Accounts Receivable Management Quiz

Projected credit sales for the year under the old credit policy were $35 million ($50,000,000 × 70%). The level of average receivables was calculated as follows:

Receivables turnover = Days in year ÷ Average collection period
                                            = 360 days ÷ 75 days
                                            = 4.8 times per year

Average receivables= Net credit sales ÷ Receivables turnover
                                        = $35,000,000 ÷ 4.8 times
                                        = $7,291,667

Under the new policy, total sales will be $47.5 million ($50,000,000 × 95%), and credit sales will be $28.5 million ($47,500,000 × 60%).

The new level of average receivables is calculated as follows: 

Receivables turnover = Days in year ÷ Average collection period
                                           = 360 days ÷ 50 days
                                            = 7.2 times per year

Average receivables = Net credit sales ÷ Receivables turnover
                                         = $28,500,000 ÷ 7.2 times
                                        = $3,958,333

The average receivables balance will therefore be reduced by $3,333,334 ($7,291,667 – $3,958,333).

The normal operating cycle is the period from the acquisition of inventory to the collection of the account receivable. If trade credit is for a period longer than the normal operating cycle, the seller must be financing more than just the purchase of inventory

The firm has daily sales of $45,000 consisting of 150 units at $300 each.

For 30 days, sales total $1,350,000. Of these sales, 40%, or $540,000 ($1,350,000 × 40%), will be uncollected because customers do not take their discounts.

The remaining $810,000 ($1,350,000 × 60%) will be paid within the discount period.

Average collection period equals average receivables divided by daily sales. The corporation’s average daily sales were $51,666 ($18,600,000 ÷ 360).

The average collection period was thus 26.7 days ($1,380,000 ÷ $51,666).

Changing its credit terms to encourage earlier payment by customers increases the firm’s cash flow and decreases the need for short-term borrowing.

If the change is adopted, Hest’s average balance in receivables will increase by $625,000 {$45,000,000 [(35 days – 30 days ) ÷ 360 days]}.

The company’s additional required investment in receivables is therefore $375,000 ($625,000 × 60% variable cost ratio), and the incremental pretax
cost of this investment is $22,500 ($375,000 × 6%).

Accordingly, the collection costs must be reduced by a pretax minimum of $22,500 to offset the cost of the increased investment in receivables.

The average collection period measures the number of days between the date of sale and the date of collection. It should be related to a firm’s credit terms. For example, a firm that allows terms of 2/15, net 30, should have an average collection period of somewhere between 15 and 30 days.

The average balance of receivables is $120,000 ($4,000 × 30 days).

Whether customers pay by credit card or check, collection requires 30 days.

The purpose of an aging of receivables is to classify receivables by due date. Those that are current (not past due) are listed in one column, those less than 30 days past due in another column, etc.

The amount in each category can then be multiplied by an estimated bad debt percentage that is based on a company’s credit experience and other factors. The theory is that the oldest receivables are the least likely to be collectible.

Aging the receivables and estimating the uncollectible amounts is one method of arriving at the appropriate balance sheet valuation of the accounts receivable account.

The projected average balance in receivables under the old policy was $383,333 [$4,600,000 × (30 days ÷ 360 days)].

Under the new policy, the average balance will be $482,222 [$4,960,000 × (35 days ÷ 360 days)].

Hence, the average balance is $98,889 higher under the new policy ($482,222 – $383,333).

The pre-tax cost of carrying the additional investment in receivables can be calculated as follows:

Increased investment in receivables -- gross $98,889

Times: variable cost ratio × 50%

Increased investment in receivables -- net = $49,444

Times: opportunity cost of funds × 11%

Incremental cost of new credit plan = $ 5,439

The total amount of sales overdue at any time during the year is $400,000 ($2,000,000 gross credit sales × 20% received after 30 days). The average collection period for these sales is 45 days.

The projected amount of overdue receivables is therefore $50,000 [$400,000 × (45 days ÷ 360 days)].

The average collection period, also called the days sales outstanding in receivables, is calculated as the number of days in the year over the receivables turnover ratio. The firm’s can be thus calculated as follows:

Average collection period = Days in year ÷ Accounts receivable turnover

                                                    = 365 ÷ (Net credit sales ÷ Average net receivables)

                                                     = 365 ÷ [(20,000 × $25,000) ÷ $30,000,000]

                                                    = 365 ÷ ($500,000,000 ÷ $30,000,000)

                                                    = 365 ÷ 16.667

                                                    = 21.9 days

The company’s manufacturing and selling costs exclusive of bad debts equal 70% of sales. Hence, the gross profit on the $100,000 increase in sales will be $30,000 ($100,000 × 30%).

The increase in after-tax profit is calculated as follows:

Increase in gross profit =  $30,000

Less: uncollectible accounts  ($100,000 × 15%) = (15,000)

Less: collection costs  ($100,000 × 5%) = (5,000)

Increase in pre-tax income = $10,000

Less: income tax expense  ($10,000 × 40%) = (4,000)

Increase in after-tax income =$ 6,000

If the change is adopted, the company’s average balance in receivables will increase by $450,000 {$27,000,000 × [(34 days – 28 days) ÷ 360 days]}.

The minimum savings that Best must experience to justify the change is therefore $36,000 ($450,000 × 8%)

A firm’s average gross receivables balance can be calculated by multiplying average daily sales by the average collection period (days’sales outstanding).

lternatively, annual credit sales can be divided by the accounts-receivable turnover (net credit sales ÷ average accounts receivable) to obtain the average balance in receivables.

Because these terms involve an annual interest cost of over 36%, a company would not offer them unless it desperately needed cash. Also, credit terms are typically somewhat standardized within an industry. Thus, if most companies in the industry offer similar terms, a firm will likely be forced to match the competition or lose market share.

The company can calculate the net benefit (loss) from the proposed change in credit policy as follows:

Increase in sales $720,000

Times: variable cost ratio × 80%

Increase in variable costs $576,000

Increased investment in receivables = $576,000 × (75 days ÷ 360 days) = $120,000

Increased investment in receivables $120,000

Times: opportunity cost of funds × 20%

Cost of new credit plan $ 24,000

Increase in sales $720,000

Times: contribution margin ratio × 20%

Increase in contribution margin $144,000

Less: cost of new credit plan (24,000)

Benefit of new credit plan $120,000

A quantity discount is an attempt to increase sales by reducing the unit price on bulk purchases. It concerns only the price term of an agreement, not the credit term, and thus is unrelated to credit and collection policy.