Accounts Receivable Management Quiz

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 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

Opportunity cost is the maximum benefit forgone by choosing an investment. Thus, the missing relevant information is the best alternative return on the funds to be invested in receivables.

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

Increasing the quality of the accounts rejected means that fewer sales will be made. The company is therefore not trying to maximize its sales or increase its bad debt losses. The objective is to reduce bad debt losses and thereby maximize profits.

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).

All factors should be considered that differ between the two policies. Factors that do not differ, such as the current bad debt experience, are not relevant. The company must estimate the expected bad debt losses under each new policy.

The company’s manufacturing and selling costs exclusive of bad debts equal 75% of sales. Hence, the gross profit on the $150,000 increase in sales will be $37,500 ($150,000 × 25%).

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

Increase in gross profit = $37,500

Less: uncollectible accounts ($150,000 × 16%) = (24,000)

Less: collection costs  ($150,000 × 4%) = (6,000)

Increase in pre-tax income = $ 7,500

Less: income tax expense = ($7,500 × 38%) = (2,850)

Increase in after-tax income= $ 4,650

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.

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.

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 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

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 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%)

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

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).

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