Fundamentals of Financial Management (Concise 6th Edition)

492 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management

subsidiaries.^14 Some companies actually earn more on credit than cash sales, and

their salespeople earn higher commissions when they make a credit sale.

The carrying charges on outstanding consumer credit are generally about 18%

on a nominal basis: 1.5% per month, so 1.5% $ 12 " 18%. This is equivalent to an

effective annual rate of (1.015)^12 # 1.0 " 19.6%. Having receivables outstanding that

earn more than 18% is highly pro! table unless there are too many bad debt losses.

Legal considerations must also be taken into account when setting credit pol-

icy. Under the Robinson-Patman Act, it is illegal for a! rm to charge prices that

discriminate between customers unless the different prices are cost-justi! ed.

The same holds true for credit—it is illegal to offer more favorable credit terms to

one customer or class of customers than to another unless the differences are

cost-justi! ed.

15-8c Monitoring Accounts Receivable

The total amount of accounts receivable outstanding at any given time is deter-

mined by the volume of credit sales and the average length of time between sales

and collections. For example, suppose Boston Lumber Company (BLC), a whole-

sale distributor of lumber products, has sales of $1,000 per day (all on credit) and

it requires payment after 10 days. BLC has no bad debts or slow-paying customers.

Under those conditions, it must have the capital to carry $10,000 of receivables:

15-5 Accounts receivable! Sales per day $ Length of collection period

! $1,000 $ 10 days! $10,000

If either sales or the collection period changes, so will accounts receivable. For

example, if sales doubled to $2,000/day, receivables would also double; and the

! rm would need an additional $10,000 to! nance this increase. Similarly, if the col-

lection period lengthened to 20 days, this too would double the receivables and

require additional capital.

If management is not careful, the collection period will creep up, as good cus-

tomers take longer to pay and as sales are made to weaker customers, who tend to

pay slowly or not at all and thus create bad debts. So it is important to monitor re-

ceivables. One easy-to-use monitoring technique employs the DSO. Here’s Allied

Foods’ DSO as calculated back in Chapter 4:

DSO!

Days

sales^

outstanding

! ___________________Rec eiv ables

Average sales per day

! _______________Receiv ables

Annual sales/365

! __________$375

$3,000/365

! _______$375

$8.2192

! 45.625 days ≈ 46 days

Industry average! 36 days

Allied has an average daily sales (ADS) of $8.2192 million, and those sales are out-

standing for 45.625 days. If we multiply the DSO by the average daily sales, we

determine the capital tied up in receivables:

Receivables! (ADS)(DSO)

! ($8.2192)(45.625)! $375 million

(^14) Companies that do a large volume of sales! nancing typically set up subsidiary companies called captive " nance
companies to do the actual! nancing. For example, General Motors, Chrysler, and Ford have captive! nance com-
panies, as do Sears, IBM, and General Electric.