Question for Working capital management-Accounting?

Posted:: 3+ months ago by springwood
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Would anybody kindly answer the below question? I tried few hours but couldn't get there. Many thanks in advance.

Q.Excelsior Ltd has sold all its products in the past on a cash basis. The company’s directors are considering whether to give credit to all its customers so as to increase sales. Existing sales are $500 000 per annum and it is estimated that sales will increase to $750 000 per annum if credit is offered, and that debtors will pay accounts as follows:

• For 20% - one month from time of sale
• For 30% - two months from time of sale
• For 25% - three months from time of sale
• For 20% - four months from time of sale
• For 5% - bad debts

The variable costs are 80% of sales and such costs are paid at the same time as sales are made. The company’s cost of capital is 1% per month. Advise the directors whether the company should proceed with the proposal.

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Answers (1)

burst4x

Yes, based on the figures only, they should proceed with the proposal. Currently, selling for cash, they make 500,000-500,000*80% = 100,000 USD Profit

If they go for credit:
750,000 revenue - 600,000 variable costs = 150,000 USD
Less:
Bad debt (750,000*0.05*0.8) = 30,000
1 month credit: 150,000*0.8*0.01 = 1200 USD
2 months credit 225,000*0.8*0.01*2 = 3600 USD
3 months credit 187,500*0.8*0.01*3 = 4500 USD
4 months credit 150,000*0.8*0.01*4 = 4800 USD
Total credit cost = 44,100 USD

Net profit: 150,000-44,100 = 105,900 USD

So, based on figures it is worth giving Customers credit terms. However, what the directors should observe is that the increase in profit is just 5,9% and this is based on estimates. A 10% bad debts will put the company in a worse position compared to the previous business model. Net profit margin actually goes down which can be tricky if the company will want to further expand using debt. More, the new model will bring in additional complexity related to managing credit limits, chasing Customers etc - it does not seem that Management considered these complexities and associated costs when they made their assumptions. So, if the directors are somewhere around 99% certain on their assumptions they should go with the credit term, but if not I would recommend to wait for a better opportunity.

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