Magazine article Business Credit

Size Relationships and the Ability to Manage DSO and Terms

Magazine article Business Credit

Size Relationships and the Ability to Manage DSO and Terms

Article excerpt

To what degree does a company really have control over its credit terms? Its ability to set and control its terms is affected by a number of factors, many of which are relational in nature. The more competitive a supplier market, the less control suppliers have over their terms. In these cases, terms will tend to lengthen and adjust to the benefit of the customers. Likewise, with less competition among suppliers, preferable terms may lean in their direction.

Credit managers are always seeking ways in which they can reduce both DSO and delinquency, which can be measured by the average days delinquent (ADD). (1)

One method employed is to tighten terms by reducing the credit period, while another is to offer discounts to induce earlier payment. Tightening terms carries the risk of lost sales, and thus, these decisions must always balance the potential gains against the risks of losing sales and/or deteriorating customer relationships.

In some cases, companies may actually find it acceptable to experience increases in DSO in exchange for increases in or, in the case of highly competitive markets, maintenance of sales levels. This may be particularly true in selling products that carry higher margins, in which case profitability offsets the cost of carrying the additional receivables.

What Happens if I Change Terms?

A recent Credit Research Foundation (CRF) study focused on the impact of supplier and customer size relationships on the ability to manage DSO and, more importantly, ADD by changing credit terms. (2)

It is important to focus on the impact of changing terms on the ADD rather than on the DSO. The reason is that ADD measures the difference between DSO and best possible DSO (BPDSO). The BPDSO represents the DSO outcome in cases where customers are in compliance with a company's credit terms. A positive and/or lingering ADD observed after changing credit terms would indicate a lower degree of customer compliance with the intent of the change.

DSO, Supplier Size and Customer Inventory Turnover

The survey sample included 20 companies with annual sales less than $500 million (MM), 33 with annual sales between $500MM and $2,500MM and 31 with annual sales greater than $2,500MM. Table 1 reports the findings regarding DSO, BPDSO and ADD for each of three size categories.

As can be seen in Table 1, firms in the larger size category average much smaller DSO and BPDSO, at 35 and 31 days, as compared to the smallest companies, which average 53 and 43 days respectively. This indicates that larger suppliers can demand and enforce shorter terms.

Generally, the DSO for companies selling products that turn more rapidly is lower than those for companies selling products that move more slowly through the customer's inventory. This also appears to be affected by the size of the seller. As can be seen in Table 2, the average DSO increases with longer customer inventory turnover in each of the three size categories. As before, the DSO measures are also shorter for the larger than for the smaller suppliers.

The Impact of Changing Terms

The survey included responses from firms who changed terms in a variety of ways. The most common examples of credit tightening were shortening the credit or discount period and/ or reducing the discount rate itself. The opposite was true in cases where terms were loosened. There were also cases in which the net change in terms might be expected to have a neutral effect on DSO and ADD. Almost all survey respondents indicated that they either did not know the impact of changing in terms on sales, or that the change had little or no impact on sales.

Of the 84 companies responding to the survey, 51 made some kind of change to their credit policies. Of these, 20 made changes that tightened, 10 that loosened and the remaining 21 made changes having a neutral effect on credit terms. Results indicate that ADD measures are associated with policy changes, and that the size of the company influences the relationship. …

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