Accounts Receivable Management

(See attached files for full problem description)

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Case 30 A Switch in Time Saves Nine

Simon sat at his office desk pondering over what was discussed at his last meeting with the Treasurer, Angela Krampf. The working capital of their firm, Progressive Farm Equipment Incorporated, had increased at an alarming rate over the past couple of years making the directors and top managers very concerned. Despite the implementation
of a "just in time" inventory system and more efficient cash management methods, the working capital continued to rise. This time, however, it was the accounts receivable that needed attention. Angela received a memo from the board asking her to review and rectify the credit management problem as soon as possible. One of the sentences in the memo read "...we simply cannot continue to carry our customers as long as we have been." Angela had therefore called on her assistant, Simon
Martinez, and briefed him of the situation.

Progressive Farm Equipment Inc. had been in business since 1945, producing small and medium sized tractors, tillers, and other farm equipment. Its customer base included various local and regional hardware stores, farm equipment stores, and repair shops. Most of the clients were strapped for cash and were accustomed to fairly flexible
credit terms. The firm had been hard pressed to offer terms of net 60 to its clients, primarily to counter competition from national suppliers and to maintain good customer relationships.

Sales had steadily increased over the years but over the past year, higher interest rates and a weakening economy had caused a slump in the agricultural sector leading to a drop in sales of farm equipment. Moreover, the number of farmers filing for bankruptcy had been increasing at an alarming rate.

As Angela and Simon reviewed the accounting statements (see Tables 1 and 2) and the aging schedule of receivables, they realized that despite the fairly liberal credit terms of net 60, on average, 40% of the
credit sales were being collected 10 days late. The company had not implemented a policy of charging interest or late fees for fear of losing customers. They also noticed that over the past year the number of bad debts had gone up from 1% of sales to its current level of 2% of sales.

Angela told Simon that the directors expected to see a proposal that would be realistic and effective. "On the one hand, we have to be careful about not turning customers away," said Angela. "But on the other hand, we simply cannot afford to continue the current policy of allowing customers to pay late. Some credit will have to be given, but
collections have to be tightened up. I guess the time has come for us to switch or suffer."

About six months earlier, Angela Krampf had recruited Simon Martinez, a certified financial manager, to assist her in managing the company's working capital. Initially, it was the management of cash and inventory that needed modification. After much debate and discussion, a more conservative policy of cash management was implemented, followed by a successful integration of a just-in-time inventory management system. The quarterly statements showed that the
modifications had worked. Angela and Simon were aware that the company's collection policy was rather liberal. However, given the economic conditions and sensitivity of the issue, they had refrained from suggesting any changes.

As Simon pondered about what changes in the firm's collection policy he should recommend he realized that he would have to get some more data. He called up the folks in marketing and inquired about what effect a tighter collection policy would have. Upon being asked to be
more specific, he told them that he was considering two alternatives:

1) 2/ 10 net 30, and
2) 2/ 10 net 60.

He was told that under the first alternative, sales would probably decrease
by about 10%. The sales people had built up a very good relationship
with their customers and were confident that, despite the tighter credit
terms, they could retain most of the accounts provided there was some
incentive for paying early. Moreover, they informed Simon that most
retailers could avail of commercial loans from banks at an average rate of
interest of 14% per year. If the second alternative were implemented, the
accounts receivable figure would be reduced without any loss of sales.
Obviously, the sales people preferred the second approach. Simon
estimated that under the new terms approximately 50 percent of sales
would be collected within 10 days. Of the remaining 50% of sales,
roughly 60% would be collected within the credit period and the
remaining 40% would be approximately 10 days late, as usual. Simon
figured that he had better prepare pro forma statements showing the
impact that these policies would have on the company's bottom line and
on the accounts receivable balance, before recommending any harsh
penalties and so on.

Questions:

5. What are some other ways in which the company could
speed up collections and reduce the receivables?

6. Why has this slow buildup in accounts receivable occurred?
Could it have been avoided? How? Please explain.

7. Develop the pro forma financial statements for the company
under the two credit policy alternatives, i. e. 2/ 10, net 60; and
2/ 10 net 30 using the assumptions given. What would be the
impact on the firm's return on sales, return on investment,
and return on equity?

8. Which policy should Simon recommend to the board? Why?
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