Credit Policy

The success or failure of a business depends primarily on the demand for its products as a rule, the higher its sales, the larger its profits and the higher its stock price. Sales, in turn, depend on a number of factors, some exogenous but others under the firm’s control. The major controllable determinants of demand are sales prices, product quality, advertising and the firm’s credit policy. Credit policy in turn, consists of these four variables.

1.    Credit period, which is the length of time buyers are given to pay for their purchases.

2.    Credit standards, which refer to the required financial strength of acceptable credit customers.

3.    Collection policy, which is measured by its toughness or laxity in attempting to collect on      slow-paying accounts.

4.    Discounts given for early payment, including the discount percentage and how rapidly payment must be made to qualify for the discount.

                  

The credit manager is responsible for administering the firm’s credit policy. However, because of the pervasive importance of credit, the credit policy itself is normally established by the executive committee, which usually consists of the president plus the vice-presidents of finance, marketing and production.

Marketable Securities

Realistically the management of cash and marketable securities cannot be separated-management of one implies management of the other. We focused on cash management. Now we turn to marketable securities.

Marketable securities typically provide much lower yields than operating assets. For example, recently Chrysler held a $8.7 billion portfolio of short-term marketable securities that yielded about 6 percent but its operating assets provided a return of about 14 percent. Why would a company such as Chrysler have such large holdings of low-yielding assets?

In many cases, companies hold marketable securities for the same reasons they hold cash. Although these securities are not the same as cash, in most cases they can be converted to cash on very short notice (often just a few minutes) with a single telephone call. Moreover, while cash an most commercial checking accounts yield northing, marketable securities provide at least a modest return. For this reason, many firms hold at least some marketable securities in lieu of larger cash balances, liquidating part of the portfolio to increase the cash account when cash outflows exceed inflows. In such situations the marketable securities could be used as a substitute for transactions balances, for precautionary balances for speculative balances or for all three. In most cases the securities are held primarily for precautionary purposes most firms prefer to rely on bank credit to make temporary transactions or to meet speculative needs, but they may still hold some liquid assets to guard against a possible shortage of bank credit.

A few years ago Chrysler had essentially no cash it was incurring huge losses and those losses had drained its cash account. Then a new management team took over improved operations and began generating positive cash flows, Chryslers cash (and marketable securities) was up to $8.7 billion, and analysts were forecasting a further buildup over the next year or so to more than $10 billion. Management indicated, in various statements, that the cash hoard was necessary to enable the company to weather the next downturn in auto sales.

Although setting the target cash balance is to a large extent judgmental analytical rules can be applied to help formulate better judgments. For example, years ago William Baumol recognized that the trade-off between cash and marketable securities is similar to the one firms face when setting the optimal level of inventory. Baumol applied the EOQ inventory model to determine the optimal level of cash balances, he suggested that cash holdings should be higher if costs are high and the time to liquidate marketable securities is long, but that those holdings should be lower if interest rates are low. His logic was that if it is expensive and time consuming to convert securities to cash and if securities do not earn much because interest rates are low, then it does not pay to hold securities as opposed to cash. It does pay to hold securities if interest rates are high and the securities can be converted to cash quickly and cheaply.

Cash Management Techniques

Cash management has changed significantly over the last 20 years for two reasons. First, from the early 1970s to the mid-1980s, there was an upward tread in interest rates which increased the opportunity cost of holding cash. This encouraged financial managers to search for more efficient ways of managing cash. Second, technological developments, particularly computerized electronic funds transfer mechanisms, changed the way cash is managed.

Most cash management activities are performed jointly by the firm and its banks. Effective cash management encompasses proper management of cash inflows and outflows, which entails (1) synchronizing cash flows, (2) using float, (3) accelerating collections, (4) getting available funds to where they are needed, and (5) controlling disbursements. Most business is conducted by large firms, many of which operate regionally, nationally, or even globally. They collect cash from many sources and make payments from a number of different cities or even countries. For example, companies such as IBM, General Motors, and Hewlett Packard have manufacturing plants all around the world, even more sales officers, and bank accounts in virtually every city where they do business. Their collection points follow sales patterns. Some disbursements are made from local offices, but most are made in the cities where manufacturing occurs, or else from the home office. Thus, a major corporation might have hundreds or ever thousands of bank accounts and since there is no reason to thinks that inflows and outflows will balance in each account, a system must be in place to transfer funds from where they come in to where they are needed, to arrange loans to cover net corporate shortfalls, and to invest net corporate surpluses without delay. We discuss the most commonly used techniques for accomplishing these tasks in the following sections.

Cash Flow Synchronization

If you as an individual were to receive income once a year, you would probably put it in the bank, draw down your account periodically, and have an average balance during the year equal to about half your annual income. If you received income monthly instead of once a year, you would operate similarly, but now your average balance would be much smaller. If you could arrange to receive income daily and to pay rent, tuition, and other charges on a daily basis, and if you were confident of your forecasted inflows and outflows, then you could hold a very small average cash balance.

Exactly the same situation holds for businesses – by improving their forecasts and by arranging things so that cash receipts coincide with cash requirements, firms can reduce their transactions balances to a minimum. Recognizing all this, utility companies, oil companies, credit card companies and so on, arrange to bill customers and to pay their own bills, on regular “billing cycles” throughout the month. This synchronization of cash flows provides cash when it is needed and thus enables firms to reduce cash balances, decrease bank loans, lower interest expenses, and boost profits.

Speed up the Check-Clearing Process

When a customer writes and mails a check, this does not mean that the funds are immediately available to the receiving firm. Most to us have been told by someone that “the check is in the mail”, and we have also deposited a check in our account and then been told that we cannot write our own checks against this deposit until the check-clearing process has been completed. Our bank must first make sure that the check we deposited is good and the funds are available before it will give us cash.

In practice, it may take a long time for a firm to process incoming checks and obtain the use of the money. A check must first be delivered through the mail and then be cleared through the banking system before the money can be put to use. Checks received from customers in distant cities are especially subject to delays because of mail time and also because more parties are involved. For example, assume that we receive a check and deposit it in our bank. Our bank must send the check to the bank on which it was drawn. Only when this latter bank transfers funds to our bank are the funds available for us to use. Checks are generally cleared through the Federal Reserve System or through a clearinghouse set up by the banks in a particular city. Of course, if the check is deposited in the same bank on which it was drawn, that bank merely transfers funds by bookkeeping entries from one depositor to another. The length of time required for checks to clear is thus a function of the distance between the payer’s and the payee’s banks. In the case of private clearinghouses, it can range from one to three days. Checks are generally cleared through the Federal Reserve System in about two days, but mail delays can slow down things on each end of the Fed’s involvement in the process.

The Cash Budget

The firm estimates its needs for cash as a part of its general budgeting, or forecasting, process. First, it forecasts sales, its fixed asset and inventory requirements, and the times when payments must be made. This information is combined with projections about when accounts receivable will be collected, tax payment dates, dividend and interest payment dates, and so on. All of this information is summarized in the cash budget, which shows the firm’s projected cash inflows and outflows over some specified period. Generally, firms use a monthly cash budget forecasted over the next year, plus a more detailed daily or weekly cash budget for the coming month. The monthly cash budgets are used for planning purposes, and the daily or weekly budgets for actual cash control.

The cash budget provides more detailed information concerning a firm’s future cash flows than do the forecasted financial statements. We developed Allied Food Products 2012 forecasted financial statements. Allied projected 2012 sales were $3,300 million, resulting in a net cash flow from operations of $162 million. When all expenditures and financing flows are considered, Allied cash account is projected to increase by $1 million in 2012. Does this mean that Allied will not have to worry about cash shortages during 2012? To answer this question, we must construct Allied cash budget for 2012.

To simplify the example, we will only consider Allied cash budget for the last half of 2012. Further, we will not list every cash flow but rather focus on the operating cash flows. Allied sales peak is in September, shortly after the majority of its raw food inputs have been harvested. All sales are made on terms of 2/10, net 40, meaning that a 2 percent discount is allowed if payment is made within 10 days, and if the discount is not taken, the full amount is due in 40 days. However, like most companies, Allied finds that some of its customers delay payment up to 90 days. Experience has shown that payment on 20 percent of Allied dollar sales is made during the month in which the sale is made – these are the discount sales. On 70 percent of sales, payment is made during the month immediately following the month of sale, and on 10 percent of sales payment is made in the second month following the month of sale.

The costs to Allied of foodstuffs, spices, preservatives, and packaging materials average 70 percent of the sales prices of the finished products. These purchases are generally made one month before the firm expects to sell the finished products, but Allied purchase terms with its suppliers allow it to delay payments for 30 days. Accordingly, if July sales are forecasted at $300 million, then purchases during June will amount to $210 million, and this amount will actually be paid in July.

Such other cash expenditures as wages and rent are also built into the cash budget, and Allied must make estimated tax payments of $30 million on September 15 and $20 million on December 15. Also, a $100 million payment for a new plant must be made in October. Assuming that Allied target cash balance is $10 million, and that it projects $15 million to be on hand on July 1, 2012, what will its monthly cash surpluses or short fails be for the period from July to December?

Stock Dividends and Stock Splits

Stock dividends and stock splits are related to the firm’s cash dividend policy. The rationale for stock dividends and splits can best be explained through an example. We will use Porter Electronic Controls Inc, a $700 million electronic components manufacturer, for this purpose. Since its inception, Porter’s markets have been expanding and the company has enjoyed growth in sales and earnings. Some of its earnings have been paid out in dividends, but some are also retained each year, causing its earnings per share and stock price to grow. The company began its life with only a few thousand shares outstanding, and after some years of growth, each of Porter’s shares had a very high EPS and DPS. When a ‘normal’ P/E ratio was applied, the derived market price was so high that few people could afford to buy a “round lot” of 100 shares. This limited the demand for the stock and thus kept the total market value of the firm below what it would have been if more shares, at a lower price had been outstanding. To correct this situation, Porter “split its stock” as described in the next section.

Stock Splits

Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, hence the firm’s value will be maximized. Many observers, including Porter’s management, believe that the best range for most stocks is from $20 to $80 per share. Accordingly if the price of Porter’s stock rose to $80, management would probably declare a two-for-one stock split, thus doubling the number of shares outstanding halving the earnings and dividends per share, and thereby lowering the stock price. Each stockholder would have more shares, but each share would be worth less. If the post-split price were $40, Porter’s stockholders would be exactly as well off as they were before the split, However, if the stock price were to stabilize above $40, stockholders would be better off. Stock splits can be of any size-for example, the stock could be split two-for-one, three-for-one, one-and-a half-for-one, or in any other way.

Stock Dividends

Stock dividends are similar to stock splits in that they “divide the pie into smaller slices” without affecting the fundamental position of the current stockholders. On a 5 percent stock dividend, the holder of 100 shares would receive an additional 5 shares (without cost); on a 20 percent stock dividend the same holder would receive 20 new shares; and so on. Again, the total number of shares is increased so earnings dividends and price per share all decline.

If a firm wants to reduce the price of its stock, should it use a stock split or a stock dividend? Stock splits are generally used after a sharp price run-up to produce a large price reduction. Stock dividends used on a regular annual basis will keep the stock price more or less constrained. For example, if a firm’s earnings and dividends were growing at about 10 percent per year, its stock price would tend to go up at about that same rate, and it would soon be outside the desired trading range. A 10 percent annual stock dividend would maintain the stock price within the optimal trading range. Note, though that small stock dividends create bookkeeping problems and unnecessary expenses so firms today use stock splits far more often than stock dividends.

Dividend Stability

The stability of dividends is also important. Profits and cash flows vary over time, as do investment opportunities. Taken alone, this suggests that corporations should vary their dividends over time, increasing them when cash flows are large and the need for funds is low and lowering them when cash is in short supply relative to investment opportunities. However, many stockholders rely on dividends to meet expenses and they would be seriously inconvenienced if the dividend stream were unstable. Further reducing dividends to make funds available for capital investment could send incorrect signals and that could drive down stock prices. Thus, maximizing its stock price requires a firm to balance its internal needs for funds against the needs and desires of its stockholders.

How should this balance be struck: that is, how stable and dependable should a firm attempt to make its dividends? It is impossible to give a definitive answer to this question, but the following points are relevant:

1.    Virtually every publicly owned company makes a five to ten year financial forecast of earnings and dividends. Such forecasts are never made public they are used for internal planning purposes only. However, security analysts construct similar forecasts and do make them available to investors; see value line for an example. Further, virtually every internal five to ten year corporate forecast we have seen for a normal company projects a trend of higher earnings and dividends. Both managers and investors know that economic conditions may cause actual results to differ from forecasted results, but “normal” companies expect to grow.

2.    Years ago, when inflation was not persistent, the term “stable dividend policy” meant a policy of paying the same dollar dividend year after year. AT&T was a prime example of a company with a stable dividend policy - it paid $9 per year ($2.25 per quarter) for 25 straight years. Today, though most companies and stockholders expect earnings to grow over time as a result of retained earnings and inflation. Further, dividends are normally expected to grow more or less in line with earnings. Thus today a “stable dividend policy” generally means increasing the dividend at a reasonably steady rate. For example, Rubbermaid made this statement in a recent annual report:

Dividends per share were increased for the 34^th consecutive year out goal is to increase sales, earnings and per share by 15% per year, while achieving a 21% return on beginning shareholders equity. It is also the Company’s objective to pay approximately 30% of current year’s earnings as dividends, which will permit us to retain sufficient capital to provide for future growth.

Rubbermaid used the word “approximately” in discussing its payout ratio because ever if earnings vary a bit from the target level the company still planned to increase the dividend by the target growth rate. Even though Rubbermaid did not mention the dividend growth rate in the statement, analysts can calculate the growth rate and see that it is the same 15 percent as indicated for sales and earnings:

g=b(ROE)

=(1-Payout) (ROE)

=0.7(21%)=15%

Here b is the fraction of earnings that are retained, or 1.0 minus the payout ratio.

Companies with volatile earnings and cash flows would be reluctant to make a commitment to increase the dividend each year so they would not make such a detailed statement even so most companies would like to be able to exhibit the kind of stability Rubbermaid has shown, and they try to come as close to it as they can.

Dividend stability has two components: (1) How dependable is the growth rate, and (2) can we count on at least receiving the current dividend in the future? The most stable policy, from an investor’s standpoint, is that of a firm whose dividend growth rate is predictable such a company’s total return (dividend yield plus capital gains yield) would be relatively stable over the long run, and its stock would be a good hedge against inflation. The second most stable policy is where stockholders can be reasonably sure that the current dividend will not be reduced it may not grow at a steady rate, but management will probably be able to avoid cutting the dividend. The least stable situation is where earnings and cash flows are so volatile that investors cannot count on the company to maintain the current dividend over a typical business cycle.

3.    Most observers believe that dividend stability is desirable. Assuming this position is correct; investors prefer stocks that pay more predictable dividends to stocks which pay the same average amount of dividends but in a more erratic manner. This means that the cost of equity will be minimized and the stock price maximized, if a firm stabilizes its dividends as much as possible.

Other Dividend Policy Issues

Before we discuss how dividend policy is set in practice, we must examine two other theoretical issues that could affect our views toward dividend policy: (1) the information content or signaling hypothesis and (2) the clientele effect.

Information Content, or Signaling, Hypothesis

When MM set forth their dividend irrelevance theory, they assumed that every-one investors and managers alike has identical information regarding the firm’s future earnings and dividend. In reality, however, different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments and managers have better information about future prospects than public stockholders.

It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock while a dividend cut generally leads to a stock price decline. This could indicate that investors, in the aggregate, prefer dividends to capital gains. However, MM argued differently. They noted the well-established fact that corporations are reluctant to cut dividends, hence do not raise dividends unless they anticipate higher earnings in the future. Thus, MM argued that a higher-than-expected dividend increase is a “signal” to investors that the firm’s management forecasts good future earnings.⁴ Conversely a dividend reduction or a smaller-than-expected increase, is a signal that management is forecasting poor earnings in the future. Thus MM argued that investor’s reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price changes following dividend actions simply indicate that there is an important information or signaling content in dividend announcements.

Like mot other aspects of dividend policy, empirical studies of signaling have had mixed result. There is clearly some information content in dividend announcements. However, it is difficult to tell whether the stock price changes that follow increase or decreases in dividends reflect only signaling effects or both signaling and dividend preference. Still signaling effects should definitely be considered when a firm is contemplating a change in dividend policy.

Clientele Effect

As we indicated earlier, different groups, or clienteles of stockholders prefer different dividend payout policies. For example retired individuals and university endowment funds generally prefer cash income so they may want the firm to pay out a high percentage of its earnings. Such investors (and pension funds) are often in low or even zero tax brackets so taxes are of no concern. On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less need for current investment income and would simply reinvest dividends received, after first paying income taxes on those dividends.

If a firm retains and reinvests income rather than paying dividends those stockholders who need current income would be disadvantaged. The value of their stock might increase but they would be forced to go to the trouble and expense of selling off some of their shares to obtain cash. Also some institutional investors (or trustees for individuals) would be legally precluded from selling stock and then “spending capital”. On the other hand, stockholders who are saving rather then spending dividends might favor the low dividend policy for the less the firm pays out in dividends the less these stockholders will have to pay in current taxes, and the less trouble and expense they will have to go through to reinvest their after-tax dividends. Therefore, investors who want current investment income should own shares in high dividend payout firms, while investors with no need for current investment income should own shares in low dividend payout firms. For example investors seeking high cash income might invest in electric utilities, which averaged a 79 percent payout from 1991 through 1995, while those favoring growth could invest in the semiconductor industry, which paid out only 7 percent.

To the extent that stockholders can switch firms, a firm can change from one dividend payout policy to another and then let stockholders who do not like the new policy sell to other investors who do. However, frequent switching would be inefficient because of (1) brokerage costs, (2) the likelihood that stockholders who are selling will have to pay capital gains taxes, and (3) a possible shortage of investors who like the firms newly adopted dividend policy. Thus, management should be hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary, but it might also be permanent if few new investors are attracted by the new dividend policy, then the stock price would remain depressed. Of course, the new policy might attract an even larger clientele than the firm had before in which case the stock price would rise.

Evidence from several studies suggests that there is an fact a clientele effect.⁵ MM and others have argued that one clientele is as good as another, so the existence of a clientele effect does not necessarily imply that one dividend policy is better than any other. MM may be wrong, though and neither they nor anyone else can prove that the aggregate makeup of investors permits firms to disregard clientele effects. This issue, like most others in the dividend arena, is still up in the air.