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					AGRIBUSINESS PROFITS AND THE
EXTENSION OF CREDIT

There exists no single sector of our                   has fulfilled a major role in the development
economy that has not been impacted by the              of numerous agricultural supply markets.
rapidly rising costs of extending trade and            The fertilizer industry, for instance, provides
customer credit. As interest rates reached             a classic example of how credit, extended
unprecedented levels, many firms adjusted              by both wholesale suppliers and retail
upwards their monthly charges for unpaid               dealers, can be both used and abused.
accounts or otherwise changed their credit             When dealing with homogeneous products
terns. The agribusiness sector has been                of comparable use and value, the industry
similarly affected by rising interest rates, but       concluded that credit and services remained
competition, market conditions, and the                as an important factor in competitive
normal seasonality of agricultural operations          differentiation. Particularly as new firms
have prevented many agribusiness firms                 entered a market, the liberal extension of
(particularly those in the supply and                  credit provided a means for carving out a
services industries) from passing on to their          competitive position. In numerous cases the
customers the full costs of credit extended.           extension of credit reached liberal
Often these agribusiness customers had                 dimensions. As other firms scrambled to
grown accustomed to penalty-free terms for             match these provisions, the industry soon
credit extended during the growing season.             found itself awash in aged accounts
Other firms, fearful of a decline in sales             receivable. For some firms, the period of
during a period of economic recession,                 recovery was both long and painful. For
initiated innovative credit terms designed             others, a total restructuring of their total debt
specifically to lessen the so-called "sticker-         position was required.
shock" for their customers of agricultural
equipment and machinery. Regardless,                   How do such situations develop and why do
customers and/or trade credit has become a             they deteriorate so rapidly? How are the
commonly accepted method of handling a                 participating firms impacted and why is
large majority of agribusiness sales. While            remedial action not taken? The answer to all
some firms claim to adhere to a cash basis,            these questions probably relates to the fact
they represent an ever-declining minority of           that while trade and customer credit have
total industry sales volume.                           become common business practices, many
                                                       firms have only a peripheral understanding
There is little doubt that credit sales, when          of the true costs of credit and others fail to
based on sound judgment and basic                      relate such costs directly to firm profitability.
business principles, enhance profitable                In an attempt to address this problem, this
operations by expanding sales opportunities            discussion shall review the pros and cons of
and broadening the market. Yet it must not             extending credit. Second, I shall review
be forgotten that if credit is being extended,         those areas where the true costs of credit
then credit costs are being incurred and the           often lie hidden. Finally, I shall illustrate
firm's   profits    are     being    impacted.         graphically the impact such costs have on
Historically, the extension of customer credit         firm profitability.


                                                   1

        WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING
The Advantages of Extending Credit                      and strengthen a feeling of loyalty, one
                                                        towards the other.
It should first be recognized that all
customers,       farmers     especially,   are          As noted earlier, credit sales increase the
becoming more credit conscious. While the               range of customers to which your product or
product, price, and service remain important
                                                        service might appeal. Farmers confronting a
factors to the farmer, the nature and extent
                                                        short-term cash deficiency might be
of credit terms have taken on a greater
                                                        discouraged from purchasing products sold
importance. As the farmer confronts a rising
                                                        on a cash basis only. By removing this
cost of production (short-term) loans, he               barrier, the potential market has been
views supplier credit terms more seriously.             expanded.
It is a fact, therefore, that the extension of
customer credit has a positive influence on
                                                        Finally, as a purely competitive factor, the
a firm's ability to expand the ranks of its
                                                        retailer may use credit as one of the many
clientele.                                              means available for improving his market
                                                        position. As such, credit becomes an
Some research work has shown that credit
                                                        important management tool or vehicle
customers tend to buy a higher quality of
                                                        through which the entire array of
merchandise and perhaps more of it.
                                                        competitive factors can be more effectively
Unfortunately, such research has been                   utilized.
conducted only in consumer product areas
and it is only conjecture as to its applicability
                                                        The Disadvantages of Extending
to the agribusiness industry. We can
surmise, however, that liberal credit terms             Credit
might induce a farmer to purchase a more                An      early   impact   experienced      by
expensive, high-quality, fertilizer and/or              agribusiness firms extending credit is that
increase his rates of application.                      normally described as a shortage of working
                                                        capital. Those funds normally used to
The extension of credit encompasses a                   restore inventories, meet payrolls, and
convenience factor of some value to the                 cover daily operating expenses are tied up
customer. While the ability to pay all of your          in the form of a growing accounts
monthly bills at once may be less of a                  receivable. When a firm is caught in such a
convenience      to   farmers      than     to          squeeze,      management's    flexibility  is
homeowners and families, it does provide                severely restricted and the short-term
the farmer an opportunity to better manage              liquidity of the business is directly
his monthly cash flows. Included within this            threatened.
convenience factor are the added
dimensions that goods can be purchased                  As working capital shrinks to that point
and delivered on an approval basis and that             where daily operations are impacted, the
adjustments on merchandise returned to the              firm is forced to adjust its debt position by
retailer can be more easily handled.                    borrowing short-term funds. The interest
                                                        expense accruing to this debt is directly
A less measurable, but still important factor           assigned against the credit policy.
associated with the extension of customer
credit is the establishment of a more direct            Of course, a natural corollary of any
or personal relationship between the                    customer credit provision is an allowance
customer and the retailer. The extension of             for bad debts. Regardless of the past record
credit, of course, implies a substantial                of collection efficiency, some losses due to
degree of trust and respectability. This                bad debts are bound to be realized. Again
mutual sense of commitment and obligation               such losses are directly assigned to the
tends to solidify retailer-customer relations           credit policy.




                                                    2
Insofar as customer credit attracts added           closely predict this balance, given some
sales volume, this same attraction may              reference to past performance and current
prove so strong that some customers are             sales trends. As noted earlier, a retailer may
enticed to purchase more product than is            be forced to borrow funds to cover those
actually needed. Stated a little differently,       monies tied up in unpaid customer
this practice may encourage some                    accounts. If this is not needed, and internal
customers to purchase beyond their ability          funds are used to support accounts
to pay. Their own financial position is,            receivable, then this restricts investment
thereby, threatened. In severe cases where          opportunities and deprives the business of
this leads to their operational failure, a          additional profits that might have been
customer is permanently lost and the total          generated had such funds been used in
market suffers.                                     another manner. The academic terminology
                                                    used to describe such "profits sacrificed" is
It can be argued that credit customers are          generally referred to as "opportunity costs."
more likely to return merchandise. While            Hence even if external funds are not used
this is less prevalent in the agribusiness          and an interest expense is not incurred, one
industry, any merchandise returned does             must treat the internal investment of funds
impose inefficiencies on the retailer's             no differently than if such monies were
operations.                                         invested in other assets, i.e., some
                                                    opportunity cost is assigned to it.
As credit is extended, it must be supported
by an accounting system. Records must be            Also overlooked are those administrative
maintained, statements must be prepared,            costs associated with an accounts
and additional postal expenses must be              receivable policy. In large agribusiness
incurred. The direct costs of an accounts           firms, the salaries of credit personnel are
receivable record keeping system are                more readily identifiable since the people
commonly underestimated. Even where the             responsible for this function are easily
program is computerized, the processing             isolated from the other phases of the
and mailing of customer statements can              business. Yet most agribusiness firms are
easily take two working days out of each            relatively small and do not separately
month.                                              employ a credit manager and support staff.
                                                    In such cases, the general manager or
Some Hidden Costs                                   another person spends only a portion of
                                                    their working day on credit matters. In the
Those items noted above represent costs
                                                    absence of a detailed study there is little
normally recognized as attributable to
                                                    basis for correctly measuring the salary
customer credit. Yet it must be remembered          expense attributable to the credit function.
that not all costs are so easily recognized.        Moreover, a portion of that management
For example, it should be noted that a
                                                    expense is rarely assigned to the credit
business invests in its accounts receivable
                                                    function. However, the credit expense is
in much the same way that it invests in
                                                    very much incurred and should be
other assets such as buildings, inventory,          recognized. Also associated with the credit
and equipment. To a larger degree, this             function are those costs associated with
investment in accounts receivable is just as
                                                    membership in local credit bureaus and
permanent as is an investment in any fixed
                                                    direct credit investigations. Again, smaller
asset. While the names of customers listed
                                                    companies may simply incur such expenses
under this account may change from month
                                                    and account for them only as a normal
to month, the average monthly unpaid                operational cost of doing business. Here we
balance may change very little during the
                                                    must also recognize certain legal costs
course of a year. Aside from some seasonal
                                                    associated with a firm's compliance with
variation, most agribusiness firms can
                                                    such recent legislation as Truth in Lending,



                                                3
the Fair Credit Billing Act, and the Fair             Figure 1 is designed to emphasize just how
Credit Act. Compliance, of course, is                 rapidly unpaid accounts can erode firm
mandatory for businesses of all types and             profits. For example, if a firm is operating at
sizes and the process of disclosing various           a 15 percent profit margin and allows its
facts to your customers may be costly in              average aged accounts receivable to reach
both labor and machine (computer) time. In            six months, profit levels have been reduced
many cases a firm is required to mail                 to half those anticipated. Should some of
notices    regularly  and     make      other         these accounts go uncollected for one year,
appropriate disclosures. Penalties for failure        a net loss has been incurred. Many in the
to comply may take the form of forfeiture of          trade have argued that the value of past due
interest on past-due accounts, forfeiture of          accounts should be even more aggressively
the entire account, and/or the imposition of          deflated to reflect the increased likelihood of
a fine.                                               bad debt loss as an account remains unpaid
                                                      beyond three to six months1. Should such
When dealing on the input side of farm                an allowance be made, the present value
production supplies, the agribusiness                 lines in Figure 1 would decrease at an ever-
retailers must also remember that they are            increasing rate.
selling a product which often cannot be
repossessed. For example, when fertilizer
or fuel is sold and remains unpaid, the               Figure 1: Unpaid Accounts and
retailer has no vehicle for physically                Agribusiness Profits
recovering that product which has already
been applied or consumed. When dealing in             If your firm expects to generate $15 in profit
credit with their supplier, the retailer must         for each $100 in sales and the interest rate
also remember that the use of credit may              on debt capital used to support accounts
cause them to sacrifice cash or early                 receivable is 12, 14, 16, or 18 percent,
payment discounts offered by that supplier.           profits are diminished by the relationship
In a similar sense, your relationship with            shown below:
your supplier may be jeopardized when your
uncollected receivables get out of control.                                12%
Finally, it should be noted that time spent                                      14%
attempting to collect slow receivables                    $15                             16%
represents time that might better be spent
                                                                                                   18%
on matters relating to management                             10
                                                     Profit




planning, personnel, or marketing. Such a
sacrifice may, in the long run, prove to be
the most costly of all factors associated with                 5
the extension of credit.
                                                               0
The Profit Impact                                                  1   2   3 4   5   6   7 8   9 10 11 12
                                                              -5
Most agribusiness managers have a good                                           Months
understanding of both the advantages and
disadvantages associated with credit
provisions. As the cost of debt capital has
risen, many managers have been forced to
reevaluate their credit practices. As the
agricultural economy weakens, firms will
likely find it necessary to reassess those
                                                      1
costs associated with a growing accounts               W. R. Ruzek, “The Costs of Extending Credit,”
receivable operation. As provided below,              Fertilizer Progress, p. 23, September-October
                                                      1976.




                                                 4
                                         Table 1
                             Assuming $15 Profit on $100 Sales

 Profits After        With Interest Costs of:       12%          14%         16%            18%

 One Month                                          $14.00       $13.85      $13.69         $13.52
 Two Months                                          13.02         12.71       12.39         12.06
 Three Months                                        12.05         11.58       11.11         10.63
 Six Months                                           9.20          8.28        7.38          6.45
 Nine Months                                          6.43          5.08        3.73          2.45
 Twelve Months                                        3.74          2.00         .34         -1.37


Summary                                                      degree to which your credit
                                                             provisions meet their needs.
The extension of customer and trade credit
has become a permanent operational                     5. Encourage cash or 30-day sales
feature of the agribusiness industry. The                 through the establishment of early
objective of management is to use credit to               payment discounts. Make sure such
their sales advantage while minimizing its                discounts reflect accurately your
adverse impact on firm profits. If this                   costs and margins.
objective is to be reached, management
must seek to manage its accounts
receivable. Some suggestions for                       6. Pay attention to your receivable
maintaining a reasonable credit practice                  records. Analyze each monthly
include the following:                                    report in an attempt to detect early
                                                          any general trends or specific
   1. Regularly review your firm's credit                 customer problems.
      policy and practice prudent account
      management. This requires that                   7. Don't hesitate to demand payment
      credit customers be billed regularly,               from customers who have violated
      systematically, and in compliance                   the terms of sale. This should be
      with existing credit legislation.                   done tactfully and in a manner such
                                                          that the customer understands fully
   2. Meet with your credit customers for                 the reasons and logic.
      purposes of relating to them the
      terms of sale or any change therein.             8. Do not delay shutting off credit when
                                                          an account is judged to be
   3. Make sure that firm agreements are                  delinquent and of doubtful liquidity.
      made between you and your                           Commensurate with this decision
      customers at the time of sale or                    you should provide the debtor with
      delivery as to when and in what                     provisions by which reinstatement
      manner payments are to be made.                     might be granted.

   4. Seek to improve, where possible,
      the general caliber of your credit
      customers. Keep up-to-date as to                       Ken D. Duft
      their financial abilities and the                      Extension Marketing Economist




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