TRADE CREDIT DECISION MAKING BASED ON PORTFOLIO MANAGEMENT APPROACH

The basic financial purpose of an enterprise is maximization of its value. Trade credit management should also contribute to realization of this fundamental aim. Many of the current asset management models that are found in financial management literature assume book profit maximization as the basic financial purpose. These book profit-based models could be lacking in what relates to maximization of enterprise value. The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences that can result from operating risk related to purchasers using payment postponement for goods and I or services. The present article offers a method that uses portfolio manage ment theory to determine the level of accounts receivable in a firm. An increase in the level of accounts receivables in a firm increases both the net working capital and the costs of holding and managing accounts receivables.


Introduction
The basic financial aim of an enterprise is maximization of its value. At the same time, both the theoretical and practical meanings are researched for determinants that increase the enterprise value. Financial literature contains information about numerous factors that influence enterprise value. Among those contributing factors is the extent of the net working capital and the elements shaping it, such as the level of cash tied up in accounts receivable, inventories, the early settlement of accounts payable, and opera-40 tional cash balances. The greater part of classic financial models and proposals relating to optimum current assets management was constructed with net profit ma.ximization in mind. This is the reason why these models need reconstruction to make them suitable to firms that want to maximize their value.

Literature review
The decision whether to extend the trade credit terms is a compromise between limiting the risk of allowing for the payment postponement from unreliable purchasers and gaining new customers by way of a more liberal enterprise trade credit policy. This decision shapes thc level and quality of accounts receivable. Robichek et al. (1965) discuss the risk involved in accounts receivable decisions, which must be accepted by financial institutions pledging of accounts receivable of the firm. Smith (Smith, 1973) predicts that portfolio theory may be used to decrease accounts receivable risk. Friedland (Friedland. 1966) agrees that current assets could be viewed in portfolio context. Pringle and Cohn (1974) even try to adapt CAPM theory to working capital elements. Bierman and Hausman (1970) discuss the granting policy of a firm and show that trade credit policy requires balancing the future sales gains against possible losses. Lewellen, Edmister and 10hnson (1972,1973) explain how and why traditional devices used for monitoring accounts receivable should be replaced by new and better ones.
The question disclLssed in this article concerns the possibility of using portfolio theory in making decisions about selecting which customers should be given trade credit. We will show that it is possible that the firm sells on trade credit terms to some customers who were previously rejected because of too great an operational risk, with a positive outcome of the creation of increased firm value. This extension of trade credit is possible only if the firm has purchasers from various branches, and if these branches have different levels of operating risk. The key to success for a firm is to perform portfolio analysis with the result of a varied portfolio of customers with a spectrum of managed levels of operating risk.

Value-based management of accounts receivable
If holding accounts receivable on a level defined by the enterprise provides greater advantages than a negative influence, the firm value will grow. Changes in the level of accounts receivable affect the value of the firm. To measure the effects that these changes produce, we use the following formula based on the assumption that the firm present value is the sum of the future free cash flows to the firm (FCFF) discounted by the rate of the cost of capital financing the firm: where t'1Vp = firm value growth, MCFF r = future free cash flow growth in period t, and k = discount rate I.

Future free cash flow is expressed as
where CRr = cash revenues on sales; CEI = cash expenses resulting from fixed and variable costs in time t; NCE = non-cash expenses; T = effective tax rate; iWWC = net working growth; and Capex = capital expenditure resulting from the growth of operational investments (money used by a firm to acquire or upgrade physical assets, such as property, industrial buildings, or equipment).
Similar conclusions, related to the results of changes in trade credit policy on the firm value can be estima ted on the basis of economic val ue added, i.e. the extent to which residual profit (the added value) increased the value of the firm during the period: where EVA = economic value added; NWC = I To estimak changes in accounts n.:ceivahle levels. we accl.!pt a discount rate equal to the average weighted cost of capital (WACC). Such changes and their results are stralegic and long·term in their character. although thl.!Y rdn 10 accounls receivahle and short-run area decisions. sce: (Maness. Zietlow. 1l)!)X. rp. (,2-63). net working capital; 01 = operating investments; and NOPAT = net operating profit after tax, estimated on the basis of the formula: The net working capital (NWC) is the part of current assets that is financed with fixed capital. The net working capital (current assets less current liabilities) results from the lack of synchronization of the formal rising receipts and the real cash receipts from each sale. It is also caused by a divergence during time of rising costs and the time when a firm pays its accounts payable.
where NWC = net working capital; CA = current assets; CL = current liabilities;AAR = average level of accounts receivable; INV = inventory; G = cash and cash equivalents; andAAP = average level of accounts payable. During estimation of the free cash flows, the holding and increasing of net working capital ties up money used for financing the net working capital. If the net working capital increases, the firm must utilize and tie up more money, and this decreases free cash flows. Production level growth necessitates increa<;ed levels of cash, inventories, and accounts receivable. Part of this growth will be covered with current liabilities that automatically grow with the growth of production and sales. The remaining cash requirements (that are noted as net working capital growth, illYWC) will require a different form of financing.
Trade credit policy decisions changing the terms of trade credit create a new accounts receivable level. Consequently, trade credit policy has an influence on the firm value. This comes as a result of alternative costs of money tied in accounts receivable and general costs associated with managing accounts receivable. Both the first and the second involve modification of future free cash flows and, as a consequence, the firm value changes. In Figure 1, we show the influence of trade credit policy changes on firm value. These decisions change: • future free cash flows (FCFF), • life of the firm (t) and • rate of the cost of capital financing the firm (k).
Innu"ncC on I.

Intlucncc on FCfF
Trade credit policy changc~ mllucnl'c: Changes to these three components influence the creation of the firm value (~Vp).
Accounts receivable changes (resulting from changes in trade credit policy of the firm) affect the net working capital level and also the level of accounts receivable management operating costs in a firm; these operating costs are a result of accounts receivable level monitoring and recoverycharges).
Trade credit terms give evidence about a firm trade credit policy. They are the parameters of trade credit and include: • the maximum delay in payment by purchasers (trade credit period); • the time the purchaser has to pay with a cash discount; and • the rate of the cash discount.
The length of the cash discount period and the maximum delay in payment by purchasers give information about the character of a firm trade credit policy. These trade credit conditions are: where ps = cash discount rate, os = cash discount period, and ok = maximum payment delay period. The terms of a trade credit sale are the result of a firm's management decision made on the basis of information about factors such as: • market competition, • the kind of goods or services offered, • seasonality and elasticity of demand, • price, • type of customer, and • profit margin from sale.
H is important to match the length of the trade credit of a firm to its customer's capabilities. The enterprise giving the trade credit should take into account the purchasers' inventory conversion cycle as well as its accounts receivable con-version cycle. These two elements make up the operating cycle of a purchaser. The shorter this cycle, the shorter the maximum payment delay period offered to a purchaser should be. The maximum payment delay period for purchaser is the maximum expected period of accounts receivable cycle for a seller.
In order to choose what terms of sale should be proposed to the purchaser, a firm management can use the incremental analysis as final criterion, as well as to compare the influence of these proposals on firm value. Incremental analysis is a tool for estimating the effects of changes in trade credit policy on the enterprise. This analysis usually takes into account three basic elements: (1) estimation of the results of changes on sales as well as losses resulting from bad debts, (2) estimation of the changes in the firm accounts receivable level.
Accounts receivable growth is where tvtAR = accounts receivable growth, ACP o = receivables collection period before trade credit policy change,ACP I = receivables collection period after trade credit policy change, CR II = cash revenue before trade credit policy change, CR, = cash revenue after trade credit policy change, and VC = variable costs (in percent from sales incomes).
(3) Estimation of the firm value change: x tvtAR +-(11 xCR I -I() xCR II ) -(sP I x (8) where DEBIT = earnings before interests and taxes growth, k t _ 1R = operating costs of accounts receivable management in a firm, 10 = bad debts loses before trade credit policy change, II = bad debts loses after trade credit policy change, sPI! = cash discount before trade credit policy change, sP I = cash discount after trade credit policy change, Wo = part of purchasers using cash discount before trade credit policy change, and w l = part of purchasers using cash discount after trade credit policy change.
To check how changes in the accounts receivable level andEBITinfluence the firm value, it is possible to use changes in future free cash flows. First we have changes in FCFF in time 0: Next, the free cash flows to the firm in periods (from 1 to 11) as:  As one can see through the above case, the first half and then .tore of sales are realized on the principle of cash sale. This results from the fact that those customers who created sales only for cash did not fulfil the requirements relating to the risks, which is considered as a percentage of delayed payments. Therefore, the firm stopped offering these purchasers sales on the principle of trade credit. This was despite the fact that their financing wi th the trade credit made it possible to notice much greater activity and a higher level of income from sales than at the trade credit relinquishment.

Portfolio theory approach in trade credit decisions
A portfolio is a set of assets (for example, accounts receivable). The portfolio approach to accounts receivable management can be used by utilizing the rate of profit (rate of advantage from assets) as one of the basic criteria that the firm  where P, = based on historical data probabili ty of R" and R, = expected rate of return from accounts receivable from the group of purchasers i.
The measure of risk also can be defined according to the standard deviation: (13) Both the variation and the standard deviation can be estimated for the historical data of a purchaser.
The next element is the correlation of profit from the trade credit given to the purchaser (or to a group of purchasers) in which the profits of the trade credit are given to other purchasers (or to different groups of purchasers). If the firm completes transactions with more than one group of purchasers, it is possible to distinguish two or more homogeneous groups in relation to the risk and profit from giving a trade credit. In this case, the portfolio approach can be used. These groups can belong to definite trades", and a connection does or may exist between the accounts receivables of these groups of purchasers. The measure of such a connection is usually the coefficient of correlation: fp, x(R I , -RI)x(R~; -R~) where PI" =the coefficient of the first and second groups of accounts receivable correlation, R J = the expected rate of return from accounts receivable ofthe first group of purchasers, R2 = expected rate of return from accounts receivable of the second group of purchasers, s, = standard deviation for the first group, S2 = standard deviation for the second group, R}, = individual rate of return from accounts receivable of purchaser i from the first group of purchasers, R 2 , = individual rate of return from accounts receivable of purchaser i from the second group of purchasers, and P, = probability of individual rate of return from accounts receivable of purchaseri.
To show how the portfolio approach may be used in accounts receivable management, we will use the portfolio of two groups of accounts receivable as an example.
Example 2. The firm cooperates with two homogeneous groups of purchasers. The first group of purchasers delivers its services to industry A, the second group of purchasers serves customers from industry B. Creating a portfolio of two kinds of accounts receivable makes sense only when the correlation between profits from the giving trade credit for these groups is less than 1. Example 2, Case 1. The correlation coefficient between accounts receivable profits from groups A and B equals 1, P A. B = l. Source: our own sll/dy based on (Jajuga, Jajuga, 1994).
In such a situation, the only possible is a partial reduction of risk. The reasonable finn should not choose any portfolio of charge lying on the A-AJBJline, because it is always possible to find a more profitable equivalent on the AJBJ-AJB~ line, which with the same risk S gives a higher profit R. The skilful construction of two groups of accounts receivable portfolio can lead to a considerable reduction of risk. Inclusion to the single-asset portfolio ofthe second component almost always leads to risk decrease, sometimes even with a simultaneous profit growth (Brigham, Daves, p. 77).
Example 3 (continuation of example 1). After the historical data analysis had been made, firm managers noticed that the expected profits were higher and correlated negatively with profits generated from purchases by current customers. This came certainly from allowing a trade credit to customers who had made cash purchases because of the high risk during the receivables collection period. These trends lead to the expectation) of a lower risk of profits from accounts receivable and to a simultaneous growth in profits from sales in general. A 3% cash discount was proposed to customers who paid within 10 days, along with an extension of the payment deadline to 45 days for any remaining customers. As a result, 4% of sales would be paid for in cash, while 40% of customers would take advantage of the cash discount by paying by the 10 th day. The remaining customers (46% of sales) would make their payments on the 45 th day. Bad debts = 1% x CR. CRi = 700000000 €. The effect of these changes in the trade credit policy would be felt for three years. In addition, VC would be reduced from 50% to 49% thanks to the advantages of scales resulting from larger sales (and increased production).
So, we have: The firm value will increase. The proposed change will be more profitable than in example ) With admillancc of taking hoth groups simultancously on trade credit principics. 1 without using the portfolio approach. This related information comes from the estimation of EVA growth: LlEVA =O.8Ix98 671889-15%x x27140 556 = 75 853147 f

s. Conclusions
Accounts receivable management decisions are very complex. On the one hand, too much money is tied up in accounts receivables because of the extremely liberal policy of giving a trade credit. This burdens the business with higher costs of accounts receivable service with additional high alternative costs. Additional costs are further generated by bad debts from risky customers. On the other hand, the liberal trade credit policy could help enlarge income from sales. In the article, the problem was linked to the operational risk of purchasers interested in receiving a trade credit who, as separately considered groups, may characterize a too high risk level. However, if they are considered as one of several groups of enterprise customers, and if their payment habits are correlated with the payment habits ofthe remaining groups, what had been impossible could become possible and may even turn profitable. The portfolio of assets, like the portfolio of accounts receivables, sometimes presents a lower risk to acceptable advantages than the independently considered groups of purchasers.

Summary
The basic financial purpose of an enterprise is maximization of its value. Trade credit management should also contribute to realization of this fundamental aim. Many of the current asset management models that are found in financial management literature assume book profit maximization as the basic financial purpose. These book profit-based models could be lacking in what relates to another aim (i.e., maximization of enterprise value). Financial literature contains information about numerous factors that influence enterprise value. Among those contributing factors is the extent of the net working capital and the elements shaping it, such as the level of cash tied up in accounts receivable.
The decision if extend the trade credit terms, is a compromise between limiting the risk of allowing for the payment postponement from unreliable purchasers and gaining new customers by way of a more liberal enterprise trade credit policy. This decision shapes the level and quality of accounts receivable.
The question discussed in this article concerns the possibility of using portfolio theory in making decisions about selecting which customers should be given trade credit. In this article, we showed that it is possible that the firm can sell on trade credit terms to some customers, who previously were rejected because of too great an operational risk, with a positive outcome the creation of increased firm value. This extension of trade credit is possible only if the firm has purchasers from various branches, and if these branches have different levels of operating risk. The key to success for a firm is to perform portfolio analysis with the result of a varied portfolio of customers with a spectrum of managed levels of operating risk.
If holding accounts receivable on a level defined by the enterprise provides greater advantages than negative influence, the firm value will grow. Changes in the level of accounts receivable affect on the value of the firm. To measure the effects that these changes produce, we use the following formula, which is based on the assumption that the firm present value is the sum of the future free cash flows to the firm, discounted by the rate of the cost of capital financing the firm. The net working capital is the part of current assets that is financed with fixed capital. During estimation of the free cash flows, the holding and increasing of net working capital ties up money used for financing net working capital. If net working capital increases, 50 the firm must utilize and tie up more money, and this decreases free cash flows. Production level growth necessitates increased levels of cash, inventories, and accounts receivable. Part of this growth will be covered with current liabilities that automatically grow with the growth of production and sales. Trade credit policy decisions changing the terms of trade credit create a new accounts receivable level. Consequently, trade credit policy has an influence on firm value. This comes as a result of alternative costs of money tied in accounts receivable and general costs associated with managing accounts receivable. Both the first and the second involve modification of future free cash flows and as a consequence firm value changes. Accounts receivable changes affect the net working capital level and also the level of accounts receivable management operating costs in a firm; these operating costs are a result of accounts receivable level monitoring and recovery charges. The length of the cash discount period and the maximum delay in payment by purchasers give information about the character of a firm trade credit policy. It is important to match the length of the trade credit of a firm to its customer's capabilities. The enterprise giving the trade credit should take into account the purchasers' inventory conversion cycle as well as its accounts receivable conversion cycle. These two elements make up the operating cycle of a purchaser. The shorter this cycle. the shorter should be the maximum payment delay period offered to a purchaser.
Accounts receivable management decisions arc very complex. On the one hand. too much money is tied up in accounts receivables, because of an extreme liberal policy of giving trade credit. This burdens the business with higher costs of accounts receivable service with additional high alternative costs. Additional costs are further generated by bad debts from risky customers. On the other hand, the liberal trade credit policy could help enlarge income from sales. In the article, the problem was linked to the operational risk of purchasers interested in receiving trade credit who, as separately considered groups, may characterize too high risk level. However, if they are considered as onc of several groups of enterprise customers, and if their payment habits are correlated with the payment habits of the remaining groups. what was formerly impossible could become possiblt:. and may even turn profitable.