Question Tag: Trade Credit

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  • 20 Marks

FM – DEC 2023 – L2 – Q5 – Cost of capital | Foreign exchange risk and currency risk management

Calculation of the effective cost of various financing options and explanation of internal strategies to manage foreign currency risk.

a) Markwei Pharmaceuticals Ltd plans to import active ingredients to produce vitamin syrup. The company’s managers are considering three financing options for the cedi equivalent of an invoice value of GH¢2.5 million. The options are detailed below:

Option 1: Use supplier’s credit. The credit term is 1.5/10 net 45.

Option 2: Issue a commercial paper to raise the money from the Ghanaian money market. The commercial paper will pay interest at the rate of 18% per annum. Issue costs totaling GH¢15,000 will be incurred.

Option 3: Obtain a 3-month bank loan. The interest rate on the loan is 22% per annum. Loan arrangement and processing fees are expected to be GH¢5,000.

Required:
i) Compute the effective annual cost of each financing option and recommend the most cost-effective option. (10 marks)
ii) Explain TWO (2) advantages of financing the invoice through the issue of a commercial paper instead of a bank loan. (5 marks)

b) Abongo Shoes Ltd (Abongo) imports leather from Italy. Abongo’s demand for euros to settle its import bills exposes its cash flow to foreign exchange risk. Abongo’s Management is looking for internal strategies they can deploy to hedge the company’s currency risk exposure as external hedging strategies might be too expensive for the company.

Required:
Explain TWO (2) internal strategies for managing foreign currency risk exposures that Abongo’s Management can use. (5 marks)

i) Computation of Effective Annual Cost

Option 1: Supplier’s Credit

Effective Cost= 

Effective Cost=

Alternative using 360 days

Effective Cost=

Option 2: Commercial Paper

  • Interest on GH¢2,515,000 for 3 months at 18% per annum:

Interest=

  • Total cost (including issue costs):

Effective Cost=

Alternative assuming issue cost is paid from existing funds:

Effective Cost

Option 3: Bank Loan

  • Interest on GH¢2,505,000 for 3 months at 22% per annum:

Interest=

  • Total cost (including loan arrangement and processing fees):

Effective Cost=

Recommendation:
Based on the effective annual costs, the supplier’s credit option (15.88%) is the most cost-effective choice compared to the commercial paper (20.39%) and bank loan (22.80%).

(10 marks)

ii) Advantages of Financing Through Commercial Paper

  • Lower Interest Rate: As commercial papers are financial securities issued by large and reputable entities, the interest rates quoted are typically lower than those on comparable bank loans, providing potential savings.
  • Larger Fundraising Capacity: Commercial papers can be issued in multiple amounts to several investors in a single issue, making it easier to raise larger sums of money compared to a bank loan.

(5 marks)

b)
Internal Strategies for Managing Foreign Currency Risk

  • Invoice Currency: Abongo Shoes Ltd can negotiate with suppliers to have invoices denominated in its local currency (cedi), thereby transferring the currency risk to the supplier.
  • Matching: The company could match its foreign currency receivables with its payables. For example, if Abongo has some euro-denominated receivables, these can be set off against the euro payables to reduce net exposure.
  • 20 Marks

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

Assessing XYZ Ltd's overtrading status and evaluating proposals to improve cash flow management.

XYZ Ltd is a leading producer of mineral water in Ghana. The company sells all of its output to wholesalers on credit terms net 40. The company’s collection policy is somewhat relaxed, and so the receivables turnover days are currently 53 days. This fairly liberal credit policy has resulted in significant increases in sales revenue in recent years. However, the company has been facing cash flow problems as a significant number of customers take longer than the credit period to settle their accounts. The company typically falls on overdraft facilities from its bankers when it fails to generate adequate cash flows from operations to meet working capital requirements. The average cost of the overdraft facilities is 15% per annum.

Last week, the management team met and discussed the company’s cash flow and liquidity problems with a view to finding solutions to the problems. In that meeting, two proposals were offered to help solve the problems:

Proposal 1: Introduce an early settlement discount of 1.5% on accounts that are settled within 10 days of invoice while the current credit period is maintained. It is estimated that 60% of accounts will be paid within the discount period.

Proposal 2: Switch from financing working capital requirements using the bank overdraft facilities at 15% interest to financing working capital requirements using suppliers’ trade credit. Suppliers are willing to supply on credit terms 1/10, net 40.

Set out below are the company’s income statement and statement of financial position for the past three years.

Income statement for the year ended 31st December

2012 2013 2014
Revenue 40,000 60,000 122,000
Cost of sales (15,000) (31,000) (90,000)
Gross profit 25,000 29,000 32,000
Selling and administrative expenses (11,000) (13,000) (17,500)
Operating profit 14,000 16,000 14,500

Statement of financial position as at 31st December

2012 2013 2014
Noncurrent assets:
Property, plant and equipment 13,400 19,000 22,500
Current assets:
Inventory 8,000 15,500 25,500
Trade receivables 6,900 11,210 24,210
Cash 1,110 – –
Total current assets 16,010 26,710 49,710
Total assets 29,410 45,710 72,210
Equity:
Stated capital 100 100 100
Income surplus 18,510 28,110 36,810
Shareholders’ equity 18,610 28,210 36,910
Non-current liabilities:
Medium-term loan 3,000 2,500 2,000
Current liabilities:
Trade payables 2,200 3,500 8,600
Dividend payable 5,600 6,400 7,500
Bank overdraft – 5,100 17,200
Total current liabilities 7,800 15,000 33,300
Total liabilities 10,800 17,500 35,300
Total equity and liabilities 29,410 45,710 72,210

Required:
a) Considering the background information and financial data provided above, would you conclude that XYZ Ltd is experiencing overtrading? Explain with relevant computations. (9 marks)

b) Appraise the proposal for early settlement discount (i.e. Proposal 1) and advise on whether it should be accepted for implementation or not. Your appraisal should focus on how the discount policy will influence the company’s profitability. Show all relevant computations. (5 marks)

c) Appraise the proposal to switch from financing working capital needs using bank overdraft to using suppliers’ trade credit, and advise management accordingly. Show all relevant computations. (3 marks)

d) Assuming XYZ Ltd cannot raise additional funds from external sources such as borrowing and new share offers, suggest to management three steps they can take to ease the cash shortages the company is facing. (3 marks)

a) Is XYZ Ltd Overtrading?
To conclude whether the company is overtrading, candidates are expected to identify the symptoms of overtrading and diagnose the company’s situation from the information given.

Overtrading occurs when a company tries to do too much too quickly with too little long-term capital. Typically, a company that is overtrading would exhibit the following symptoms:

  • Rapid growth in sales revenue.
  • Rapid growth in current assets, particularly inventory and receivables.
  • Small growth in equity capital, which may be through reinvestment of profit.
  • Significant increases in debt ratios such as total debt ratio and debt-to-equity ratio.
  • Significant decreases in liquidity ratios such as current ratio and quick ratio.

Based on the financial data:

  • Sales revenue increased by 50% in 2013 and 103% in 2014.
  • The company’s liquidity ratios decreased, with the current ratio dropping from 2.05:1 in 2012 to 1.54:1 in 2014.
  • There is a significant increase in bank overdraft, rising by 237% in 2014.

There has been significant growth in sales revenue (50% in 2013 and 103% in 2014). This
is accompanied by significant growth in current assets, particularly receivables and
inventory. However, receivables turnover days and inventory turnover days have both
shortened from 55 to 53 days and from 138 to 83 days respectively. What is more, the
payables turnover days has shortened significantly from 34 days to 25 days due to the
increased use of bank overdraft in financing working capital needs. Bank overdraft
increased by a whopping 237% in 2014.
The company’s liquidity ratios kept dropping over the three years under review. The
current ratio dropped from 2.05:1 in 2012 to just 1.54:1 in 2014 while the quick ratio
dropped from 1.03:1 in 2012 to 0.75:1 in 2014. Besides, the ratio of long-term capital to
total assets kept reducing over the same periods. Long-term capital that stood at 73% of
total assets in 2012 had dropped to 54% of total assets. The decreases in liquidity ratio is
due to the significant increase in current liabilities, mainly due to the high increment in
bank overdraft financing. The growth in long-term capital is due to reinvestment of
profits as stated capital stood the same and medium-term loan was being amortised
over the period. These suggest that the company is financing most of the rapid growth
in sales with short-term funds rather than long-term capital.
Sales revenue is increasing rapidly, liquidity ratios are falling, long-term capital ratio is
falling, and there is significant increase in bank overdraft. On the face of it, one would
concluded that the company is overtrading. However, the ratio of long-term capital is
not yet too low to permit the conclusion that the company is trying to do too much too
quickly with too little long-term capital. If the current trends in long-term capital ratio,
sales growth, and liquidity ratios continue in the future, the company might experience
overtrading in the near future.

On the face of it, one could conclude that XYZ Ltd is overtrading. However, the ratio of long-term capital is not yet too low to make that conclusion definitive.

(b) Introduction of early settlement discount policy
Under current policy:

Candidates are expected to match the cost of the early discount policy against the
benefit of it. The policy change is worthwhile when the benefit, measured in terms of
annual interest savings, exceeds the cost, measured in terms of the cash discount that
would be given

Current credit sales = GHS122 million
Current credit period = 40 days
Receivables turnover days = 53 days
Trade receivables, 2014 = GHS24.210 million
Trade receivables, 2013 = GHS11.210 million
Under discount policy:
Credit sales = GHS122 million (assumed to be kept at recent
sales level)
Credit period = 40 days
Discount period = 10 days
Discount rate = 1.5%
Early payment probability =60%
Other relevant data:
Financing cost = 15%

Summary:

Benefit of new discount policy: Interest saved every year = 1.554
Cost of new discount policy: Cash discount allowed every year = 1.098
Net benefit of new discount policy = 0.456

Conclusion:
If the early settlement discount is introduced and 60% of accounts are settled early to
take the discount, the company’s profit will increase by GHS0.456m every year.
Therefore, management should accept the early settlement discount proposal for
implementation.

(c) Switch from financing working capital needs with bank overdraft to financing with
trade credit
If the company continues to finance working capital needs with bank overdraft, the
annual financing cost would be 15%.
If the company finances working capital needs with suppliers trade credit the
annual financing cost would be 12.3% (assuming simple interest):

Conclusion:
Since the cost of financing with suppliers’ trade credit is lower than the cost of
financing with the overdraft facilities, the company should discard its current
working capital financing method and finance with trade credit.
Note:
Full credit should be given to candidates who estimate the cost of trade credit
based on compound interest:

d) Easing Cash Shortages

  1. Postpone capital investments.
  2. Accelerate collection from customers by offering incentives.
  3. Reduce investment in inventory to minimize funds tied up in working capital.
  4. Postpone dividend payments.
  5. Negotiate with creditors for more favourable payment terms.
  6. Reverse past investment decisions by selling assets previously acquired but
    are surplus to the company’s needs, or producing negative or lower returns.
    Even assets that are needed can be sold and leased back.
  • 20 Marks

FM – MAR 2024 – L2 – Q5 – Working Capital Management

Evaluates different financing options for working capital requirements and compares forward and futures currency contracts.

a) Edziban Foods Ltd has just signed a contract to sell food items worth GH¢120,000 per month to the School Feeding Secretariat on credit. With the average collection period expected to be 45 days, the company will increase its working capital requirement by GH¢177,534. The company’s managers are considering three options for financing the additional working capital requirement:

  • Option 1 – Trade credit: The company buys about GH¢72,000 of food items per month on terms of “2.5/20, net 60.” Going forward, the company may choose to forgo the discount.
  • Option 2 – Factoring: The company enters a non-recourse factoring contract, under which the factor takes up the receivables to be created from the credit sales under the contract (i.e., GH¢120,000 per month) for a fee of 2% of the credit sales. The average collection period for the credit sales will remain at 45 days. The factor will advance up to 80% of the face value of the average receivables at an annual interest rate of 16%. It has been estimated that the factor’s services will save the company GH¢1,500 per month in debt collection costs.
  • Option 3 – Bank loan: The company takes a loan of GH¢197,260 at 15% from its bankers. A 10% compensating balance will be required.

Required:

i) Recommend the best financing option to the managers of the company based on annualized percentage cost.
(11 marks)

ii) Distinguish between “without recourse” factoring agreement and “with recourse” factoring agreement.
(4 marks)

b) Explain THREE (3) differences between a forward currency contract and a futures currency contract.
(5 marks)

a)
i) The best financing option based on annualized percentage cost.
Trade credit:
The discount is not taken, it will cost the company 23.4% per annum to use the
supplier’s credit:
Annualized cost of credit =

Factoring:
Factoring fees = 2% × (GH¢120,000 × 12) = 2% × GH¢1,440,000 = GH¢28,800
Interest on advance = 16% × (0.8 × GH¢177,534) = GH¢22,724.35
Savings on debt collection = GH¢1,500 × 12 = GH¢18,000

Net cost

Annual Net cost

Bank loan:

Annual cost =

Annual cost =

Recommendation:
The company should use the bank loan to finance the additional working capital
requirements as it presents the lowest cost.

 

ii) Distinction between a without recourse factoring agreement and a with a
recourse factoring agreement:
A “without recourse” factoring contract implies that the company selling the
receivables to the factor would not be liable for any receivables that become
uncollectible whereas a “with recourse” factoring contract implies that the
company selling the receivables remains liable for any uncollectible accounts and
the factor will only use its best efforts to collect the receivables.

Thus, the company selling the receivables bears bad debt losses when the factoring
agreement is with recourse, but the factor bears bad debt losses when the factoring
agreement is without recourse.

 

b) Differences between a forward currency contract and a futures currency contract.

 

 

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