switch in Time Saves Nine Simon sat at his office desk pondering over what was discussed at his last meeting with the Treasurer, Angela Krampf. The working capital of their firm, Progressive Farm Equipment Incorporated, had increased at an alarming rate over the past couple of years making the directors and top managers very concerned. Despite the implementation of a “jut in time” inventory system and more efficient cash management methods, the working capital continued to rise. This time, however, it was the accounts receivable that needed attention. Angela received a memo form the board asking her to review and rectify the credit management problem as soon as possible. One of the sentences in the memo read “…we simply cannot continue to carry our customers as long as we have been.” Angela had therefore called on her assistant, Simon Martinez, and briefed of the situation. Progressive Farm Equipment Inc. had been in business since 1945, producing small and medium sized tractors, tillers, and other firm equipment. Its customer base included various local and regional hardware stores, farm equipment stores, and repair shops. Most of the clients were strapped for cash and were accustomed to fairly flexible credit terms. The firm had been hard pressed to offer terms of net 60 to its clients, primarily to counter competition from national suppliers and to maintain good customer relationships. Sales had steadily increased over the years but over the past year, higher interest rates and a weakening economy had caused a slump in the agricultural sector leading to a drop in sales of farm equipment. Moreover, the number of farmers filing for bankruptcy had been increasing at an alarming rate. As Angela and Simon reviewed the accounting statements (see Tables 1 and 2) and the aging schedule of receivables, they realized that despite the fairly liberal credit terms of net 60, on average, 40% of credit sales were being collected 10 days late. The company had not implemented a policy of charging interest or late fees for fear of losing customers. They also noticed that over the past year the number of bad debt had gone up from 1% of sales to its current level of 2% of sales. Angela told Simon that the directors expected to see a proposal that would be realistic and effective. “On the one hand, we have to be careful about not turning customers way,” said Angela. “But on the other hand, we simply cannot afford to continue the current policy of allowing customers to pay late. Some credit will have to be given, but collections have to be tightened up. I guess the time has come for us to switch or suffer.” About six months earlier, Angela Krampf had recruited Simon Martinez, a certified financial manager, to assist her in managing the company’s working capital. Initially, it was the management of cash and inventory that needed modification. After much debates and discussion, a more conservative policy of cash management was implemented, followed by a successful integration of a just-in-time inventory management system. The quarterly statements showed that the modifications had worked. Angela and Simon were aware that the company’s collection policy was rather liberal. However, given the economic conditions and the sensitivity of the issue, they had refrained from suggesting any changes. As Simon pondered about what changes in the company’s collection policy he should recommend he realized that he would have to get some more data. He called up the folks in marketing and inquired about what effect a tighter collection policy would have. Upon being asked to be more specific, he told them that he was considering two alternatives: 1) 2/10 net 30, and 2) 2/10 net 60. He was told that under the first alternative, sales would probably decrease by about 10%. The sales people had built up a very good relationship with their customers and were confident that, despite the tighter credit terms, they could retain most of the accounts provided there was some incentive for paying early. Moreover, they inform Simon that most retailers could avail of commercial loans from banks at an average rate of interest of 14% per year. If the second alternative were implemented, the accounts receivable figure would be reduced without any loss of sales. Obviously, the sales people preferred the second approach. Simon estimated that under the new terms approximately 50 per cent of sales would be collected within 10 days. Of the remaining 50% of sales, roughly 60% would be collected within the credit period and the remaining 40% would be approximately 10 days late, as usual. Simon figured that he had better prepare pro-forma statements showing the impact these policies would have on the company’s bottom line and on the accounts receivable balance, before recommending any harsh penalties and so on. Table 1 Progressive Farm Equipment Incorporated Latest Fiscal Year’s Income Statement (‘000s) Sales 45,000 Costs of Goods Sold 29,250 Gross Profit 15,750 Operating Expenses 7,200 Earning Before Interest and Taxes (EBIT) 8,550 Interest Expenses (10% per year) 1400 Earning Before Taxes (EBT) 7150 Income Taxes (40%) 2860 Net Income 4290 Table 2 Progressive Farm Equipment Incorporated Latest Fiscal Year’s Balance (‘000s) Cash 2,000 Account Payable 3,200 Accounts receivable 7,890 Notes Payable 6,000 Inventory 6,000 Total Current Assets 15,890 Total Current Liabilities 9,200 Long-term Debt 8,000 Fixed Assets 20,000 Stockholders’ Equity 18,690 Total Assets 35,800 Total Liabilities & Owners’ Equity 35,890 Questions: Q1. What are the elements of a good credit policy? Evaluate Progressive Farm Equipment’s credit policy. Q2. Why is the increase in accounts receivable of concern to the board of directors? Are they justified in their demand for a tighter credit policy? Why? Q3. What is the amount of annual expense to the firm as a result of the delay in collections? What other risks do such delays entail? Q4. Calculate the cost of foregoing the 2% cash discount offered under the 2/10 net 30 and 2/10 net 60 terms respectively. Given that most retailers could take short-term loans from banks at the rate of 14% or less, evaluate the attractiveness of each policy. Q5. What are some other ways in which the company could speed up collections and reduce the receivables? Q6. Why has this slow built up in accounts receivable occurred? Could it have been avoided? How? Please explain. Q7. Develop the pro forma financial statements for the company under the two credit policy alternatives, i.e. 2/10, net 60; and 2/10 net 30 using the assumptions given. What would be the impact on the firm’s return on sales, return on investment, and return on equity? Q8. Which policy should Allan recommend to the board? Why?
Posted on: Sun, 22 Sep 2013 14:17:29 +0000
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