Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

customers taking the cash discount pay a lower price for the product). Companies that consider offering

a cash discount must perform a cost–benefit analysis to determine if the discount yields sufficient profits.

example

Leederville Industries has an average collection
period of 45 days: 37 days until the customers place
their payments in the mail; and a further eight days to
receive, process and collect payments. Leederville is
contemplating a change in its credit terms from net
30 to 2/10 net 30. The change is expected to reduce
the average collection period to 26 days.
Leederville currently sells 1,200 units of its
product for $2,500 per unit. Its variable cost per unit
is $2,000. It estimates that 70% of its customers will

take the 2% discount, and that offering the discount

will increase sales by 50 units per year, but will

not alter its bad debt percentage for this product.

Leederville’s opportunity cost of funds invested

in accounts receivable is 13.5% per year. Should

Leederville offer the proposed cash discount? The

cost–benefit analysis, presented in Table 18.4, shows

that the net cost of the cash discount is $2,846. Thus,

Leederville should not implement the proposed cash

discount.

TABLE 18.4 ANALYSIS OF OFFERING A CASH DISCOUNT AT LEEDERVILLE INDUSTRIES

Marginal profit from increased sales [50 units × ($2,500 – $2,000)] $ 25,000

Current investment in accounts receivable ($2,000a × 1,200 units) × (45 ÷ 365) $295,890

New investment in accounts receivable ($2,000a × 1,250 units) × (26 ÷ 365)b 178,082

Reduction in accounts receivable investment $117,808

Cost savings from reduced investment in accounts receivable (0.135 × $117,808)c 15,904

Cost of cash discount (0.02 × $2,500 × 1,250 × 0.70) (43,750)

Net profit (cost) from proposed cash discount $ (2,846)

a In analysing the investment in accounts receivable, we use the $2,000 variable cost of the product sold, rather than its $2,500 sales price,

because the variable cost represents the company’s actual cash expense incurred and tied up in receivables.

b The new investment in accounts receivable is tied up for only 26 days instead of the 45 days under the original terms. The 26 days is

calculated as (0.70 × 10 days) + (0.30 × 37 days) + 8 days = 26.1 days, which is rounded to 26 days.

c Leederville’s opportunity cost of funds is 13.5% per year.

CONCEPT REVIEW QUESTIONS 18-4

8 Why do a company’s regular credit terms typically conform to its industry’s standards? On what

basis other than credit terms should the company compete?

9 How are the five Cs of credit used to perform in-depth credit analysis? Why is this framework

typically used only on high-dollar credit requests?

10 How is credit scoring used in the credit selection process? In what types of situations is it most useful?

11 What are the key variables to consider when evaluating the benefits and costs of changing credit

standards? How do these variables differ when evaluating the benefits and costs of changing credit terms?

12 Why do we include only the variable cost of sales when estimating the average investment in accounts

receivable? Why do we apply an opportunity cost to this investment when estimating its cost?

13 What are the key elements of a company’s credit terms? What is a key determinant of the credit

terms offered by a company?