Accounts Receivable Management Quiz

Projected credit sales for the year under the old credit policy were $37,500,000 ($50,000,000 × 75%),

resulting in an average balance in receivables of $2,083,333 [$37,500,000 × (20 days ÷ 360 days)].

Under the new policy, credit sales will be $46,875,000 ($37,500,000 × 1.25),

resulting in an average receivables balance of $3,906,250 [$46,875,000 ×(30 days ÷ 360 days)].

Hence, the expected increase in the balance is $1,822,917 ($3,906,250 – $2,083,333).

The first step is to calculate the gross proceeds the firm will receive from the factoring transaction:

Amount of receivable $100,000

Less: reserve ($100,000 × 6%)= (6,000)

Less: factor fee ($100,000 × 1.4%) =(1,400)

= Gross proceeds $ 92,600

This amount must be reduced by the interest charged on the gross proceeds:

Gross proceeds $92,600

Times: annual finance charge × 15%

Annualized interest expense $13,890

Times: portion of year (60 days ÷ 360 days) × 16.7%

Interest expense $ 2,315

The actual cash the firm will receive from this factoring transaction is thus calculated as follows:

Gross proceeds $92,600

Less: interest expense (2,315)

Net proceeds $90,285

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

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.

To calculate the firm’s net cost of adding the cash discount to its credit terms, find both the total cash lost to discounts and the offsetting savings which arise from earlier customer payments. The calculations are as follows:

Cash to be discounted = $5,000,000 × 60% = $3,000,000

Cost of discount = $3,000,000 × 2% = $60,000

Average daily sales = $5,000,000 ÷ 365 days = $13,698.63 per day

Cost of A/R for 60 days = $13,698.63 × 60 days × 12% = $98,630.14

Cost of A/R for 30 days = $13,698.63 × 30 days × 12% = $49,315.07

Savings from discount = $98,630.14 – $49,315.07 = $49,315.07

Net cost of discount = $60,000 (cost) – $49,315 (savings) = $10,685

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.

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

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

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 additional annual income (loss) from using the lockbox service is the excess (deficit) of interest earned on the early deposits over (under) the
cost of the service.

If the plan is adopted, the firm’s average cash balance will increase by $3,000,000 ($600 value per check × 2,500 checks received
per day × 2 days).

Benefit (loss) = Interest earned – Cost. Thus, the loss of $45,500 is calculated from the interest earned of $210,000 ($3,000,000 ×
7%) minus the cost of $255,500 ($0.28 per check × 2,500 checks per day × 365 days in a year)

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

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 projected average balance in receivables under the old policy was $300,000 [$3,600,000 × (30 days ÷ 360 days)]. Under the new policy, the average balance will be $396,000 [$3,960,000 × (36 days ÷ 360 days)].

Hence, the average balance is $96,000 higher under the new policy ($396,000 – $300,000). The pre-tax cost of carrying the additional investment in receivables can be calculated as follows:

Increased investment in receivables -- gross =  $96,000

Times: variable cost ratio × 60%

Increased investment in receivables -- net =$57,600

Times: opportunity cost of funds × 10%

Incremental cost of new credit plan = $ 5,760

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 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 increase in estimated gross profit is $32,000 ($80,000 × 40%).

The incremental bad debt loss is $4,800 ($80,000 × 6%). Accordingly,

the estimated net increase in operating income is $27,200 ($32,000 – $4,800).

The before-tax return on sales is 34% ($27,200 ÷ $80,000).

If the cost of borrowing is low, the firm can satisfy its working capital needs otherwise than by encouraging early payment from customers. Also, loosening credit policies tends to increase repeat sales.

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%)

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.