Ch 28: Accounts Receivable Management & Factoring
CHAPTER 28 ACCOUNTS RECEIVABLE MANAGEMENT AND FACTORING
Problem 1 Current
Policy
Policy
Policy Policy
policy
X
Y
Z
25
40
50
60
3,000
3,012
3,027
3,047
-
12
27
47
2,400
2,407
2,416
2,428
E. Receivable invst. at cost (Rs cr), [D/360 x A]
167
267
336
405
F. Inc. receivable receivable invst. at cost (Rs cr), [E - 167]
-
101
169
238
G. Inc. contribution contribution (Rs lakh), [B x (10-6)/10]
-
4.8
10.8
18.8
H. Expected rate of return (%), [G/F]
-
4.8%
6.4%
7.9%
I. Required rate of return (%)
-
12%
12%
12%
A. Credit period B. Annual sales (Rs lakh) C. Inc. sales (Rs lakh), [B - 3,000] D. Cost of sales (Rs lakh), [B/10 x 8+600]
Note: Cost of sales includes variable cost plus fixed cost. None of the new policies is desirable since the required rate of return is higher than the expected rate of return. Cost calculations:
Average cost (Rs)
8
Unit variable cost (Rs)
6
Price (Rs)
10
Total cost of sales (Rs lakh)
2,400
Total variable cost (Rs lakh)
1,800
Total fixed cost (Rs lakh)
600
Problem 2
Current sales (Rs cr)
300
Current level of receivable receivable (Rs cr)
30
Bad debts losses (%)
3%
Incremental cost(%)
80%
Current collection period (days) New collection period (days)
(30/300) x 360 36 + 30
New levels of sales (Rs cr) New levels of receivable (Rs cr)
36 66 360
Incremental receivable invst. (Rs cr)
(360/360) x 66 66 - 30
36
Contribution from addl. sales (Rs cr)
60 x 0.20
12
Bad debts on addl. sales (Rs cr)
60 x 0.03
1.8
Net contribution (Rs cr)
12 - 1.8
Rate of return (%)
10.2/(66-30) 10.2/(66-30)
Required rate of return (%) Net surplus return (%)
66
10.2 28.3% 15%
28.3% 15.0%
13.3%
I. M. Pandey, Financial Management, 9 th Edition, New Delhi: Vikas.
Problem 3 Policy
Policy
Policy
Policy
A
B
C
D
A. Collection period (days)
40
45
55
70
300,000
400,000
500,000
600,000
C. Inc. invst. in receivable (Rs cr), [D x 0.20]
33,333
50,000
76,389
116,667
D. Inc. contribution (Rs cr), [D x (1 - 0.85)] x (1 - .35)
29,250
39,000
48,750
58,500
E. Expected return (%), D/E
88%
78%
64%
50%
F. Required rate of return (%)
20%
25%
32%
40%
B. Incremental sales (Rs)
Assuming that there are no other costs (bad debt, collection charges etc.) involved, the company will benefit if it liberalises credit period to 70 days. Problem 4 Current
Policy
Policy
Policy
Policy
policy
1
2
3
4
A. Credit period (days)
30
45
60
75
90
B. Annual sales (Rs cr)
60
64
64.5
65.3
66.5
54.00
57.20
57.60
58.24
59.20
4
4.5
5.3
6.5
C. Cost of sales (Rs cr), [B x 0.8 + 6] D. Inc. sales (Rs cr), [C - 54] E. Level of receivable (Rs cr), [C/360 x A]
7.15
9.60
12.13
14.80
F. Inc. receivable invst. (Rs cr), [E - 4.50]
2.65
5.10
7.63
10.30
G. Inc. contribution (Rs cr), [D x 0.20]
0.80
0.90
1.06
1.30
1.5%
1.7%
2.0%
2.5%
I. Bad-debt loss (Rs cr), [D x H]
0.06
0.08
0.11
0.16
J. Inc. expected profit (Rs cr), [G - I]
0.74
0.82
0.95
1.14
27.9%
16.1%
12.5%
11.0%
18%
18%
18%
18%
H. Bad-debt loss (%)
4.50
1.5%
K. Expected return (%), [J/F] L. Required rate of return (%)
The firm should shift to credit policy 1. Other policies are not desirable since the expected rates are lower than the required rates of return. Cost calculation:
Sales (Rs cr)
60
Total cost (Rs cr), [0.90 x 60]
54
Variable cost (Rs cr), [0.80 x 60]
48
Fixed cost (Rs cr), [54 - 48]
6
Problem 5
Required rate of return (%) Credit sales (Rs cr)
15 120
Current collection period (days)
60
Current level of receivable (Rs cr),[120/360x60]
20
New collection period (days) New level of receivable (Rs cr), [120/360x40] Discount rate (%)
40 13.33 0.02
Cost of cash discount (Rs cr), [120 x 0.6 x 0.02]
-1.44
Decrease in receivable invst. (Rs cr),[13.33-20]
-6.67
Expected return (%), [-1.44/-6.67]
21.6%
Required rate of return (%)
15.0%
Net gain (%)
6.6%
Ch 28: Accounts Receivable Management & Factoring
Problem 6
A. Current sales B. New credit period C. New collection period D. Bad-debt losses E. Increased sales F. Variable cost G. Tax rate H. Required rate of return I. Incremental sales J. Contribution from incr. sales, I × (1 - 0.70) K. Bad-debt losses on incr. sales (I × D) L. Profit before tax, J - K M. Less: tax, L × G N. Profit after tax, L - M O. Incr. receivable investment (at selling price) P. Expected return, N/O Q. Net gain (%), P - H
(Rs) 7,200,000 45 45 3% 360,000 70% 35% 15% 360,000 108,000 10,800 97,200 34,020 63,180 345,000 18.3% 3.3%
Incremental investment in receivable includes 15 days increase collection period for existing sales. Investment in receivables = 7,200,000 × (45-30)/360 + 360,000 × 45/360 = Rs 345,000. Problem 7
Current sales Increase in sales New level of sales Current collection period (days) Current level of receivables New level of re ceivables Cash discount Discount period (days) Percentage customers taking discount Bad debt losses Variable cost Corporate tax rate Opportunity cost of capital A. Increased sales B. Contribution from increased sales, A × (1-0.70) C. Bad debt loss, A × 2% D. Cost of cash discount: 740,000 × 0.02 ×0.5 E. After-tax profit, (B - C -D)×(1-0.5) F. Decrease receivable investment, 41,111 - 60,000 G. Expected return, E/F H. Net gain %, 10% -G
(Rs) 720,000 20,000 740,000 30 60,000 41,111 2% 10 50% 2% 70% 50% 10% 20,000 6,000 400 7400 -900 -18,889 4.8% 5.2%
I. M. Pandey, Financial Management, 9 th Edition, New Delhi: Vikas.
The investment in receivables is the difference between new level of receivables and the current level of receivables. Since the average collection period for 50 per cent sales is 10 days and for remaining 50 per cent 30 days, the new level of receivables is calculated as follows: New level of receivables = 740,000 × 0.50 × 10/360 + 740,000 × 0.50 ×30/360 = Rs 41,111 Decrease in receivables investment = 41,111 – 60, 000 = - Rs 18,889 In decline in after-tax profit is –Rs 900 which translates to 4.8 per cent loss of return while the company can earn 10 per cent on its investment. Hence, th ere is a gain of 5.2 per cent, or -900 – 0.10 × -18,889 = + Rs 989. Problem 8
Total
A. Sales
Good
(Rs crore) Slowpaying
accounts
accounts
22.00
17.60
4.40
18.70
14.96
3.74
b. Selling, [0.026xA]
0.57
0.46
0.11
c. Administration, [0.016xA]
0.35
0.28
0.07
d. Warehousing, [0.014xA]
0.31
0.25
0.06
e. Bad debts. [0.004x22]
0.09
0.09
f. Collection charges, [0.002x22]
0.04
0.04
B. Variable costs: a. Cost of goods sold, [0.85xA]
C. Total variable costs, [a +b + c + d + e +f]
20.06
15.95
4.12
1.94
1.65
0.28
g. Selling, [0.02x22]
0.44
0.44
h. Administration, [0.008x22]
0.18
0.18
i. Warehousing, [0.01x22]
0.22
0.22
F. Total fixed costs, [g + h + i]
0.84
0.84
G. Profit before tax, [D-F]
1.10
0.82
0.28
5.0%
4.7%
6.4%
D. Contribution, [A-C] E. Fixed costs:
H. Pre-tax profit margin (%), [G/A] Consequences of not selling to slow-paying customers: Lost contribution (excluding bad debts and collection charges), [4.4 x 0.094]
0.41
Less bad debt and collection charges avoided
0.13
Net loss
0.28
Decrease in receivable investment
0.885
Expected return (%)
31.8%
If the company does not sell to slow-paying customers, it shall avoid the outstanding receivable balance of Rs 0.885 crore (Rs 88.5 lakh).
Ch 28: Accounts Receivable Management & Factoring
Problem 9 Current
Alternate
Alternate
policy
policy 1
policy 2
A. Sales (Rs cr)
60
60
60
B. Collection period (CP)
45
20
14
60%
80%
95%
1%
2%
3%
0.50%
1%
1.50%
F. Cost of discount (Rs cr), [A x C x D]
0.36
0.96
1.71
G. Cost of default (Rs cr), [A x C x E]
0.18
0.48
0.86
H. Total loss (Rs cr), [F + G]
0.54
1.44
2.57
0.90
2.03
3.33
2.33
C. Percentage taking discount D. Discount rate (%) E. Default percentage
I. Incremental loss, [H - 0.54]
-
J. Receivable invst. (Rs cr), [(A/360) x B]
7.50
K. Inc. receivable invst. (Rs cr), [J - 7.50]
-
4.17
5.17
L. Expected return (%), [I/J]
-
21.6%
39.2%
18%
18%
M. Required rate of return (%)
18%
Problem 10
Annual sales (Rs cr)
200
Credit sales, 80% (Rs cr)
160
Average collection period (days) Level of receivable (Rs cr): (160/360) x 80
80 35.56
Factoring commission (Rs cr): 1.75% x 35.56
0.62
Reserve (Rs): 10% x 35.56
3.56
Available advance (Rs cr): 35.56 - 3.56- 0.62
31.38
Upfront interest on advance (Rs cr): (16.5% x 31.38)/360/80
1.15
Net available advance (Rs cr): 31.38 - 1.15
30.23
Annual cost of factoring :
Commission: 0.62 x (360/80)
2.80
Interest on advance: 1.15 x (360/80)
5.18
Total
7.98
Savings from factoring (Rs cr):
Bad debt avoided: 0.9% x 160
1.44
Cost of administration avoided
0.20
Total
1.64
Net cost of factoring
6.34
Effective cost of factoring: 6.34/30.23 (%)
21.0%
I. M. Pandey, Financial Management, 9 th Edition, New Delhi: Vikas.
CASES Case 28.1: Relax Pharmaceutical Limited
The case can be used to answer the following questions: (1) How to determine the investment in receivable? Increment investment in receivable means additional investment (on new and current sales) caused by a change in the credit policy. This investment may be measured in terms of selling price or cost – just the variable cost or total cost (including both variable and fixed). (2) What are ‘marginal accounts’? What is their cost and contribution? Generally fixed costs will not change whether a firm sells or does not sell to marginal accounts because all fixed costs are expected to be recovered from sales to ‘good accounts’. Relaxing credit terms may increase sales to marginal accounts. There will be trade-off between the increased revenue and the increased cost. (3) What does a credit policy involve? How does change in a credit policy affect a firm’s sales revenue and profitability? (4) How can debtors (or receivable be monitored)? Collection period or aging schedule will not be useful when sales show periodic fluctuations. In this situation ‘collection experience matrix’ is an appropriate approach. This case helps to explain most of issues with regard to a firm’s credit policy. The calculations are shown below. Current Situation
Credit
Cash
Total
Sales to good customers (Rs million)
900
120
1,020
Sales to marginal customers (Rs million)
180
0
180
1,080
120
1,200
Current sales (Rs million) Average collection period - good cusomers (days)
60
Average collection period - marginal cusomers (days)
70
Credit sales per day - good customers (Rs million)
900/360
2.5
Investment in receivables- good customers (Rs million)
2.5 × 60
150
Credit sales per day - marginal cuistomers (Rs million)
180/360
0.5
Investment in receivables - marginal customers (Rs million)
0.5 × 70
35
Total investment in receivables at selling price (Rs million)
185
Contribution from marginal accounts Avoidable variable cost (excluding 1/4th collection costs of good customers)
86.97%
Contribution ratio Contribution loss from marginal customers (Rs million)
13.03% 180 x 13.03%
23.45
Tax (35% rate assumed)
8.21
After-tax contribution loss (Rs million)
15.25
Investment in receivables - marginal customers (Rs million)
35
Rate of return
43.6%
Required rate of return
15%
Marginal accounts are proftable. They should continue. Proposed policy (without cash discount)
Credit period (days)
70
New sales (Rs million)
1,440
Credit Incremental sales to good customers
Cash
Total
60
0
60
Incremental sales to marginal customers (Rs million)
180
0
180
Incremental sales (Rs million)
240
0
240
Average collection period - good cusomers (days)
75
Average collection period - marginal cusomers (days)
90
Ch 28: Accounts Receivable Management & Factoring
Bad-debt losses from sale to marginal customers
0.0550
Collection costs (marginal accounts)
0.0009
Collection charges (marginal accounts) (Rs million)
0.05
Contribution ratio
13.03%
Contribution from incremntal sales (rs million)
31.27
Incremental bad-debt losses and collection costs (Rs million)
10.11
Net contribution (Rs million)
21.16
After-tax contribution (Rs million)
13.75
Investment in receivables- good customers (Rs million)
(900 + 60)/360*75
200
Investment in receivables - marginal customers (Rs million)
(180 + 180)/360*90
90
Total investment in receivables (Rs million)
290
Rate of return
4.7%
Required rate of return
15%
It's not desirable to change the credit terms. Proposed policy (with cash discount)
Credit period (days) New sales (Rs million)
70 1,440 Credit
Incremental sales to good customers
Cash
Total
60
0
60
Incremental sales to marginal customers (Rs million)
180
0
180
Incremental sales (Rs million)
240
0
240
Cash discount Sales to customers availing cash discount (Rs million) Cash discount (Rs million)
2% (900 + 60)*0.3
288 5.76
Average collection period - good customers (days)
75
Average collection period - marginal customers (days)
90
Bad-debt losses from sale to marginal customers
0.0550
Collection costs (marginal accounts)
0.0009
Collection charges (marginal accounts) (Rs million)
Contribution ratio
0.05
13.03%
Contribution from incremental sales (Rs million)
31.27
Incremental bad-debt losses and collection costs (Rs million)
10.11
Incremental cash discount (Rs million)
5.76
Net contribution (Rs million)
15.40
After-tax contribution (Rs million)
10.01
I. M. Pandey, Financial Management, 9 th Edition, New Delhi: Vikas.
Investment in receivables- good customers (Rs million)
0.3*(900 + 60)/360*75
Investment in receivables - marginal customers (Rs million)
(180 + 180)/360*90
Total investment in receivables (Rs million)
164 90 254
Rate of return
3.9%
Required rate of return
15%
It's not desirable to change the credit terms.