Question: A company extends its trade credit terms by four days to all its credit customers. The most likely effect of this change to the company’s credit customers is a four-day:
Answer: decrease in the company’s net operating cycle.
To me the answer to the question is confusing, because of the “trade credit (…) to all its customers”. Who are the customers? In my opinion the customers are those who buy the company’s products. If the company extends the trade credit then acc. rec. should go up. That would increase the operating and also net operating cycle.
Answer explanation : The company’s customers are receiving a four-day increase in their number of days of payables, which will reduce the company’s cash conversion cycle (net operating cycle) by four days.
Can someone please explain to me, why the company’s cash conversion cycle decreases when the customers can pay four days later than before. Thanks a lot.
They’re asking you the effect on the credit customers, not the effect on main company offering the relaxed credit terms. You’re right; if the company itself offers more relaxed credit terms, their A/R will increase (most likely), thus increasing their net operating (cash conversion) cycle. _ However _, the question asks for the effect on the creditcustomers. If you’re a credit customer, your A/P will grow (most likely) when you are allowed more lax credit terms. This should reduce your net operating cycle.
Starting to think that the answer is incorrect. And should be an increase in the net operating cycle, since the receivables conversion period will have increased.
I see what you’re saying (I think): The solution is referring to the main company.
All was doing was looking at what (I thought) the question was asking for, in this case what happens to the customers. I think you’re right in that something is a little mixed up in this question/answer pair.
The original company (the one offering the credit terms) has an increasing operating cycle (and increasing net operating cycle), since this company’s payables are unaffected by what they’re offering the customers.
Simply: Company A offers more relaxed credit terms to its customers, say Company B and Company C. Ceteris paribus, Company A will experience an increase in the net operating cycle via an increase in the average collection period (Days Sales Outstanding). Company B and Company C (the customers) will both experience a decrease in their respective net operating cycles, due to the increase in their average payment period (Days Sales in Payables), ceteris paribus.
At first glance, I thought nothing of it-- I actually answered this question in the CFAI self-assessment with the same logic you did (saying the offering company would have an increase in the net operating cycle through increasing A/R). When I saw it was wrong, I thought maybe I didn’t read the full question to see it applied to the customers…I think a potential spot for confusion is the lack of clarity in the way both the question and answer are phrased. The more I read it, the less clear the wording seems.
I ran into this question this weekend and I was upset when I got it wrong.
If we were reviewing the company issuing the trade credit, it would increase the net operating cycle (days in inventory plus days in receivables minus days in payables) because we’re adding to the “days in receivables.”
However, for the customers, the additional time being granted would be their respective “days in payables.” Therefore, looking at the net operating cycle for the customer, the answer is correct. I don’t remember on the exam the wording in the solution, though.