Question

John Young is a new assistant controller at Richmond Electronics, a large regional consumer electronics chain. Before John’s recruitment, he was aware of Richmond’s long trend of moderate profitability. The reports on his desk confirm the slight, but steady, improvements in net income in recent years. The issue he is facing as he reviews the reports is the decline and erratic trend in cash flows from operations.

John sketched the following comparison ($ in millions):	Income from operations	Net income	Cash flow from operations
2014	$ 140.0	38.5	1.6
2013	$ 132.0	35.0	19.0
2012	$ 127.5	34.5	14.0
2011	$ 127.0	29.5	15.5

His sketch shows increasing profits but ominous trend in cash flow, which is consistently lower than net income. Upon closer review, Ben noticed three events in the last two years that, unfortunately, seemed related:

Richmond loosened its credit policy. In other words, Richmond relaxed its credit terms and lengthened payment periods.

Accounts receivable balances increased dramatically.

Several of the company’s compensation arrangements, including that of the controller and the company president, were based on reported net income.

What is so ominous about the combination of events John sees? If you were John, what course of action will you take?

Answer 1

Credit period is the number of days allowed to a customer to make payment against credit sales. It is an indicator of the number of days for which amount of sales that remains blocked in form of receivables. A longer period may result in shortage of cash, forcing the company to rely on short term credit for meeting working capital requirements. However, a very short credit period or a credit period shorter than that of competitors may induce the customer to buy products from elsewhere.

In the given case, the company has relaxed its credit norms and elongated the credit period. Resultantly, the receivables increased dramatically. This implies, that it will take longer for the company to realise payment against credit sales. As stated earlier, a long credit period can result in shortage of cash and the company face trouble in meeting its commitments.

It has also been stated, that the compensation arrangements are based on net income. Compensation results in cash outflow. Although there has been an increase in the net income, there has not been a similar increase in cash inflow. Thus, the company will be liable for higher compensation payments as the net income increases and consequently will face shortage of cash as there is not a matching increase in inflows.

Steps that can be taken in the following cases:

• Reduce the length of the credit period
• Offer cash discounts for making early payments, that is, the comapny can offer a 2% discount for making payment in the first 10 days. This will ensure earlier realisation of receivables.
• Link the compensation arrangements with operating cash inflows, so that cash outflow can be matched with cash inflow.