ACCOUNTS RECEIVABLE ANALYSIS AND THE ASSESSMENT OF CREDIT POLICY CHANGES

ACCOUNTS RECEIVABLE ANALYSIS AND THE ASSESSMENT
OF CREDIT POLICY CHANGES

The combination of sagging sales and greatly reduced rates of interest has caused many agribusiness
firms to reevaluate their current credit policies. As much as 20% of an agribusiness firm's assets may be
invested in accounts receivables, generated as a result of their sales on credit. Their credit policies,
therefore, would warrant careful review even when the economic conditions noted above do not provide
an added incentive. In general, most firms would rather do business on a cash basis, but competition and
the seasonal nature of their agricultural clients often require that credit terms be offered. While this
granting of credit may have a positive influence to the extent that it stimulates sales, it also generates
both direct and indirect costs for the firm. Herein lies the basic dilemma as agribusiness managers
attempt to balance the added costs and benefits of providing credit.

Good accounts receivable management begins first with the decision concerning whether or not to grant
credit. Second, much depends on the subsequent decision concerning whether or not to alter pre-existing
credit policies. Much has already been written regarding the first of these two decisions. Managers and
sales personnel are well indoctrinated regarding the firm's current credit policy, the expected credit
standards of its customers and the need to regularly monitor and control their accounts receivables
position. However, the second decision relating to credit policy alternatives and impacts is generally less
well understood by agribusiness industry personnel. The objective of this paper is to explore more fully
the basic relationships underlying the accumulation of receivables. Next, a means by which credit policy
changes can be evaluated is reviewed. And finally, I shall demonstrate how an agribusiness manager can
compute that break-even point where the added costs (e.g., bad debt) of a credit policy change are just
offset by the benefits accruing from sales increases which the credit policy change may have directly
stimulated.

Receivables Accumulation

The balance outstanding in your accounts receivable at a given point in time is largely a function of: (1)
the volume of credit sales, and (2) the average length of time intervening between those credit sales and
the collection of those accounts.

To create a simple scenario describing receivables accumulation, let's assume that you open a new retail
store on January 1 and generate $100 in credit sales per day and every business day thereafter. To
further simplify matters, let's assume that customers are given 10 days within which to settle their unpaid
accounts. At the end of the first day's business, your new firm will have $100 in accounts receivable and
this will reach $1000 by the tenth day. Beginning on the eleventh day of business, the $100 addition to
receivables will be offset by the collection of $100 from January 1 credit sales. In general, therefore, when
a firm is experiencing stable sales the following will exist:

?credit sales ? ?






length of
?
Accounts Receivable = ?
?× ?
?
per day
collection period
?
? ?
?
$1,000 = $100 ×10days

It's very easy now to see how a change in either sales or collection period will directly impact accounts
receivable. Notice also that the $1000 invested in accounts receivable is not a “free good.” In fact, that
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investment must be financed by someone. Suppose in our simple example that as the owner of your
business you had provided $100 in common stock to purchase the products sold during the first day of
business. On January 1, as you open for business, your firm's balance sheet would be:


Inventories
$100
Common Equity
$100

Total Assets
$100
Total Lib & Eqty.
$100

By the close of business on January 1 the balance sheet would appear as:1


Accounts Receivable
$ 100
Owner Equity
$100

Inventories
0
Total Lib. & Eqty.
$100

Total Assets
$ 100



To remain in business, however, you must replenish inventories each and every business day. Assuming
you borrow $100 from the bank for this purpose, and assuming the bank is willing to lend you this money
daily, by the eleventh day of business your balance sheet will appear as:


Accounts Receivable
$1000
Notes Payable
$1000

Inventories
100
Owner Equity
$ 100

Total Assets
$1100
Total Lib. & Eqty.
$1100

Under stable conditions, this balance sheet will have reached a "steady state" condition as the $100 in
receivables collected every day can be used to finance the credit sales made that day. But consider now
what would happen if after 10 business days, sales doubled to $200 per day. After yet another 10-day
transaction period, your notes payable to the bank would reach $2100 before once again reaching a
stable state. This example shows clearly that accounts receivable depend jointly on the magnitude of
credit sales and the length of the collection period. It also demonstrates that any increase in receivables
must be financed from some source other than product revenue.

You Should Change Your Credit Policy Components

Most agribusiness managers are aware that a general “easing” of credit policy components tends to
stimulate sales. For example, a lengthening of the credit period, a relaxation of minimum customer credit
standards, employing less rigorous and costly collection practices and/or offering cash discounts have all
been used within the agribusiness industry as means for stimulating sales. But, it's not a simple world! As
sales respond positively to such credit policy changes, some operating costs will also rise. To support the
added sales, more labor and other resources will need to be employed. As outstanding receivables
increase, the firm will confront greater carrying costs. And finally, bad debt and/or discount expenses can
be expected to mirror those sales increases. The first critical question which management must ask,
therefore, is whether sales revenues will rise more or less than the associated costs? Until this question
can be answered in a credible manner, managers will not be prepared to consider changes in any credit
policy components.

To better illustrate a procedure for analyzing proposed credit policy changes, the following income
statements for a hypothetical agribusiness firm “Agriserve” is provided (see Table 1). Column 1 reflects
the projected 1992 income for Agriserve under the assumption that the "current" credit policy is
maintained throughout the year. We're assuming that Agriserve has excess capacity so sales can be
increased without adding to the firm's general facilities or overhead expenses. Column 2 shows the "net
income (item j) impact" of those credit policy changes on each statement element. We're also assuming
that the “current” and "new” credit policy assumptions and components can be described as shown below
in Table 2: Column 3 shows the projected 1992 income reflecting the expected effects of “easing" in a
"new credit policy.”

As described above and in Tables 1 and 2, the new policy is expected to increase sales and lower
collection costs. However, discount expenses and other costs are expected to rise. We must next

1 Abstracting that some small profit on sales should have been generated.
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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)
(2)
(3)
Current Policy
Impact of
New Policy
Projected 1992 Policy Change Projected 1992
Income

Income
($ million)
($ million)
($ million)
a. Gross Sales
300
+ 100
400
b. - Discounts
1.46
+ 3.05
4.512
c. Net Sales
298.540
+ 96.95
395.488
d. Prod. Expense/Overhead (60%)
180.00
60.000
240.000

Credit Related Costs:


e. Cost of Carrying Receivables
1.575
+ 1.03
2.600
f.
Credit Analysis/Collection
5.000
- 3.00
2.000
g. Bad Debt
7.500
+ 16.50
24.000
h. Profit Before Taxes
104.465
+ 22.42
126.888
i.
Taxes (40%)
41.786
+ 8.97
50.755
j.
Net Income
62.679
+ 13.45
76.133

Additional Opportunity Cost
---
---
.250

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
-
60% of customers who pay do so on day
10 with discount
10 with discount
-
40% of customers who pay do so on day
-
half of remaining customers who pay do
30
so on day 40
-
10% of customers who pay do so on day
-
remaining other half of customers who
40
pay, do so on day 60
-
2.5% of sales are never collected
-
6.0% of sales are never collected
-
cash collections are reduced by
-
cash collections are reduced by
discounts taken
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
delinquent but pay on day 40. Therefore, ACP = .50 10 + .40 30 + .10 40 = 21days . Under the
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
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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

? $300,000,000 ?
21?
?(.60)(.15) = $1.575 million for the current policy
?
360
?

? $400,000,000 ?
26?
?(.60)(.15) = $2.600 million for the new policy
?
360
?

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/360)( ACP)(1-V)(k)
?
(
= $300,000,000/360)( 26 ? 2 )
1 (1? .60)(.15)
= $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.
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One added advantage of this computational procedure is that it provides a means by which management
can judge the firm's net income sensitivi ty to credit policy changes and the “bad debt” response to such a
change. For example, in the case of Agriserve, the easing of the credit policy, the relaxed efforts at
collections, etc. were expected to result in an increase in bad debt from 2.5 to 6.0% of sales. Yet despite
this added bad debt loss, the stimulus to sales and profits more than offset the impact. This may not
always be the case, of course, and management often questions just how large the bad debt loss could
grow before it would cause net income to decline. A “bad debt break-even analysis” can be linked to the
computational procedure described above such that this question can be answered.

Bad Debt Break-Even

Let's refer again to the Agriserve assumptions and conditions described earlier in our example; except
that the magnitude of the increase in bad debt is unknown. Agriserve's manager now wishes to know how
large this bad debt loss could grow under the new credit policy before it would begin to adversely impact
net income. Reviewing the computational arithmetic producing Table 1, Column 3 entries, we must simply
ask ourselves how large an entry in row g (also impacting row b) could be before the net income under
the new policy dropped to $62,679,000 (or that net income under the current policy)?

The mathematical solutions which are shown in Table 3 show that under the new credit policy, bad debts
could actually rise to 11.67% before net income would fall to that experienced under the current policy;
i.e., you would be no worse off (break-even) with 11.67% bad debt under the new policy than you were
with 2.5% bad debt under the current policy.

Table 3
New Credit Policy Specifications and Break-Even Computations

Row
Item
Amount

a.
1991 Gross Sales
= A
b.
$ Discounts
= A (1-B.D.)(% Discount)(% Paying ?10 days)

where: B.D .= bad debt as a decimal percent
% Discount = .02
% Paying
? 10 days = .60
c.
Net Sales
= A – ($ Discounts)
d.
Production Expense/Over.
= .60 A
e.
Cost of Carrying Receivables
=
? A ?
?
?(
ACP VCR )(
)
CFF
? 360 ?

where: ACP=.6(10)+.2(40)+.2(60)=26days
VCR=variablecostratio = .60
C. off. = cost of funds = .15
f.
Credit An./Col.
= cost of credit analysis and collection =$2,000,000
g.
$ Bad Debt
= (B.D.) A
h.
PBT
= profit before tax = Net Sales – (Prod. Exp./Over + Cost of
Cor. Rec. + Crd. Ap./Col. + $ Bad Debt
i.
Tax
= .40 (PBT)
j.
Net Income = N.I.
= PBT – Tax = $62,679,000 under current policy

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Our computations show that:

N.I. = (
1-.4) PBT, where:

PBT = (
A - $ Discounts) ? (Prod. Exp./Over + Cost of Car. Rec. + Cred. Ap./Col. + $ Bad Debt)
A = $400,000,000
$ Discounts = A (1 - B.D ). (.02)(.60)
Prod. Exp/Over = .6 A

? A ?
Cost of Car. Rec. = 26 ?
?(
.60) (.15 )
? 360 ?
Cred. An/Col. = $2,000,000
$ Bad Debt = (B.D.) A

?
?
?
(
?
?
?
=
? ?
? B D )( )( )? ?
?
(
)
400,000,000
$62,679,000
.6 400,000,000
400,000,000 1
. . .02 .6
.6 400,000,000 ? 26?
?
?
?
360
?


(.6)(.15)? 2,000,000 ?400,000,000B.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



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