Accounts Receivable Management Quiz

The projected average balance in receivables under the old policy was$300,000 [$3,600,000 × (30 days ÷ 360 days)]. Under the new policy, theaverage 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 additionalinvestment 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

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

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

The additional annual income (loss) from using the lockbox service is theexcess (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 balancewill 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)

Average collection period equals average receivables divided by dailysales. 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).

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 averagecollection period for these sales is 45 days.

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

Projected credit sales for the year under the old credit policy were$32,400,000 ($40,500,000 × 80%).

The projected average balance inreceivables was therefore $2,700,000 [$32,400,000 × (30 days ÷ 360days)].

Under the new policy, projected credit sales will be $38,880,000($32,400,000 × 1.2),

resulting in a new average receivables balance of$4,320,000 [$38,880,000 × (40 days ÷ 360 days)].

Hence, the expectedincrease in the balance is $1,620,000 ($4,320,000 – $2,700,000).

Expected discounts taken under the new credit policy can be calculated asfollows:

Total sales $20,000,000

Times: percentage on credit × 80%

= Credit sales $16,000,000

Times: subject to discount × 60%

= Sales subject to discount $9,600,000

Times: discount percentage × 3%

= Expected discounts taken $288,000

The company can calculate expected discounts taken under the new creditpolicy as follows:

Total sales $24,000,000

Times: percentage on credit × 90%

= Credit sales $21,600,000

Times: subject to discount × 50%

= Sales subject to discount $10,800,000

Times: discount percentage × 2%

= Expected discounts taken $ 216,000

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

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

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

Aging thereceivables and estimating the uncollectible amounts is one method ofarriving at the appropriate balance sheet valuation of the accountsreceivable account.

If the change is adopted, Hest’s average balance in receivables willincrease 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, thecollection costs must be reduced by a pretax minimum of $22,500 to offsetthe cost of the increased investment in receivables.

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

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

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

The average collection period, also called the days sales outstanding inreceivables, is calculated as the number of days in the year over thereceivables 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 debtsequal 75% of sales. Hence, the gross profit on the $150,000 increase insales will be $37,500 ($150,000 × 25%).

The increase in after-tax profit iscalculated 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

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

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

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

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

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