Corporate Finance

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Corporate Finance

Receivables must be financed from current income or new debt or equity. Money doesn’t come free.
There are costs attached to these. Firms will have to incur capital expenditure on computing equipment to
maintain sales ledger, pay salaries to clerks and other personnel for follow up action, pay rent, etc. These are
the administrative expenses. All customers may not pay on or before the due date. Some collection efforts
are required to prompt them, which involves additional expenditure. Some of the accounts may turn bad
resulting in bad debt losses. The effect of granting credit on profits is rarely understood. The following
numerical, considering three companies, illustrates the same:

Company A Company B Company C

Sales 1.2 lac 1.8 lac 2.1 lac
Credit period 60 days 90 days 120 days
Debtors 20,000 45,000 70,000
EBIT 6,000 9,000 10,500
Cost of financing @ 13 percent p.a. 2.16 percent or 3.25 percent or 4.33 percent or
i.e., 1.08 percent p.m. Rs 432 Rs 1,463 Rs 3,033
PBT 5,568 7,537 7,967

Company A sells on 60-day credit, B on 90-day credit, and C on 120-day credit. As demonstrated by the
illustration, net profit decreases when credit period is extended to 120 days, because the cost of financing
outweighs the increase in profit on additional sales.

Credit Terms

These are terms of the sales that define credit variables like number of days of credit, percentage of discount
on selling price for prompt payment, and penalty for extension of credit period. A number of factors affect a
company’s credit terms:

• Nature of product and industry. In capital equipment businesses like industrial boilers, customers typically
  make an advance payment to the company to manufacture a custom-built boiler. At the other extreme,
  customers get three months’ credit or deferred payment in some businesses. Most companies fall in this
  continuum. In case of hotels, customers pay concurrently as and when they consume service.


• Credit terms of the company’s suppliers. Companies that get generous credit from suppliers would be
  able to pass on at least a part of the benefit to their customers.


• Cash flow position of the company. A company facing a cash crunch would be working towards accelerating
  receipts rather than decelerating. So we would expect a company facing cash flow problems to enforce
  stricter credit terms.


• Structure of the industry. In a buyer’s market, other things remaining constant, a company may have to
  extend credit just to match competition.


• Volume of sales involved. The higher the offtake, the more generous would be the credit terms.


• Cost of capital for the company. A company can offer credit if the cost of capital is less than the benefits
  of sale. A higher cost of capital would discourage a company from offering credit.


• Character of the customer. Previous experiences with a customer tend to get reflected in the attitude of
  the company. Customers who make prompt payments get better terms than delinquent customers.

The sale may require a company to make payment in advance, or on receipt of invoice/delivery of goods
or after delivery at some specified point in future. Cash discounts are generally offered on invoice price if