FM - April 2022 - L2 - Q5a - Management of receivables and payables

FM – April 2022 – L2 – Q5a – Management of receivables and payables

Evaluate the impact of a proposed change in credit policy on Poh-Poh Electronics Ltd’s profitability and recommend whether the policy should be implemented, along with advice on procedures for receivables collection.

Question

Poh-Poh Electronics Ltd is a wholesale distributor of household electrical products of major electronic brands. The company currently sells on credit to all its customers. Although the credit term is net 20 days, the receivables turnover days have been 15 days. The company’s annual credit sales revenue is GH¢80 million, and its contribution margin ratio is 30%. Bad debt is 2% of sales revenue, and credit collection cost is GH¢50,000 per annum.

Management is considering extending the credit period to net 30 days. It is expected that the implementation of this proposal would attract new customers, and the annual revenue would increase by 20%. It is also expected that both the existing and the new customers will probably take the full 30 days credit. To mitigate the probable lengthening in the receivables turnover days, management proposes that the extension in the credit period be combined with the introduction of a cash discount policy of 2% on all payments made within the first 10 days of the credit period. It is expected that 30% of all customers will pay their accounts early to take the discount. Consequently, the receivables turnover days would increase to 24 days. While the bad debt will remain at 2% of sales revenue, the annual credit collection cost will increase to GH¢65,000.

The company’s cost of capital is 24%.

Required:
i) Evaluate the proposed change in the credit policy and recommend whether the proposed change should be implemented. (9 marks)
ii) Advise the management team on THREE (3) procedures for the collection of its receivables. (6 marks)

Answer

i) Evaluation of the proposed credit policy change
The evaluation of a proposed credit policy change requires the estimation of the value of benefits and costs associated with the policy change.

Benefit from the proposed policy change:
The benefit from the proposed policy change will be the increment in contribution margin.
Additional sales = $20% \times G H ¢80, 000, 000 = G H ¢16, 000, 000$ $Additional CM = 30% \times G H ¢16, 000, 000 = G H ¢4, 800, 000$
Cost of the proposed policy change:
The cost of the proposed policy change will be the increment in credit-related costs. $Additional collection costs = G H ¢65, 000 - G H ¢50, 000 = G H ¢15, 000$ $Additional bad debt loss = 2% \times G H ¢16, 000, 000 = G H ¢320, 000$
Additional cost of receivables:
$Receivables under existing policy = 36515 \times G H ¢80, 000, 000 = G H ¢3, 287, 671$ $Receivables under proposed policy = 36524 \times G H ¢96, 000, 000 = G H ¢6, 312, 329$ $Additional receivables = G H ¢6, 312, 329 - G H ¢3, 287, 671 = G H ¢3, 024, 658$ $Additional cost of receivables = G H ¢3, 024, 658 \times 24% = G H ¢725, 918$
Total additional credit-related costs:
GH¢15,000 + GH¢320,000 + GH¢725,918 = GH¢1,060,918
Net benefit:
GH¢4,800,000 − GH¢1,060,918 = GH¢3,739,082

Recommendation:
The policy change should be implemented as it will increase the profit of the company.

(Marks allocation: Computation of incremental contribution = 2; Computation of incremental credit-related costs = 6; Incremental net income and recommendation = 1)

ii) Procedures for debt collection

The management team can employ several procedures to effectively and efficiently collect its receivables to enhance cash flows while reducing the incidence of default. The collection procedures may include the following:

Early billing: Invoices must be generated and sent to customers promptly as soon as goods have been supplied.
Prompt notice of balance: Statements of account should be sent to customers regularly to inform them of how much they owe and what portion is currently due for payment.
Prompt reminders: Reminders in a variety of forms (e.g., telephone calls, letters) should be sent to customers whose accounts are overdue.
Debt collection agency: In the case of difficult-to-collect debts, the company may use the services of a debt collection agency.
Legal action: As a procedure of last resort, the company may send an official letter from its lawyers to threaten legal action or go to court to obtain a judgment against the customer to force payment.

(Marks allocation: 2 marks for each of 3 procedures = 6 marks)

Tags: Cash discount policy, Contribution margin, Cost of Capital, Credit Policy, Receivables Management
Level: Level 2

Topic: Management of receivables and payables
Series: APR 2022

Uploader: Theophilus

FM – April 2022 – L2 – Q5a – Management of receivables and payables

Evaluate the impact of a proposed change in credit policy on Poh-Poh Electronics Ltd’s profitability and recommend whether the policy should be implemented, along with advice on procedures for receivables collection.

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