Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVII. Short−Term Financial
Planning and Management- Credit and Inventory
Management
(^738) © The McGraw−Hill
Companies, 2002
immediate purchase and sale of our merchandise. The reason is that the buyer effec-
tively has a loan from us even after the merchandise is resold, and the buyer can use that
credit for other purposes. For this reason, the length of the buyer’s operating cycle is
often cited as an appropriate upper limit to the credit period.
There are a number of other factors that influence the credit period. Many of these
also influence our customer’s operating cycles; so, once again, these are related sub-
jects. Among the most important are:
1.Perishability and collateral value.Perishable items have relatively rapid turnover
and relatively low collateral value. Credit periods are thus shorter for such goods.
For example, a food wholesaler selling fresh fruit and produce might use net seven
days. Alternatively, jewelry might be sold for 5/30, net four months.
2.Consumer demand.Products that are well established generally have more rapid
turnover. Newer or slow-moving products will often have longer credit periods
associated with them to entice buyers. Also, as we have seen, sellers may choose to
extend much longer credit periods for off-season sales (when customer demand is
low).
3.Cost, profitability, and standardization.Relatively inexpensive goods tend to have
shorter credit periods. The same is true for relatively standardized goods and raw
materials. These all tend to have lower markups and higher turnover rates, both of
which lead to shorter credit periods. There are exceptions. Auto dealers, for
example, generally pay for cars as they are received.
4.Credit risk.The greater the credit risk of the buyer, the shorter the credit period is
likely to be (assuming that credit is granted at all).
5.Size of the account.If an account is small, the credit period may be shorter because
small accounts cost more to manage, and the customers are less important.
6.Competition.When the seller is in a highly competitive market, longer credit
periods may be offered as a way of attracting customers.
7.Customer type.A single seller might offer different credit terms to different buyers.
A food wholesaler, for example, might supply groceries, bakeries, and restaurants.
Each group would probably have different credit terms. More generally, sellers
often have both wholesale and retail customers, and they frequently quote different
terms to the two types.
Cash Discounts
As we have seen, cash discountsare often part of the terms of sale. The practice of
granting discounts for cash purchases in the United States dates to the Civil War and is
widespread today. One reason discounts are offered is to speed up the collection of re-
ceivables. This will have the effect of reducing the amount of credit being offered, and
the firm must trade this off against the cost of the discount.
Notice that when a cash discount is offered, the credit is essentially free during the
discount period. The buyer only pays for the credit after the discount expires. With 2/10,
net 30, a rational buyer either pays in 10 days to make the greatest possible use of the
free credit or pays in 30 days to get the longest possible use of the money in exchange
for giving up the discount. By giving up the discount, the buyer effectively gets 30 10
20 days’ credit.
Another reason for cash discounts is that they are a way of charging higher prices to
customers that have had credit extended to them. In this sense, cash discounts are a con-
venient way of charging for the credit granted to customers.
CHAPTER 21 Credit and Inventory Management 711
cash discount
A discount given to
induce prompt payment.
Also, sales discount.