Receivables management: a case study.(Instructor's Note)

Amoah, Nana ; Rao, Arundhati

CASE DESCRIPTION

The primary subject matter of this case concerns receivables management. Secondary issues examined include the impact of a client's financial distress on a firm's cashflows; the use financial accounting data to challenge a firm's going concern principle and the formulation of new business strategies when the unexpected happens to a firm. The case is appropriate for first year graduate level. The case is designed to be taught in two class hours and is expected to require five hours of outside preparation by students.

CASE SYNOPSIS

Delta Inc. was formed in 1998 by Thomas Dake and George Roberts. The firm was organized and located in Baltimore, Maryland. It provided brokerage services for a wide range of financial transactions for businesses in the state of Maryland. Delta's strategy was to position itself as a discount broker because it perceived that borrowers' resistance to broker fees was much weaker when the lender paid the fees. Pink Tree Finance, a public company listed on the New York Stock Exchange, was Delta's major business partner. About 60 percent of Delta's receivables were due from Pink Tree. Although Delta regarded new client and lender relationships as opportunities for growth within the brokerage business, it also looked for opportunities in other businesses. As a result, the firm identified the West Baltimore Senior Housing Project as a good investment opportunity.

Delta planned to develop a property on West Baltimore Street into a senior housing facility and commercial spaces. The entire project was estimated to cost $10.5 million. Delta executed the purchase agreement for the existing West Baltimore Street property in September, 2001. In October, 2001, Delta applied to a bank in Baltimore for a commercial loan of $10.5 million to purchase and develop the property. The term sheet provided Delta with 90 days to close the loan transaction. It required a refundable fee of $100,000 on executing the term sheet. Delta planned to use the outstanding brokerage fees to be collected from Pink Tree to close its loan transaction. In the middle of January, 2002, Pink Tree filed for chapter 11 bankruptcy. Mr. Thomas Dake, CFO of Delta Group was now in a difficult situation of raising $100,000 to close the loan and to ensure that the West Baltimore Senior Housing Project would be realized.

INSTRUCTORS' NOTES

Research Methods

This is a field-based research case. The case utilizes information from a firm's internal documents. The names of both firms and individuals involved have been altered to protect their privacy. Some of Delta's financial information was altered at the firm's request.

Recommendation for Teaching Approaches

The recommended approach for teaching the case is the three-stage learning process which involves students first analyzing the case individually, then in a small group, and finally discussing the case in a large group (Naumes, P., and Naumes, W., 1999).

A less structured discussion of the case is recommended. It is ideal to have the students analyze the case prior to the class discussion and then have group presentations in class. The case analysis should clearly identify the critical issues facing Delta Inc., provide alternatives, recommend a solution and provide justification for the recommended solution. The time for each presentation may be about 20 minutes, and then the remaining period may be used for class discussion and the instructor's summary. The instructor may assign the following discussion questions before or during the class discussion.

Discussion Questions

1. What is the critical issue facing Delta Inc.?

2. List some topics related to receivables management.

3. To what extent did Delta's business strategy impact the firm's accounts receivable and cash flow problems?

4. Calculate the Altman's Z-Score for Pink Tree and discuss whether Delta Inc. should have anticipated the risk of dealing with Pink Tree?

5. How should Delta report the Pink Tree debt in its financial statements?

6. What are the major constraints against the continued success of Delta as a discount broker?

7. What suggestions related to the liquidity and solvency of Delta's operations would you make?

8. What recommendations related to Delta's financing of the $100,000 would you make?

ANSWERS TO DISCUSSION QUESTIONS

1. What is the critical issue facing Delta Inc.?

Receivables management and the risk of failure are critical issues for Delta Inc. A key issue was how to ensure financial flexibility in relation to the amount and timing of its cash flows. Financial flexibility would enable the firm to respond to unexpected needs such as Pink Tree's bankruptcy. However in order to survive in a highly competitive market Delta Inc sacrificed one of two sources of revenue. This resulted in Delta's inability to respond to the unexpected situation of Pink Tree defaulted on the outstanding broker fees. Delta had liquidity and solvency problems as well. The firm's liquidity ratios were below the industry averages. Delta's current ratio was 1.46 in 2001, 1.12 in 2000, and 0.58 in 1999 while the industry averages were 3.22, 3.20, and 2.27 respectively. Current cash debt coverage ratio was 0.082 in 2000 and 0.061 in 2001 while the industry averages were 0.08 and 1.15 respectively.

Delta's solvency ratios were higher than the industry averages. The firm's debt to asset ratio was 0.80 in 1999, 0.74 in 2000, and 0.66 in 2001 while the industry averages were 0.60, 0.63, and 0.64 respectively. Cash debt coverage ratio was 0.033 in 2000 and 2001 while the industry averages were 17.67 and 10.55 respectively.

Delta's liquidity and solvency ratios:

Current ratio for 2001 = current assets / current liabilities = 752,999 / 514,227 = 1.46

Current ratio for 2000 = current assets / current liabilities = 425,142 / 380,986 = 1.12

Current ratio for 1999 = current assets / current liabilities = 112,286 / 195,224 = 0.58

Current cash debt coverage ratio (2001) / net cash provided by operating activities--average current liabilities = 58,210 / (514,227+380,986) = 0.065

Current cash debt coverage ratio (2000) = net cash provided by operating activities average / current liabilities = 47,146 / (195,224+380,986) = 0.082

Cash debt coverage (2001) = net cash provided by operating activities / average total liabilities = 58,210 / (944,257+811,016) = 0.033

Cash debt coverage (2000) = net cash provided by operating activities / average total liabilities = 47,146 / (811,016+625,254) = 0.033

Debt to total asset ratio for 2001 = total debt / total asset = 944,257 / 1,427,180 = 0.66

Debt to total asset ratio for 2000 = total debt / total asset = 811,016 / 1,099,323 = 0.74

Debt to total asset ratio for 1999 = total debt / total asset = 625,254 / 786,467 = 0.80

A related issue was ensuring the collectibility of Delta's accounts receivables, and evaluating the risk of financial distress of the firm's major business partners such as Pink Tree. For the graduate class, the instructor may want to assign an additional reading on the subject of corporate financial distress such as: E. I. Altman, Corporate Financial Distress and Bankruptcy, (New York: John Wiley and Sons, 1993).

Delta should revisit and revise their receivables management policies. They should look into various factoring options, securitizing their receivables and regularly analyzing the default risk of all receivables.

2. List some topics related to receivables management.

i. Granting Credit: Delta must establish procedures and guidelines for evaluating which clients qualify for credit. These guidelines should be based on credit investigation of clients such as examining the payment record or history of clients as well as other risk factors such as business risk and bankruptcy risk of clients.

ii. Billing: Delta must establish procedures for prompt billing for services provided. Delta must also maintain information on the status of all unbilled accounts to insure that all actions necessary for the preparation of the bill have been taken as required so that the bill may be issued as expeditiously as possible.

iii. Aging and Analysis: Delta must maintain adequate information concerning the age of outstanding bills and claims for proper overall control of accounts receivable and related reserves for bad debts. Delta must collect, maintain, report, and act upon aging information in a standardized and consistent manner.

iv. Collection: For effective collection, Delta must establish who is responsible for collection and when to refer the receivables to collection agencies. Delta must also analyze the levels of effort in record keeping and collection to ensure that it is commensurate with collection value.

v. Factoring: Delta can improve collection and obtain financing by factoring its receivables. A factoring company offers credit coverage and can guarantee payment of accounts receivable. When Delta's accounts receivable are assigned to a factoring company, customers and clients obtain business line of credit from Delta based on the credit management expertise of the factoring company. The factoring company collects the accounts receivables once they become due. If the customer or client becomes unable to pay because of financial inability, the factoring company can pay the receivables. Therefore, accounts receivable factoring can provide a business line of credit to Delta and allow the company to obtain financing by borrowing against the factored receivables.

vi. Provision for Bad Debts: Delta must establish a policy on provision for bad debts. Delta must also establish and maintain a reserve for bad debts. Procedures for writing-off of bad debts and the approval and policies for writing-off bad debts must also be established.

3. To what extent did Delta's business strategy influence the firm's accounts receivable and cash flow problem?

Delta's strategy was to be a discount broker. The firm provided brokerage services to clients without billing the clients directly. Delta collected its brokerage fees from the lender after a client's loan transaction had closed. Delaying the collection of brokerage fees contributed to Delta's low receivable liquidity and increased the risk of the firm's cash flows. This is common industry practice. Delta's receivables turnover ratio, a measure of receivable liquidity, was lower than the industry average. Receivable turnover was 2.5 times in 2000 and 1.6 times in 2001 while the industry averages were 5.86 and 4.14 respectively. Delta's receivable liquidity problem also contributed to the firm's low cash flow position.

Delta's receivable turnover ratios:

Accounts receivable turnover ratio in 2001 = net sales / average trade receivables = 820,226 / (668,932+359,285) = 1.6 times or 228 days

Accounts receivable turnover ratio in 2000 = net sales / average trade receivables = 531,617 / (359,285+63,575) = 2.5 times or 146 days

4. Calculate the Altman's Z-Score for Pink Tree and discuss whether Delta Inc. should have anticipated the risk of dealing with Pink Tree?

Delta should have anticipated the risk of dealing with Pink Tree because an in-depth analysis of Pink Tree's publicly available financial statements would have revealed that Pink Tree was in financial distress. Although Pink Tree's solvency ratios provided mixed signals about its financial condition, Altman's bankruptcy prediction model clearly indicated that Pink Tree was experiencing serious financial problems.

Pink Tree's debt to asset ratio was more favorable than the industry averages but its cash debt coverage ratio did not compare favorably with the industry average. The firm's debt to asset ratio was 0.91 in 2001 and 0.90 in 2000 while the industry averages were 6.05 and 5.56 respectively. Pink Tree's cash debt coverage ratio of 0.013 in 2001 was far below the industry average of 0.17.

Pink Tree's solvency ratios:

Cash debt coverage for 2000 = net cash provided by operating activities / average total liabilities = 516.7 / (18,748.8+20,278.5) = 0.013

Debt to total asset ratio for 2001 = total debt/total asset = 20,278.5/22,228 = 0.91

Debt to total asset ratio for 2000 = total debt/total asset = 18,748.8/20,838 = 0.90

Another measure that could have been used by Delta to evaluate the risk of dealing with Pink Tree was Altman's bankruptcy prediction model or Z-score. Companies with Z-core above 3.0 are unlikely to fail while those with Z-score below 1.81 are very likely to fail (Altman, E.I., 1993). Pink Tree's Z-score was 0.048 in 2001 and 0.033 in 2000. These scores were consistently far below 1.81 showing that Pink Tree was very likely to fail.

Z score = [(working capital / total assets) x 1.2] + [(retained earnings/total assets) x 1.4] + [(EBIT / total assets) x 3.3] + [(sales--total assets) x 0.99] + [(market value of equity / total liabilities) x 0.6]

Z score (2001) = [(-6,711.6 / 22,228) x 1.2] + [(98.7 / 22,228) x 1.4] + [(1069.2 / 22,228) x 3.3] + [(2,683.6 / 22,228) x 0.99] + [(4,266.01 / 20,278.5) x 0.6] = 0.048

Z score (2000) = [(-5,093.5 / 20,838) x 1.2] + [(268.9 / 20,838) x 1.4] + [(409.8 / 20,838) x 3.3] + [(2,444.8 / 20,838) x 0.99] + [(3,965.23 / 18,748.8) x 0.6] = 0.033

5. How should Delta report Pink Tree's debt in its financial statements?

As Pink Tree had filed chapter 11 bankruptcy and Delta's receivables were not securitized, the firm should report the receivable as uncollectible and write it off. The receivable must be removed from the books by debiting allowance for doubtful accounts and crediting accounts receivable.

6. What are the major constraints acting against the success of Delta as a discount broker?

The major constraints acting against Delta are the following:

i. Ensuring the timely collection of its accounts receivable.

ii. Assessing the financial risk of its business partners.

iii. Ensuring the firm's financial flexibility or the firm's ability to act effectively to alter the amount and timing of cash flows to enable it respond to unexpected needs or opportunities.

7. What suggestions related to the liquidity and solvency of Delta's operations would you make?

Some of the options available to Delta have already been discussed. The instructor can lead a discussion in this area by focusing on whether the firm should revise its business model and make clients pay for its services, how to effectively collect its receivables especially from future tenants at West Baltimore Street, and an effective accounting reporting system that would alert the management of potential problems with financial flexibility.

8. What recommendations related to Delta's financing of the $100,000 would you make?

As Delta Inc. has only two weeks to finance the $100,000 escrow and close the loan, it is recommended that the firm finance the loan transaction through a fast-track bridge financing program offered by some lending institutions. An example of such a program is the "front-end financing of commercial loan closing costs." Although the interest rate of such programs can be as high as 15% for 90-days, the advantage is that financing can be obtained in as little as 10 days and no upfront fees are required.

EPILOGUE

Delta Inc. obtained financing to close the loan transaction within the two weeks period. Since the time of the case, Delta Inc. has revised its business strategy and clients are charged a fee for the loan application process. The firm has put in place comprehensive risk analyses of both its clients and business partners and strengthened its accounts receivables collections department.

REFERENCES

Altman, E. I. (1993). Corporate financial distress and bankruptcy. New York: John Wiley and Sons. Naumes, P. & W. Naumes (1999). The art and craft of case writing. California: Sage Publications Inc.

ENDNOTES

(1) Federal bankruptcy laws govern how companies go out of business or recover from crippling debt. A bankrupt

company, the "debtor," might use Chapter 11 of the Bankruptcy Code to "reorganize" its business and try to become profitable again. Management continues to run the day-to-day business operations but all significant business decisions must be approved by a bankruptcy court (http://www.sec.gov/investor/pubs/bankrupt.htm).

Nana Amoah, Old Dominion University

Arundhati Rao, Elizabethtown College