Question

Ray Hetchka, a retired English professor, recently launched a new business in Miami called Ray’s Bonefish Paradise (RBP). Ray decided at age 62 that he wasn’t quite ready to retire early and lounge around at home living the life of leisure. Ray’s passion is fishing, and he always dreamed of opening a saltwater fly fishing specialty company. Since Ray’s educational background was in literature and not in business, he hired you, as a noted business finance expert, to help him with the company’s cash management and credit policies. Regarding his company’s credit policy, Ray also needs your help to determine if changes are needed. One of his summer interns from the local community college, who will soon graduate with a finance major, recommended that the credit terms be changed from 2/10, net 30 to 3/20, net 45 and that both the credit standards and the collection policy be relaxed. According to the intern, this change would cause sales to increase from $3.6 million to $4.0 million. Currently, 62.5% of RBP’s customers pay on Day 10 of the billing cycle and take the discount, 32% pay on Day 30, and 5.5% pay (on average) on Day 60. If the new credit policy is adopted, Ray estimated that 72.5% of customers would take the discount, 10% would pay on Day 45, and 17.5% would pay late, on Day 90. Bad debt losses for both policies are expected to be trivial. Variable operating costs are currently 75% of sales, the cost of funds used to carry receivables is 10%, and the marginal tax rate is 40%. None of these factors would change as a result of a credit policy change. Ray is very eager to learn, so he asked you to perform a detailed analysis and report to help him understand cash management and credit policies. Make sure your report includes details and examples that can help Ray better understand the following key decision points:

g. What variables make up a firm’s credit policy? In what direction would each be changed if the credit policy is relaxed? How would each variable tend to affect sales, the level of receivables, and bad debt losses?

h. How are the days sales outstanding (DSO) and the average collection period (ACP) related to one another? What would the DSO be if the current credit policy is maintained? If the proposed policy is adopted?

i. What is the dollar amount of discounts granted under the current and the proposed credit policies?

j. Should RBP make the credit policy change? Assume that operating and credit costs are paid on the day of the sale.

Answer 1

g.) Variables that makes a firms credit policy

1.Credit standards: To qualify for the credit, customer must meet the credit standards. It is the minimum acceptable financial position required to avail credit. It is driven by financial strength and varies from customer to customer. Tight credit standards would cause decrease in sales as only few customers will qualify for credit, decreased level of receivables and decreased amount of bad debts

2. Credit terms : Refers to conditons of credit sale, credit period allowed, cash discounts etc.

3. Collection Policy : Procedures the firm follows to collect past due accounts. Tight collection policy decreases account receivables and decreases bad debts.

4. Monitoring Function: Periodic evaluation of receivables and customers payment patterns to ensure credit policy is being administered correctly and to determine whether changes in the policy are necessary.  

A relaxing credit policy would tend to increase sales, receivables and bad debts, while a tightening one will have exactly the opposite effect.

h) ACP and DSO measure the same thing the average length of the time the firm must wait after making a sale before receiving payment. DSO is more preferred term.

DSO(Old)= 0.625(10) + 0.32(30) + 0.556(60) = 19.15 days~19 days

DSO(New)= 0.725(20) + 0.10 (45) + 0.175(90)= 34.75 days~35 days

i)

Discount (old) = 0.02* 3600000*0.625 = 45000

Discount (new)= 0.03* 4000000*0.725= 87000