Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

21. Credit and Inventory
    Management

(^736) © The McGraw−Hill
Companies, 2002
outstanding. If credit sales run $1,000 per day, the firm’s accounts receivable will then
be equal to 30 days $1,000 per day $30,000, on average.
As our example illustrates, a firm’s receivables generally will be equal to its average
daily sales multiplied by its average collection period, or ACP:
Accounts receivable Average daily sales ACP [21.1]
Thus, a firm’s investment in accounts receivable depends on factors that influence credit
sales and collections.
We have seen the average collection period in various places, including Chapter 3
and Chapter 19. Recall that we use the terms days’sales in receivables, receivables pe-
riod, andaverage collection periodinterchangeably to refer to the length of time it takes
for the firm to collect on a sale.
TERMS OF THE SALE
As we described previously, the terms of a sale are made up of three distinct elements:

1. The period for which credit is granted (the credit period)


2. The cash discount and the discount period


3. The type of credit instrument
   Within a given industry, the terms of sale are usually fairly standard, but these terms
   vary quite a bit across industries. In many cases, the terms of sale are remarkably ar-
   chaic and literally date to previous centuries. Organized systems of trade credit that re-
   semble current practice can be easily traced to the great fairs of medieval Europe, and
   they almost surely existed long before then.

The Basic Form

The easiest way to understand the terms of sale is to consider an example. For bulk

candy, terms of 2/10, net 60 are common.^1 This means that customers have 60 days from

the invoice date (discussed a bit later) to pay the full amount; however, if payment is

made within 10 days, a 2 percent cash discount can be taken.

Consider a buyer who places an order for $1,000, and assume that the terms of the

sale are 2/10, net 60. The buyer has the option of paying $1,000 (1
 .02) $980 in

10 days, or paying the full $1,000 in 60 days. If the terms are stated as just net 30, then

the customer has 30 days from the invoice date to pay the entire $1,000, and no discount

is offered for early payment.

CONCEPT QUESTIONS

21.1a What are the basic components of credit policy?

21.1bWhat are the basic components of the terms of sale if a firm chooses to sell on

credit?

CHAPTER 21 Credit and Inventory Management 709

(^1) The terms of sale cited from specific industries in this section and elsewhere are drawn from Theodore N.
Beckman, Credits and Collections: Management and Theory(New York: McGraw-Hill, 1962).

21.2