Using discounted cash flow analysis to evaluate the operations of a credit department
The use of discounted cash flow (DCF) analysis to evaluate ongoing internal operations is rarely considered by management In fact, the Credit Executives Handbook, published by the Credit Research Foundation, does not even mention this technique, which has been used successfully by Investors, Merger and Acquisition Specialists, Real Estate Entrepreneurs, Product Developers, Accountants and many others, for a great number of years, as the basis for analyzing competing alternatives.
One of the reasons that this technique may have been overlooked, as a management tool, is that it assumes an investment or series of investments that produce a return in the form of one or more positive cash flows. As credit is usually not considered in this light, DCF is rarely used In this article, however, we will suggest an approach that if properly applied can provide a company with an unbiased method for evaluating the operations of a credit department, a sales operation and many other internal functions, at any desired level, i. e., individual, group, overall, etc.
What is Discounted Cash Flow Analysis?
The underlying justification for discounted cash flow analysis is the time value of money. A dollar in your pocket today in worth more than a dollar to be received some time in the future. The dollar in your pocket can be invested, and the value of the dollar plus your return on its investment will be more than the dollar received in the future. This assumes, of course, that you don’t do your investing on the roulette tables in Las Vegas! In a classical DCF, several steps need to be performed. Specifically:
1. Future cash flows need to be estimated. For certain classes of assets, estimating future cash flows is easy because they are legally fixed, interest on bonds, for example, will be received when expected providing the issuer doesn’t default. Other cash flows, however, can be extremely difficult to estimate. Items such as research and development costs, and the future revenues and operating expenses from a new product like Microsoft’s Windows 2000 are some of many that can be mentioned.
2. The risk associated with the cash flows must be assessed. In most alternative investment applications using only one set of estimates may not be adequate. Any underlying uncertainty in the cash flows must also be considered. In many analyses, however, due to time constraints the discount rate used for implied risk maybe the company’s cost of capital.
3. The risk assessment must be built-in to the analysis. One can reduce the cash flows to account for risk or the discount rate can be adjusted. The higher the risk, the higher the discount rate.
4. The present value of the cash flows must be calculated. This tells a financial manager the expected value of a series of future cash flows in today’s dollars. Essentially, the discounting process does away with the problem of comparing cash flows that will occur at different times in the future.
5. Opportunity costs may need to be determined. The series of alternative cash flows, under consideration, may occur at different times. As the cash comes in, what is the company going to do with it? Reinvest it very likely, but in what? Based on when the money becomes available, the possible uses may vary and so will their opportunity costs.
Two Ways to Look At the Problem
For the purposes of the following discussion we will use NPV rather than IRR to evaluate the presented alternatives and we will also ignore risk assessment and opportunity costs, the application of which would require an additional degree of difficulty, not contemplated in this article. Also required for a DCF analysis is at least one positive cash flow (the return on investment) and one negative cash flow (the investment).
A Slight Digression
Before discussing the uses of DCF to evaluate internal operations let us apply the technique to determine whether or not providing a discount for early payment is to a company’s benefit. In a DCF analysis, at least one investment is required. One of the reasons that the technique is not readily used in internal evaluations is that there is no obvious investment. If we assume, however, that a sale to a customer represents an investment equal to the cost of the products shipped plus any other direct costs that can be directly attributed to the shipment, and the customer’s payment for the shipment is the return on the investment then DCF can be applied Consider the following stream of shipments and payments, where the shipments are the negative values (investment = cost of goods + other direct costs) and the payments are the positive values (return on investment). Both accounts are shipped the same amount of merchandise on the same day, at the same cost, however, Account 1 gets a 2% discount for paying within 10 days of shipment while Account 2 pays Net, 30 days after shipment.
Using the Excel function XNPV, which handles a series of cash flows that is not necessarily periodic and an implied interest rate of 10%:
For Account 1 XNPV = (0.1, B3: B12, A3: A12) _ $30,520, and
For Account 2 XNPV = (0.1, D3: D12, C3: C12) = $31,460
The $1,300 difference in the Gross Margins is due to Account 1 taking their 2% discount, which is expected. But the difference in the NPVs indicates that providing the 2% discount has effectively reduced the company’s realization on the sales by a NPV = $920. Unless the monies received from Account 1 are reinvested to produce a positive cash flow that has an NPV $920 more than the monies received from Account 2 produce, providing a 2% discount may not be a good policy.
Using Discounted Cash Flow to Evaluate the Credit Function
Let us assume that a given credit manager handles the few accounts, shown below. The accounts have been shipped and have paid for those shipments according to the following table:
Now let’s compare this measure to another measure that represents the absolute best the credit manager could have achieved given the fact that his accounts have taken deductions and not paid the total amount billed due to circumstances beyond the credit managers control. Consider the next table, which shows the absolute best NPV that could have been realized. This table assumes, therefore, that every shipment was paid for on the day it was shipped.
Rating The Credit Manager
The reason that this method is so powerful is that it allows evaluations, at any level of aggregation, to take into consideration the time value of money, and in so doing eliminates the inherent bias of unequal streams of cash flows that occur at different points in time. We submit that if a company were to analyze all of its accounts’ payment patterns for its previous year and determine its Optimum Percent Gross Margin for all activity that this would be a good standard against which to use the procedure described above for evaluating the performance of individual credit managers, the entire credit department, individual sales personal, as well as individual account performance, for the current period.
Albert Fensterstock is the Chief Technical Officer of Credit Risk Monitor.com, the first real time, online, financial information analysis and news service, created specifically for the corporate credit professional Users can customize CRM’s free Credit Portal www.My.CreditRiskMonitor.com so that almost every information resource needed by a credit manager is: “only a click away”.
Copyright Credit Research Foundation First Quarter 2000
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