Extending Terms to a Growing Distributor Customer
Your company, a specialty industrial distributor, sells $8.4 million annually to Meridian Pump & Valve, a 12-year customer, on net 30 terms. The account pays, on average, 42 days after invoice. Meridian is asking to move to net 60 to align with its own customer payment cycle and says it will consolidate more spend with you if approved. Sales forecasts a 6% increase in annual purchases, or $504,000, at the same 22% gross margin. Your credit team expects the customer's DSO to lengthen to 68 days, and historical experience suggests 0.4% bad debt on incremental sales. Your company funds receivables on a revolver priced at 8.5% and is under pressure to improve cash conversion. The controller asks whether the terms change is accretive and what conditions should accompany it. No credit limit change is requested, but the customer's peak receivable would rise from about $967,000 to $1.66 million if the forecast holds.
1. Calculate the incremental investment in receivables and the annual carrying cost of the proposed terms change. Show your formulas and state any assumptions.
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Use average daily sales to estimate receivables. Current: $8,400,000 × 42/365 = $966,575. Proposed: $8,904,000 × 68/365 = $1,658,827. Incremental receivables = $692,252. Carrying cost at 8.5% = $58,841 per year. Assumptions: sales and collections occur evenly; the forecast volume materializes; the revolver rate stays at 8.5%; receivables are valued at sales price. A more refined calculation would apply the 78% cost ratio to the incremental balance, reducing carrying cost to about $45,900, but the sales-price approach is conservative and matches how the controller budgets revolver usage. The key point is that the terms change ties up roughly $0.69 million of additional capital, not merely the $504,000 sales increase.
2. Compute the incremental gross profit, bad-debt cost, and net annual benefit. Recommend approval or rejection.
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Incremental gross profit = $504,000 × 22% = $110,880. Bad debt = 0.4% × $504,000 = $2,016. Net benefit = $110,880 − $58,841 − $2,016 = $50,023 before any fixed-cost or discount effects. That is positive but thin: a 1.5-percentage-point rise in bad debt or a 10-day overshoot in DSO would erase most of it. Using contribution margin rather than gross margin would also reduce the benefit. Recommendation: approve net 60 for a 12-month trial, but not as an unconditional policy change. Cap the receivable at $1.7 million, require monthly aging and quarterly financials, and review at 90 days. If DSO exceeds 72 days or any invoice goes 15 days past due, revert to net 30. Do not offer an early-payment discount unless the math shows it beats the revolver cost.
3. Identify three nonfinancial or risk factors that could reverse the analysis and describe how you would monitor them.
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Risks: (1) DSO slippage beyond 68 days, which raises carrying cost by about $10,400 per day of sales at the 8.5% rate; (2) bad-debt contagion if the customer's own customers slow payments; (3) sales growth may be low-margin or come with extended terms to weaker buyers; (4) concentration and loss of bargaining power once terms are granted. Monitor monthly AR aging, days sales outstanding, past-due percentage, credit limit utilization, and quarterly financial statements. Also watch for a change in payment pattern, such as a shift to partial payments or NSF checks. Set a hard stop and a documented exit trigger. The decision is not just yes or no on terms; it is a controlled credit experiment with a review date.