Page 266 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes These terms are usually written as 2/10 net 30. The abbreviation 2/10 net 30 means that the
customer is entitled to 2% cash discount if he pays within 10 days (discount period) after the
beginning of the credit period of 30 days). If, however, he does not want to take advantage of the
discount he may pay within 30 days. If not made within a maximum period of 30 days, the
customer would be deemed to have defaulted.

The credit terms such as the credit standards, affect the profitability as well as the cost of this
firm. The three components of credit terms, namely, the rate of discount, period of discount and
the credit period affect the trade-off. Here the analysis is restricted from the point of suppliers of
trade credit.

The cash discount has implications for the sales volume, average collection period, bad debt
expenses and profit per unit. The sales volume will increase. The grant of discount implies
reduced prices. If the demand for the products is elastic, reduction in prices will result in higher
sales volume.

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Caution A firm should determine the credit terms on the basis of cost benefit trade-off.
Since the customers would like to take advantage of the discount and pay within the discount
period, the average collection period would be reduced. The reduction in the collection period
would lead to a reduction in the investment in receivables and also the cost. The decrease in the
average collection period would also cause a fall in bad debt expenses. As a result, profits will
increase. The discount would have a negative effect in the profits. This is because the decrease in
prices would affect the profit margin per unit of sale. Increase in credit period will increase the
sales volume, average collection period and bad debt expenses. A reduction in credit period is
likely to have an opposite effect.

Example: In our example, assume that the firm is contemplating to allow 2% discount
for payment prior to the 10th day after a credit sale. It would be recalled that the current average
collection period is 30 days, credit sales are 60,000 units. The variable cost per unit is 6 as the
average cost per unit is 8.
It is expected that if discounts are offered, sales will increase by 15% i.e., to 69000 units and the
average collection period will drop to 15 days. Assume, bad debt expenses will not be affected,
return on investment expected by the firm is 15%, 60% of the total sales will be on discount.
Should the firm implement the proposal?

Solution:
Benefit:
Profit on sales = Additional units × (sales price – variable cost)
= 9000 × (10 – 6) 36,000

Saving on avg. collection period
Present: Average investment in receivable at cost

60,000 × 8
40,000
12
Proposed: Average investment in receivables
(60,000 × 8) + (9000 × 6)
22,250
24

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