5 percent per month so 15 12 18 this is equivalent to

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Unformatted text preview: standing credit are generally about 18 percent on a nominal basis: 1.5 percent 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 percent is highly profitable unless there are too many bad debt losses. Legal Considerations It is illegal, under the Robinson-Patman Act, for a firm to charge prices that discriminate between customers unless these differential prices are cost-justified. 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-justified. Self-Test Question How do profit potential and legal considerations affect a firm’s credit policy? The Payments Pattern Approach to Monitoring Receivables In Chapter 22, we discussed two methods for monitoring a firm’s receivables position: days sales outstanding and aging schedules. These procedures are useful, especially for monitoring an individual customer’s account, but neither is totally suitable for monitoring the aggregate payment performance of all credit customers, especially for a firm that experiences fluctuating credit sales. In this section, we present another way to monitor receivables, the payments pattern approach. The primary point in analyzing the aggregate accounts receivable situation is to see if customers, on average, are paying more slowly. If so, accounts receivable will build up, as will the cost of carrying receivables. Further, the payment slowdown may signal a decrease in the quality of the receivables, hence an increase in bad debt losses down the road. The DSO and aging schedules are useful in monitoring credit operations, but both are affected by increases and decreases in the level of sales. Thus, changes in sales levels, including normal seasonal or cyclical changes, can change a firm’s DSO and aging schedule even though its customers’ payment behavior has not changed at all. For this reason, a procedure called the payments pattern approach has been developed to measure any changes that might be occurring in customers’ payment behavior.3 To illustrate the payments pattern approach, con2Companies that do a large volume of sales financing typically set up subsidiary companies called captive finance companies to do the actual financing. Thus, General Motors, DaimlerChrysler, and Ford all have captive finance companies, as do Sears, IBM, and General Electric. 3See Wilbur G. Lewellen and Robert W. Johnson, “A Better Way to Monitor Accounts Receivable,” Harvard Business Review, May–June 1972, 101–109; and Bernell Stone, “The Payments-Pattern Approach to the Forecasting and Control of Accounts Receivable,” Financial Management, Autumn 1976, 65–82. The Payments Pattern Approach to Monitoring Receivables 27-5 sider the Hanover Company, a small manufacturer of hand tools that commenced operations in January 2004. Table 27-1 contains Hanover’s credit sales and receivables data for 2004. Column 2 shows that Hanover’s credit sales are seasonal, with the lowest sales in the fall and winter months and the highest during the summer. Now assume that 10 percent of Hanover’s customers pay in the month the sale is made, that 30 percent pay in the first month following the sale, that 40 percent pay in the second month, and that the remaining 20 percent pay in the third month. Further, assume that Hanover’s customers have the same payment behavior throughout the year; that is, they always take the same length of time to pay. Column 3 of Table 27-1 contains Hanover’s receivables balance at the end of each month. For example, during January Hanover had $60,000 in sales. Ten percent of the customers paid during the month of sale, so the receivables balance at the end of January was $60,000 0.1($60,000) (1.0 0.1)($60,000) 0.9($60,000) $54,000. By the end of February, 10% 30% 40% of the customers had paid for January’s sales, and 10 percent had paid for February’s sales. Thus, the receivables balance at the end of February was 0.6($60,000) 0.9($60,000) $90,000. By the end of March, 80 percent of January’s sales had been collected, 40 percent of February’s had been collected, and 10 percent of March’s sales had been collected, so the receivables balance was 0.2($60,000) 0.6($60,000) 0.9($60,000) $102,000; and so on. Columns 4 and 5 give Hanover’s average daily sales (ADS) and days sales outstanding (DSO), respectively, as these measures would be calculated from quarterly financial statements. For example, in the April–June quarter, ADS ($60,000 $90,000 $120,000)/91 $2,967, and the end-of-quarter (June 30) DSO $174,000/$2,967 58.6 days. Columns 6 and 7 also show ADS and DSO, but here they are calculated on the basis of accumulated sales throughout the year. For example, at the end of June ADS $450,000/182 $2,473 and DSO $174,000/ Table 27-1 Hanover Company: Receivables Data for 2004 (Thousands of Dollars) BASED ON QUARTERLY SALES DATA Month (1) January Credit Sales for Month (2) Receivables at End of Month (3) $ 60 BASED ON YEAR-TO-DATE SALES...
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