Strategic Debtor Management

Having begun with an over-arching definition of the normative objective of strategic financial management as the maximization of expected net cash inflows at minimum cost (the ENPV decision rule) my bookboon series on working capital develops another critique within this context.

The efficient management of working capital is not only determined by an optimum investment in current assets and current liabilities, which departs from accounting convention (where solvency and liquidity ratios of 2:1 and 1:1 may be an irrelevance). But, given the extent to that most firms sell on credit to increase their turnover.

Many practicing financial managers not only fail to model the dynamics of their company's overall working capital structure satisfactorily. They also misinterpret the functional inter-relationships between its components.

Contrary to the balance of academic literature on the subject (which focuses on cash management and inventory control as the key to success):

o The pivotal predetermining of working capital efficiency should relate to accounts receivable (debtor) policy, which is a function of a company's optimum terms of sale to discounting and non-discounting customers that may be unique and need not conform to industry "norms".

o Variations in the cash discount, discount period and credit period all represent dynamic marketing tools.

o Based upon the time value of money and opportunity cost concepts, the terms of sale create purchasing power for customers, which should enhance demand for the creditor firm and hopefully net profits from revenues.

Optimum terms of sale not only determine a company's optimum investment in debtors but as a consequence its optimum investments in inventory, cash and creditors, which when set against each other, not only define its structure of current assets and liabilities but also its overall working capital requirements.

Exercise 1: The Terms of Sale

We have assumed that companies wishing to maximize shareholder wealth using ENPV techniques within the context of project appraisal should:

o Maximize current liabilities and minimize current assets compatible with their debt paying ability, based upon future cash profitability determined by its terms of sale,

o Optimize terms of sale to determine optimum working capital balances for inventory, debtors, cash and creditors,

However, this presupposes that management can initially model the differential impact of their credit terms on future costs, revenues and hence profits when formulating an optimum debtor policy. Otherwise, they are hopelessly lost.

Required:

To prove the previous point (and as a guide to later Exercises in this study) using your bookboon reading:

Summarize how the terms of sale represented by the cash discount, discount period and credit period within a mathematical framework of effective prices underpin the demand for a firm's goods and services.

If you need help with your answer, I recommend that you refer to either Chapter Six or Chapter Two of the bookboon texts with which you are familiar: "Working Capital and Strategic Debtor Management" or "Strategic Debtor Management and Terms of Sale" respectively.

An Indicative Outline Solution

Both Chapters referenced above, depart from a conventional external Balance Sheet ratio analyses of a firm's current asset (operating) and current liability (financing) cycles to reveal why:

Optimum terms of sale determine an overall working capital structure, which comprises optimum investments in inventory, debtors, cash and creditors, where current assets need not "cover" current liabilities.

To prove the case, (using the common Equation numbering from either reference) the following mathematical framework was derived to determine optimal credit policies in future Chapters.

The incremental gains and losses associated with a creditor firm's terms of sale were evaluated within a framework of "effective" prices, based on the time value of money using the following Equations from Chapter Six and Two. These define the customers' credit price (P') and discount price (P") associated with "effective" price reductions, arising from delaying payment over the credit or discount period, respectively.

Where buyers of a firm's product at a cash price (P) are offered terms of (c/t:T) such as (2/10:30):

(c) = the cash discount (2%)

(t) = the discount period (10 days)

(T) = the credit period (30 days)

Because (P') differs from (P") we analyzed how the introduction of any cash discount into a firm's period of credit influences the demand for its product and working capital requirements. When formulating credit policy, management must therefore consider the division of sales between discounting and non-discounting customers.

For any combination of credit policy variables, the buyer's decision to discount depends upon the cost of not taking it exceeding the benefit.

The annual benefit of trade credit can be represented by the customer's annual opportunity cost of capital rate (r). Because non-discounting customers delay payment by (T- t) days and forego a percentage (c), their annual cost of trade credit (k) can be represented by:

Thus, if purchases are financed by borrowing at an opportunity rate (r) that is less than the annual cost of trade credit (k) so that:

The buyer will logically take the discount.

From the seller's perspective, we then confirmed that:

To increase the demand for its products, a firm should design its credit periods to entice low effective price (high opportunity rate) buyers, whereas the cash discounts should be utilized to provide a lower cash price for those customers with low opportunity rates.

To summarize: with a COD price (P) on terms (c/t: T) and a customer opportunity rate (r), the effective price framework and discount decision can be expressed mathematically as follows:

Summary and Conclusions

The remaining series of Exercises contained in this study are designed to complement and develop your understanding of working capital management and the strategic marketing significance of debtor policy within a theoretical context of wealth maximization and empirical research.

The accounting convention that management must present an image of solvency and liquidity to the outside world by maintaining an excess of current assets over current liabilities is seriously questioned. A firm's objectives should be to minimize current assets and maximize current liabilities compatible with its debt paying ability, based upon future cash profitability, all dictated by optimum terms of sale, which may be unique.

Squaring the circle, optimum terms of sale determine optimum working capital balances for inventory, debtors, cash and creditors.

Like my previous bookboon texts in the working capital series, some topics will focus on financial numeracy and mathematical modeling. Others will require a literary approach. There is also an expanded case study based on your earlier reading of the texts.

The rationale is to vary the pace and style of the learning experience by not only applying the mathematics and accounting formulae, but also by developing your own arguments and critique of the subject as a guide to further study.

Selected References

Text Books:

Strategic Financial Management, 2008. Strategic Financial Management: Exercises, 2009. Portfolio Theory and Financial Analyses, 2010. Portfolio Theory and Financial Analyses: Exercises, 2010. Corporate Valuation and Takeover, 2011. Corporate Valuation and Takeover: Exercises, 2012. Working Capital and Strategic Debtor Management, 2013.

Business Texts:

Strategic Financial Management: Part I, 2010.

Strategic Financial Management: Part II, 2010.

Portfolio Theory and Investment Analysis, 2010.

The Capital Asset Pricing Model, 2010.

Company Valuation and Share Price, 2012.

Company Valuation and Takeover, 2012.

Working Capital Management: Theory and Strategy, 2013.

Strategic Debtor Management and the Terms of Sale, 2013.