Question Tag: Credit Policy

Search 500 + past questions and counting.
Professional Bodies Filter
Program Filters
Subject Filters
More
Tags Filter
More
Check Box – Levels
Series Filter
More
Topics Filter
More
  • 13 Marks

FM – May 2020 – L2 – Q5b – Working Capital Management

Evaluate the impact of introducing credit sales on total profit before tax for a company and provide management advice.

Innovate Ghana Ltd is a dealer in household consumables in Ghana. It currently sells on a cash-only basis. The company’s current annual sales are GH¢10 million. The operating cost structure is as follows:

  • Cost of sales: 55% of sales
  • Staff cost: 10% of sales
  • Marketing and distribution cost: 15% of sales

Management in a meeting concluded that introducing credit sales will help boost sales in the light of the current tightness in liquidity in the market, the drive by other competitors, and pressure from the sales team.

It is projected that total sales will grow by 50% solely from the credit sales. The customers are offered 1-month credit, and a new credit department is set up to assess and monitor these credit sales. The monthly cost of running this credit department is GH¢20,000, and bad debts are expected to be 4% of the credit sales.

To finance this credit, Innovate Ghana Ltd will borrow at an interest rate of 25% per annum.

Required:

i) Calculate the total profit before tax before the introduction of the new policy.
(4 marks)

ii) Calculate the total profit before tax after the introduction of the new policy.
(6 marks)

iii) Advise management whether the initiative should be undertaken.
(3 marks)

i) Total Profit Before Tax Before the Introduction of the New Policy

Description Amount (GH¢)
Sales 10,000,000
Cost of Sales (55% of sales) (5,500,000)
Gross Profit 4,500,000
Staff Cost (10% of sales) (1,000,000)
Marketing & Distribution (1,500,000)
Net Profit Before Tax 2,000,000

(4 marks)

ii) Total Profit Before Tax After the Introduction of the New Policy

Description Amount (GH¢)
Sales (150% of 10 million) 15,000,000
Cost of Sales (55% of sales) (8,250,000)
Gross Profit 6,750,000
Staff Cost (10% of sales) (1,500,000)
Marketing & Distribution (2,250,000)
Credit Admin Cost (20,000 x 12) (240,000)
Bad Debts (4% of credit sales) (200,000)
Interest or Financing Cost (104,167)
Net Profit Before Tax 2,455,833

(6 marks)

iii) Management Advice

Profit before tax after the policy: GH¢2,455,833
Less: Profit before tax before the policy: GH¢2,000,000
Increase in Profit: GH¢455,833

The introduction of the credit sales policy has resulted in an incremental profit of GH¢455,833. Therefore, the initiative should be undertaken as it leads to higher profitability.

(3 marks)

  • 15 Marks

FM – MAY 2017 – L1 – Q4 – Management of receivables and payables | Working Capital Management

Differentiate between factoring and invoice discounting and advise ATA Ghana Ltd on whether to take on new customers based on the proposed credit policy.

a) Factoring and Invoice Discounting are both financial services that can release the funds tied up in your unpaid invoices, involving a provider who agrees to advance money against outstanding debtor balances. However, factoring is not the same as invoice discounting.

Required:
Differentiate between factoring and invoice discounting.
(5 marks)

b) ATA Ghana Ltd is a company in Ghana engaged in the trading of commodities. The annual sales are GH¢24 million. The average age of debtors is one month, and the percentage of bad debts is 1%.

A new Marketing Director has been hired by the company to improve its sales. The new Marketing Director proposed that sales could be increased up to GH¢30 million if new customers were taken on. Taking on new customers will lengthen the average credit period to 2 months and increase bad debts to 1.5% of sales.

The Finance Manager provided that the variable cost is 70% of the selling price and the company’s cost of capital is 20%.

Required:
Advise whether the company should take on the new customers.
(10 marks)

a) Difference Between Factoring and Invoice Discounting

  • Factoring:
    • Factoring involves the sale of receivables (invoices) to a third party (the factor) at a discount. The factor takes on the responsibility of collecting payments from customers.
    • The factor usually manages the sales ledger and takes over credit control, making it more visible to customers that factoring is being used.
  • Invoice Discounting:
    • Invoice discounting involves borrowing against the value of receivables without transferring ownership to the financier. The business retains control over the sales ledger and continues to manage customer relationships.
    • Invoice discounting is typically confidential, so customers are unaware that their invoices are being used as collateral.

b) Assessment of the New Credit Policy for ATA Ghana Ltd

Current Policy:

Item Calculation Value (GH¢)
Annual Sales – 24,000,000
Contribution Margin 30% of Sales 7,200,000
Bad Debts 1% of Sales x 70% Variable Cost 168,000
Cost of Debtors 20% of (1/12 * Sales * 70% Variable Cost) 280,000
Net Contribution Contribution – Bad Debts – Cost of Debtors 6,752,000

Proposed Policy:

Item Calculation Value (GH¢)
Annual Sales – 30,000,000
Contribution Margin 30% of Sales 9,000,000
Bad Debts 1.5% of Sales x 70% Variable Cost 315,000
Cost of Debtors 20% of (2/12 * Sales * 70% Variable Cost) 700,000
Net Contribution Contribution – Bad Debts – Cost of Debtors 7,985,000

Analysis:

Item Value (GH¢)
Increased Contribution 1,800,000
Increased Bad Debts (147,000)
Increased Cost of Debtors (420,000)
Net Benefit 1,233,000

Decision:
ATA Ghana Ltd should pursue the policy of taking on the new customers. The net benefit of GH¢1,233,000 justifies the additional risk associated with the longer credit period and higher bad debt percentage.

  • 20 Marks

FM – Nov 2023 – L2 – Q5 – Management of receivables and payables | Working Capital Management

Evaluate different credit policies, compute the cost of forgoing a discount, and explain types of financial risks managed by a treasury function.

a) Wahala Ltd wants to employ more liberal credit standards to increase sales. The current annual sales figure is GH¢30 million. Currently, the firm has an average collection period of 30 days. Three alternative credit policies are on the table for evaluation and selection. The management team believes that the alternative credit policies will result in the following:

Factor Alternative Credit Policy A Alternative Credit Policy B Alternative Credit Policy C
Increase in sales from the current level GH¢2.2 million GH¢3.1 million GH¢5.4 million
Average collection period for incremental sales (days) 45 60 150
Bad-debt losses on incremental sales 1.50% 3.50% 8.50%

The prices of its products average GH¢30.50 per unit and variable costs average GH¢21.35 per unit. The company’s pre-tax opportunity cost of funds is 35%.

Required:
i) Evaluate each of the three alternative liberal credit policies and advise the company on which credit policy it should pursue. (Assume a 360-day year). (12 marks)
ii) Suppose the company introduces a discount policy of 2/10 net 45. Compute the cost to a customer who forgoes the discount. (3 marks)

b) The treasury unit of a company performs various functions, including financial risk management.
Required:
Explain TWO (2) types of financial risks the treasury function manages. (5 marks)

a) Evaluation of Credit Policies:

To evaluate the credit policies, we compute the incremental contribution, and the costs associated with each policy:

Recommendation:

  • The policy with the highest net operating income should be pursued.

(12 marks)

ii) Cost to Customer Forgoing Discount:

The cost of forgoing the discount is calculated using the formula:

b) Types of Financial Risks Managed by Treasury:

  1. Currency Risk:
    • Arises from unexpected movements in exchange rates affecting companies with foreign currency exposures.
  2. Interest Rate Risk:
    • Arises from unexpected changes in interest rates, impacting companies with outstanding interest-bearing loans or investments.
  • 20 Marks

FM – NOV 2016 – L2 – Q2 – Working Capital Management

Discusses the causes of overcapitalization and overtrading, advises on credit policy changes, and explains stock splits and scrip issues.

a) Explain THREE causes each of the following situations:

i) Overcapitalized (3 marks)

ii) Overtrading (3 marks)

b) SAP Petroleum Ltd is considering relaxing its credit policy to boost sales. The change will increase the average collection period from 30 days to 60 days. The review is expected to increase sales by 25%. The current annual sales are GH¢ 6,000,000. Selling price per litre is GH¢ 30, variable cost per litre is GH¢ 27, and additional stock level is GH¢250,000.

Required:

i) Advise on whether to extend the period to customers if all customers take the longer credit of 2 months. (5 marks)

ii) Advise if existing customers do not change their payment terms and only new ones take the longer credit. (4 marks)

c) i) Explain the concepts of stock split and scrip issue and identify the main difference between the two. (3 marks)

ii) Explain why a company will embark on a scrip issue. (2 marks)

a)
i) Overcapitalization refers to a situation where a company has more or excess capital at its disposal than what is required for its normal and optimal operation or utilization. This may occur due to excessive equity or debt financing.

ii) Overtrading is when a company has insufficient cash or near-cash resources due to rapid growth. Indicators include high utilization of trade credit, large turnovers without a corresponding increase in cash, and liquidity challenges.

b)
i) Extra Profit:
Contribution Sales Ratio = (30-27)/30 = 10%
Increase in sales revenue: 25% x 6,000,000 = 1,500,000
Increase in contribution = 10% x 1,500,000 = 150,000

Return on investment = 150,000/ 450,000 = 33.33% (3 marks)
The policy is worthwhile if the existing customers stick to the 1 month and new
customers or accounts take the 2 months. The return on the latter is 33.33% which has
crossed the required rate of return of 28%.

Decision or advice

c)
i) A stock split divides existing shares into multiple shares. A scrip issue gives additional fully paid shares free of charge, similar to a bonus. The main difference is that stock splits simply increase the number of shares, whereas scrip issues involve giving additional shares. (3 marks)

ii) A company may embark on a scrip issue to improve float, liquidity, and traded volumes of the stock. It also signals the company’s confidence in its ability to service a larger equity base. (2 marks)

  • 15 Marks

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.

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)

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 =
  • Cost of the proposed policy change:
    The cost of the proposed policy change will be the increment in credit-related costs.
  • Additional cost of receivables:
  • 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:

  1. Early billing: Invoices must be generated and sent to customers promptly as soon as goods have been supplied.
  2. 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.
  3. Prompt reminders: Reminders in a variety of forms (e.g., telephone calls, letters) should be sent to customers whose accounts are overdue.
  4. Debt collection agency: In the case of difficult-to-collect debts, the company may use the services of a debt collection agency.
  5. 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)

  • 20 Marks

FM – Nov 2019 – L2 – Q5 – Inventory Management | Working Capital Management

Explain the impact of different working capital policies on profitability and liquidity, calculate profit under different credit policies, and explain reasons and costs associated with holding stock.

a) In driving the profitability and liquidity position of an organization in the current local and global business environment, one area that has become the center of focus or attention to Management is how working capital is managed. Aggressive, moderate, and conservative policies to working capital management have implications on the profitability and liquidity positions of the organization.

Required:
In the light of the above, explain and demonstrate the impact of each of the policies below on profitability and liquidity:
i) Aggressive Working Capital Management (2 marks)
ii) Moderate Working Capital Management (2 marks)
iii) Conservative Working Capital Management (2 marks)

b) Taaba Oil Ghana Ltd is an Oil Marketing Company operating in the downstream sector of the Oil and Gas industry in Ghana. The company initially was offering 4 weeks credit to its retailers until it changed its strategy to reduce the credit period from 4 weeks to 2 weeks to manage down its financing cost and bad debt.

Under the 4 weeks credit regime, annual credit sales were 500 million liters. The profit made per liter before financing charges and bad debt was GH¢0.20. The total working capital was GH¢250 million, but 50% was funded through trade credit and the remaining 50% was through Bank Overdraft at an interest rate of 25% per annum. The cost of trade credit was already factored into the margin. Bad debt was GH¢0.01 per liter of the credit sales.

The change in policy from 4 weeks to 2 weeks was done immediately without prior advance discussion and notice period granted to retailers who were also selling on credit to their customers.

After operating the new credit policy, the volume of sales was negatively impacted as sales volume per annum dropped by 25% and bad debts increased by 100% due to pressure on the working capital of the retailers. As the new Finance Manager for Taaba Oil Ghana Ltd, you are tasked to review this policy.

Required:
i) Calculate the profit under the old policy. (4 marks)
ii) Calculate the profit under the new policy. (4 marks)
iii) Based on your calculations above, advise management whether to revert to the old policy or maintain the new policy. (1 mark)

c) Holding stock and sometimes over-stocking come at a great cost to a company. Notwithstanding these costs, it is sometimes necessary to hold stock or even overstock for the smooth running of the company.

Required:
i) Explain TWO (2) reasons for holding stock. (2 marks)
ii) State and explain THREE (3) costs associated with holding stocks. (3 marks)

 

a) Impact of Working Capital Management Policies:

i) Aggressive Working Capital Management:
This approach involves maintaining lower levels of current assets (such as cash, inventory, and receivables) relative to sales. The result is higher profitability due to lower holding costs, but it also increases the risk of liquidity problems, as the company may not have enough short-term assets to meet its obligations when they come due.

ii) Moderate Working Capital Management:
This approach strikes a balance between aggressive and conservative policies. It aims to maintain an optimal level of current assets relative to sales, which helps to moderate both profitability and liquidity risks. This policy seeks to achieve a balance that neither overstretches nor underutilizes the company’s working capital.

iii) Conservative Working Capital Management:
Under this policy, a company maintains higher levels of current assets relative to sales. This reduces the risk of liquidity problems but at the expense of profitability, as holding excess cash, inventory, or receivables increases carrying costs.

c) Reasons and Costs Associated with Holding Stock:

i) Reasons for Holding Stock:

  1. Catering to Unexpected Demand:
    Holding stock ensures that the company can meet unexpected increases in demand without facing stockouts, which could result in lost sales.
  2. Smooth Production Process:
    Maintaining inventory levels helps ensure that the production process is not interrupted due to a lack of raw materials, which can lead to inefficiencies and increased costs.

ii) Costs Associated with Holding Stock:

  1. Storage Costs:
    These include the costs of warehousing, such as rent, utilities, and security, as well as the cost of maintaining the physical condition of the inventory.
  2. Obsolescence Costs:
    There is a risk that inventory may become outdated or obsolete before it is sold, particularly for products with short life cycles.
  3. Opportunity Costs:
    Funds tied up in inventory could have been used elsewhere in the business, such as for investment opportunities or to reduce debt. The cost of capital represents the opportunity cost of holding inventory.

 

 

  • 15 Marks

FM – MAY 2018 – L2 – Q4 – Working Capital Management

Evaluates the impact of extending credit terms on a company’s sales, bad debts, and working capital financing costs.

Adjaye Ltd has current sales of GH¢1.5 million per year. Cost of sales is 75% of sales and bad debts are 1% of sales. Cost of sales comprises 80% variable costs and 20% fixed costs, while the company’s required rate of return is 12%. Adjaye Ltd currently allows customers 30 days credit, but is considering increasing this to 60 days credit in order to increase sales.

It has been estimated that this change in policy will increase sales by 15% and bad debts will increase from 1% to 4%. It is not expected that the policy change will result in an increase in fixed costs, and creditors and stock will be unchanged.

Required:

Advise whether Adjaye Ltd should introduce the proposed policy. Support your answer with relevant computations.

New level of sales will be 1,500,000 x 1.15 = ¢1,725,000
Variable costs are 80% x 75% = 60% of sales
Contribution from sales is therefore 40% of sales

Decision
The financing policy is financially acceptable, although the savings are not great.

Take control of your business data with insight and in-depth understanding by taking this course. 

Services

Contact Info

  • +233203701923
    +233543919232
  • info@noohrabusiness.com

Get In Touch

Follow us on our social media and get daily updates.

Facebook-f Twitter Linkedin-in Envelope