Wholesale Building Supply Changes in Credit Terms

Wholesale Building Supply

Changes in Credit Terms

Rich Jackson, a recent finance graduate, owns a wholesale building supply business with his

brother, Jim, who majored in building construction. The firm sells primarily to general

contractors. Sales are slow during the cold months, rise during the spring, and then fall off

again in the summer, when new construction in the area slows.

The brothers are concerned about the firm’s current credit policy. The terms of sale are net 30,

but the brothers expect only 80% of the customers (by dollar value) to pay the full amount on

day 30, while the other 20% pay, on average, on Day 40. Gross sales are currently $1,000,000

per year. Of the gross sales, 2% end up as bad debt losses.

The brothers are considering a change in credit policy. The change would entail 1) changing the

credit terms to 2/10, net 20, 2) employing stricter credit standards before granting credit, and

3) enforcing collections with greater vigor than in the past. Thus, cash customers and those

paying within 10 days would receive a 2% discount, but all others would have to the pay the full

amount within 20 days. The brothers believe the discount would both attract additional

customers and encourage some existing customers to purchase more from the firm – after all,

the discount amounts to a price reduction.

The net expected result is for sales to increase to $1,100,000, for 60% of the paying customers

to take the discount and pay on the 10th day, for 30% to pay the full amount on day 20, for 10%

to pay late on day 30, and for bad debt losses to fall from 2% to 1% of gross sales. The firm’s

operating (variable) cost ratio will remain unchanged at 75%, and its cost of carrying receivables

(notes payable or required return on investments) will remain unchanged at 12%.

The company would have to purchase some new inventory to cover the additional sales.

Inventory turnover averages 6 times per year. The current income statement with relevant

information is given below.

Gross Sales $1,000,000

Less: discounts 0

Net Sales $1,000,000

Production Costs (CGS) 750,000

Profit before credit costs and taxes $250,000

Credit related costs:

Carrying costs

Bad Debt Losses

Profit before taxes

Taxes (40%)

Net Income

Case requirements:

1. Describe the four variables that make up a firm’s credit policy, and explain how each of

them affects sales, DSO, and collections.

2. Under the current credit policy, what is the firm’s days sales outstanding (DSO)? What

would the expected DSO be if the credit policy change were made?

3. What is the dollar amount of the firm’s current bad debt losses? What losses would be

expected under the new policy?

4. What would be the firm’s expected dollar cost of granting discounts under the new

policy?

5. What is the firm’s current dollar cost of carrying receivables? What would it be after the

proposed change? (Use a 365 day year)

6. Calculate the opportunity cost of the additional investment in inventory for the new

level of sales with the changed credit policy.

7. What is the incremental after tax profit associated with the change in credit terms? In

other words, what is the difference in profit from old to new credit terms? Use a 40%

tax rate. Should the company make the change? (Hint: Construct income statements

under each policy and focus on the expected change.)

8. Does your analysis up to this point consider the risks involved with a credit policy

change? In other words, what are the key variables that can affect profitability? If not,

how could risk be assessed and incorporated into the analysis?

9. Suppose the firm makes the change, but its competitors react by making similar changes

to their own credit terms, with the net result being that gross sales remain at the

current $1,000,000 level. If this were to happen, no additional inventory purchases

would be necessary. What would be the impact on the firm’s after tax profitability?