(FM02) - Chapter 9 Credit Terms
(FM02) - Chapter 9 Credit Terms
Objectives:
1. Discuss the credit terms
5. 2. Define Management of receipts and disbursements
Credit terms
Credit terms are the terms of sale for customers who have been extended
credit by the organisation.
A cash discount is a percentage deduction from the purchase price; available
to the credit customer that pays its account within a specified time.
– For example, terms of 2/10 net 30 mean the customer can take a 2
percent discount from the invoice amount if the payment is made
within 10 days of the beginning of the credit period or can pay the
full amount of the invoice within 30 days.
Example
MAX Company has annual sales of R10 million and an average collection
period of 40 days (turnover = 365/40 = 9.1). In accordance with the
organisation’s credit terms of net 30, this period is divided into 32 days until the
customers place their payments in the mail (not everyone pays within 30 days)
and 8 days to receive, process, and collect payments once they are mailed.
MAX is considering initiating a cash discount by changing its credit terms from
net 30 to 2/10 net 30. The organisation expects this change to reduce the
amount of time until the payments are placed in the mail, resulting in an average
collection period of 25 days (turnover = 365/25 = 14.6).
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FINANCIAL MANAGEMENT 2
A cash discount period is the number of days after the beginning of the credit
period during which the cash discount is available.
The net effect of changes in this period is difficult to analyse because of the
nature of the forces involved.
For example, if an organisation were to increase its cash discount period by 10
days (for example, changing its credit terms from 2/10 net 30 to 2/20 net 30),
the following changes would be expected to occur: (1) Sales would increase,
positively affecting profit, (2) bad-debt expenses would decrease, positively
affecting profit, (3) the profit per unit would decrease as a result of more people
taking the discount, negatively affecting profit.
The credit period is the number of days after the beginning of the credit
period until full payment of the account is due.
Changes in the credit period also affect an organisation’s profitability.
For example, increasing an organisation’s credit period from net 30 days to net
45 days should increase sales, positively affecting profit. But both the
investment in accounts receivable and bad-debt expenses would also increase,
negatively affecting profit.
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FINANCIAL MANAGEMENT 2
The average collection period has two components: (1) the time from sale until
the customer places the payment in the mail and (2) the time to receive,
process, and collect the payment once it has been mailed by the customer. The
formula for finding the average collection period is:
Float refers to funds that have been sent by the payer but are not yet
usable funds to the payee. Float has three component parts:
1. Mail float is the time delay between when payment is placed in
the mail and when it is received.
2. Processing float is the time between receipt of a payment and
its deposit into the organisation’s account.
3. Clearing float is the time between deposit of a payment and
when spendable funds become available to the organisation.
Speeding up collections
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FINANCIAL MANAGEMENT 2
Cash concentration
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FINANCIAL MANAGEMENT 2
Zero-balance accounts
Spontaneous liabilities
business; the two major payable and
accruals.
Spontaneous
liabilities
5
are financing that
arises from the
normal course of
short-term sources
of such liabilities
are accounts
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FINANCIAL MANAGEMENT 2
The cost of giving up a cash discount is the implied rate of interest paid to
FINANCIAL MANAGEMENT 2
• To calculate the cost of giving up the cash discount, the true purchase
price must be viewed as the discounted cost of the merchandise, which
is R980 for Lebombo Industries.
• Another way to say this is that Lebombo Industries’ supplier charges R980
for the goods as long as the bill is paid in 10 days.
• If Lebombo takes 20 additional days to pay (by paying on day 30 rather than
on day 10), they have to pay the supplier an additional R20 in ‘interest’.
• Therefore, the interest rate on this transaction is 2.04% (R20
÷ R980). Keep in mind that the 2.04% interest rate applies to a 20-day
loan.
equation provides the general expression for calculating the annual percentage
cost of giving up a cash discount:
where
CD = stated cash discount in percentage terms.
N = number of days that payment can be delayed by giving up the cash
discount.
FINANCIAL MANAGEMENT 2
A simple way to approximate the cost of giving up a cash discount is to use the
stated cash discount percentage, CD, in place of the first term of the previous
equation:
Substituting the values for CD (2%) and N (20 days) into these equations results
in an annualised cost of giving up the cash discount of 37.24% [(2% ÷ 98%)
(365 ÷ 20)] and an approximation of 36.5% [2% (365 ÷ 20)].
Accruals
Accruals are liabilities for services received for which payment has yet to
be made.
– The most common items accrued by an organisation are wages
and taxes.
– Because taxes are payments to the government, their accrual
cannot be manipulated by the organisation.
– However, the accrual of wages can be manipulated to some
extent.
Bank loans
– A fixed-rate loan is a loan with a rate of interest that is determined at a set increment
above the prime rate and remains unvarying until maturity.
A floating-rate loan is a loan with a rate of interest initially set at an
increment above the prime rate and allowed to ‘float’, or vary, above prime
as the prime rate varies until maturity.
Once the nominal (or stated) annual rate is established, the method of
computing interest is determined. Interest can be paid either when a loan
matures or in advance. If interest is paid at maturity, the effective (or true)
annual rate – the actual rate of interest paid – for an assumed 1-year period
is equal to:
When interest is paid in advance, it is deducted from the loan so that the
borrower actually receives less money than is requested (and less than they
must repay). Loans on which interest is paid in advance by being deducted from
the amount borrowed are called discount loans. The effective annual rate for a
discount loan, assuming a 1-year period, is calculated as:
FINANCIAL MANAGEMENT 2
Example
Wooster Company, a manufacturer of athletic apparel, wants to borrow R10,000
at a stated annual rate of 10% interest for 1 year. If the interest on the loan is
paid at maturity, the organisation will pay R1,000 (0.10 R10,000) for the use of
the R10,000 for the year. At the end of the year, Wooster will write a check to
the lender for R11,000, consisting of the R1,000 interest as well as the return of
the R10,000 principal.
The effective annual rate is therefore:
If the money is borrowed at the same stated annual rate for 1 year but interest is
paid in advance, the organisation still pays R1,000 in interest, but it receives
only R9,000 (R10,000 – R1,000).
The effective annual rate is therefore:
Bank B set the interest rate at 1% above the prime rate on its floating-rate note.
The rate charged over the 90 days will vary directly with the prime rate. Initially,
the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate
of interest on the note. For instance, if after 30 days the prime rate rises to
6.5%, and after another 30 days it drops to 6.25%, the organisation will be
paying 0.575% for the first 30 days (7% 30/365), 0.616% for the next 30 days
(7.5% 30/365), and 0.596% for the last 30 days (7.25% 30/365). Its total
interest cost will be R1,787 [R100,000 (0.575% + 0.616% + 0.596%)],
resulting in a 90-day rate of 1.79% (R1,787/R100,000).
Again, assuming the loan is rolled over each 90 days throughout the year
under the same terms and circumstances, its effective annual rate is 7.46%:
4.06
Effective annual rate = (1 + 0.01787) – 1 = 7.46%
Clearly, in this case the floating-rate loan would have been less expensive than
the fixed-rate loan because of its generally lower effective annual rate.
Example