The uncollected balances schedule permits a firm to

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Unformatted text preview: rlier in the year. The uncollected balances schedule permits a firm to monitor its receivables better, and it can also be used to forecast future receivables balances. When Hanover’s pro forma 2005 quarterly balance sheets are constructed, management can use the historical receivables-to-sales ratios, coupled with 2005 sales estimates, to project each quarter’s receivables balance. For example, with projected sales as given below, and using the same payments pattern as in 2004, Hanover’s projected end-of-June 2005 receivables balance would be as follows: 27-8 Chapter 27 Providing and Obtaining Credit Quarter 2, 2005 Projected Sales Receivables/Sales Projected Receivables April $ 70,000 May 100,000 60 20% $ 14,000 60,000 June 140,000 90 126,000 Total projected receivables $200,000 The payments pattern approach permits us to remove the effects of seasonal and/ or cyclical sales variation and to construct a more accurate measure of customers’ payments patterns. Thus, it provides financial managers with better aggregate information than the days sales outstanding or the aging schedule. Managers should use the payments pattern approach to monitor collection performance as well as to project future receivables requirements. Except possibly in the inventory and cash management areas, nowhere in the typical firm have computers had more of an effect than in accounts receivable management. A well-run business will use a computer system to record sales, to send out bills, to keep track of when payments are made, to alert the credit manager when an account becomes past due, and to take action automatically to collect past-due accounts (for example, to prepare form letters requesting payment). Additionally, the payment history of each customer can be summarized and used to help establish credit limits for customers and classes of customers, and the data on each account can be aggregated and used for the firm’s accounts receivable monitoring system. Finally, historical data can be stored in the firm’s database and used to develop inputs for studies related to credit policy changes, as we discuss in the next section. Self-Test Questions Define days sales outstanding (DSO). What can be learned from it? Does it have any deficiencies when used to monitor collections over time? What is an aging schedule? What can be learned from it? Does it have any deficiencies when used to monitor collections over time? What is the uncollected balances schedule? What advantages does it have over the DSO and the aging schedule for monitoring receivables? How can it be used to forecast a firm’s receivables balance? Analyzing Proposed Changes in Credit Policy In Chapter 22, we discussed credit policy, including setting the credit period, credit standards, collection policy, and discount percentage, as well as the factors that influence credit policy. A firm’s credit policy is reviewed periodically, and policy changes may be proposed. However, before a new policy is adopted, it should be analyzed to determine if it is indeed preferable to the existing policy. In this section, we discuss procedures for analyzing proposed changes in credit policy. If a firm’s credit policy is eased by such actions as lengthening the credit period, relaxing credit standards, following a less tough collection policy, or offering cash discounts, then sales should increase: Easing the credit policy stimulates sales. Of course, if credit policy is eased and sales rise, then costs will also rise because more labor, materials, and so on, will be required to produce the additional goods. Additionally, receivables outstanding will also increase, which will increase carrying costs. Moreover, bad debts and/or discount expenses may also rise. Thus, the key question when deciding on a proposed credit policy change is this: Will sales revenues increase more than costs, including credit-related costs, causing cash flow to increase, or will the increase in sales revenues be more than offset by higher costs? Analyzing Proposed Changes in Credit Policy 27-9 Table 27-4 illustrates the general idea behind the analysis of credit policy changes. Column 1 shows the projected 2005 income statement for Monroe Manufacturing under the assumption that the firm’s current credit policy is maintained throughout the year. Column 2 shows the expected effects of easing the credit policy by extending the credit period, offering larger discounts, relaxing credit standards, and easing collection efforts. Specifically, Monroe is analyzing the effects of changing its credit terms from 1/10, net 30, to 2/10, net 40, relaxing its credit standards, and putting less pressure on slow-paying customers. Column 3 shows the projected 2005 income statement incorporating the expected effects of an easing in credit policy. The generally looser policy is expected to increase sales and lower collection costs, but discounts and several other types of costs would rise. The overall, bottom-line effect is a $7 million increase in...
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