Pearson Education Management Accounting for Decision Makers_13 doc

In the case of a business that purchases goods on credit for sub-sequent resale on credit for example, a wholesaler, the OCC is as shown in Figure 11.7.Figure 11.7 shows that payment for

How much cash should be held?

Although cash can be held for each of the reasons identified, doing so may not always

be necessary If a business is able to borrow quickly, the amount of cash it needs tohold can be reduced Similarly, if the business holds assets that can easily be converted

to cash (for example, marketable securities such as shares in Stock Exchange listed businesses or government bonds), the amount of cash held can be reduced

The decision as to how much cash a particular business should hold is a difficultone Different businesses will have different views on the subject

Why do you think a business may decide to hold at least some of its assets in the form

of cash? (Hint: There are broadly three reasons.)

The three reasons are:

1 To meet day-to-day commitments, a business requires a certain amount of cash.Payments for wages, overhead expenses, goods purchased and so on must be made

at the due dates Cash has been described as the lifeblood of a business Unless it circulates through the business and is available for the payment of claims as theybecome due, the survival of the business will be at risk Profitability is not enough; abusiness must have sufficient cash to pay its debts when they fall due

2 If future cash flows are uncertain for any reason, it would be prudent to hold a balance

of cash For example, a major customer that owes a large sum to the business may

be in financial difficulties Given this situation, the business can retain its capacity tomeet its obligations by holding a cash balance Similarly, if there is some uncertaintyconcerning future outlays, a cash balance will be required

3 A business may decide to hold cash to put itself in a position to exploit profitable tunities as and when they arise For example, by holding cash, a business may be able

oppor-to acquire a competioppor-tor’s business that suddenly becomes available at an attractive price

Activity 11.7

What do you think are the major factors that influence how much cash a business will hold? See if you can think of five possible factors.

You may have thought of the following:

l The nature of the business Some businesses, such as utilities (for example, water,

elec-tricity and gas suppliers), may have cash flows that are both predictable and reasonablycertain This will enable them to hold lower cash balances For some businesses, cash bal-ances may vary greatly according to the time of year A seasonal business may accumul-ate cash during the high season to enable it to meet commitments during the low season

l The opportunity cost of holding cash Where there are profitable opportunities it may

not be wise to hold a large cash balance

l The level of inflation Holding cash during a period of rising prices will lead to a loss of

purchasing power The higher the level of inflation, the greater will be this loss

l The availability of near-liquid assets If a business has marketable securities or inventories

that may easily be liquidated, high cash balances may not be necessary

Activity 11.8

Controlling the cash balance

Several models have been developed to help control the cash balance of the business.One such model proposes the use of upper and lower control limits for cash balancesand the use of a target cash balance The model assumes that the business will invest

in marketable investments that can easily be liquidated These investments will be chased or sold, as necessary, in order to keep the cash balance within the control limits.The model proposes two upper and two lower control limits (see Figure 11.6) If the

pur-business exceeds an outer limit, the managers must decide whether the cash balance

is likely to return to a point within the inner control limits set, over the next few days.

MANAGING CASH 433

l The availability of borrowing If a business can borrow easily (and quickly) there is less

need to hold cash

l The cost of borrowing When interest rates are high, the option of borrowing becomes

less attractive

l Economic conditions When the economy is in recession, businesses may prefer to hold

cash so that they can be well placed to invest when the economy improves In addition,during a recession, businesses may experience difficulties in collecting trade receivables

They may therefore hold higher cash balances than usual in order to meet commitments

l Relationships with suppliers Too little cash may hinder the ability of the business to pay

suppliers promptly This can lead to a loss of goodwill It may also lead to discountsbeing forgone

Controlling the cash balance

Figure 11.6

Management sets the upper and lower limits for the business’s cash balance When the balance goes beyond either of these limits, unless it is clear that the balance will return fairly quickly to within the limit, action will need to be taken If the upper limit is breached, some cash will be placed on deposit or used to buy some marketable securities If the lower limit is breached, the business will need to borrow some cash or sell some securities.

If this seems likely, then no action is required If, on the other hand, it does not seemlikely, management must change the cash position by either buying or selling mar-ketable investments.

In Figure 11.6 we can see that the lower outer control limit has been breached forfour days If a four-day period is unacceptable, managers must sell marketable invest-ments to replenish the cash balance

The model relies heavily on management judgement to determine where the controllimits are set and the period within which breaches of the control limits are acceptable.Past experience may be useful in helping managers decide on these issues There areother models, however, that do not rely on management judgement Instead, these usequantitative techniques to determine an optimal cash policy One model proposed, for example, is the cash equivalent of the inventories economic order quantity model,discussed earlier in the chapter

Cash budgets and managing cash

To manage cash effectively, it is useful for a business to prepare a cash budget This is

a very important tool for both planning and control purposes Cash budgets were considered in Chapter 6, and so we shall not consider them again in detail However,

it is worth repeating that these statements enable managers to see how planned eventsare expected to affect the cash balance The projected cash flow statement will identifyperiods when cash surpluses and cash deficits are expected

When a cash surplus is expected to arise, managers must decide on the best use ofthe surplus funds When a cash deficit is expected, managers must make adequate provision by borrowing, liquidating assets or rescheduling cash payments or receipts todeal with this Cash budgets are useful in helping to control the cash held The actualcash flows can be compared with the planned cash flows for the period If there is asignificant divergence between the projected, or forecast, cash flows and the actualcash flows, explanations must be sought and corrective action taken where necessary

To refresh your memory on cash budgets, it would probably be worth looking back

at pp 194 –197 in Chapter 6

Although cash budgets are prepared primarily for internal management purposes, spective lenders sometimes require them when a loan to a business is being considered

pro-The operating cash cycle

When managing cash, it is important to be aware of the operating cash cycle (OCC)

of the business For a retailer, for example, this may be defined as the period between theoutlay of cash necessary for the purchase of inventories and the ultimate receipt of cashfrom the sale of the goods In the case of a business that purchases goods on credit for sub-sequent resale on credit (for example, a wholesaler), the OCC is as shown in Figure 11.7.Figure 11.7 shows that payment for inventories acquired on credit occurs some timeafter those inventories have been purchased and, therefore, no immediate cash outflowarises from the purchase Similarly, cash receipts from credit customers will occur sometime after the sale is made and so there will be no immediate cash inflow as a result ofthe sale The OCC is the period between the payment made to the supplier for goodsconcerned and the cash received from the credit customer Although Figure 11.7depicts the position for a wholesaling business, the precise definition of the OCC caneasily be adapted for other types of business

The OCC is important because it has a significant influence on the financing requirements of the business Broadly, the longer the cycle, the greater the financing

‘

requirements of the business and the greater the financial risks For this reason, thebusiness is likely to want to reduce the OCC to the minimum possible period.

For the type of business mentioned above, which buys and sells on credit, the OCCcan be calculated from the financial statements by the use of certain ratios It is calcu-lated as shown in Figure 11.8

Calculating the operating cash cycle

Figure 11.8

For businesses that buy and sell on credit, three ratios are required to calculate the OCC.

The financial statements of Freezeqwik Ltd, a distributor of frozen foods, for the year ended 31 December last year are set out below.

Income statement for the year ended 31 December last year

Statement of financial position as at 31 December last year

All purchases and sales are on credit There has been no change in the level of trade receivables or payables over the period.

Calculate the length of the OCC for the business and go on to suggest how the ness may seek to reduce this period.

busi-Activity 11.9

Real World 11.11 shows the average operating cash cycle for large European businesses.

Extending the period of credit taken to pay suppliers could also reduce the OCC

However, for reasons that will be explained later, this option must be given careful consideration

159568

Trade payablesCredit purchases

264820

Trade receivablesCredit sales

(142 + 166)/2544

(Opening inventories + Closing inventories)/2

Cost of sales

REAL WORLD 11.11 Cycling along

The annual survey of working capital by REL Consulting and CFO Europe (see Real World11.2 above) calculates the average operating cash cycle for the top 1,000 European busi-nesses (excluding the financial sector) Comparative figures for the five-year period end-ing in 2007 are shown in Figure 11.9

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Cash transmission

A business will normally wish to benefit from receipts from customers at the earliestopportunity The benefit is immediate where payment is made in cash However, whenpayment is made by cheque, there is normally a delay of three to four working daysbefore the cheque can be cleared through the banking system The business musttherefore wait for this period before it can benefit from the amount paid in In the case

of a business that receives large amounts in the form of cheques, the opportunity cost

of this delay can be significant

To avoid this cost, a business could require payments to be made in cash This is notusually very practical, mainly because of the risk of theft and/or the expense of con-veying cash securely Another option is to ask for payment to be made by standingorder or by direct debit from the customer’s bank account This should ensure that theamount owing is always transferred from the bank account of the customer to the bankaccount of the business on the day that has been agreed

It is also possible for funds to be transferred directly to a business’s bank account.Customers can pay for items by using debit cards, which results in the appropriateaccount being instantly debited and the seller’s bank account being instantly creditedwith the required amount This method of payment is widely used by large retail busi-nesses, and can be extended to other types of business

Real World 11.11 continued

The survey calculates the operating cash cycle using year-end figures for trade ables, inventories and trade payables We can see that there has been a slight improve-ment in 2007 compared to the two previous years

receiv-Source: Compiled from information in 2008 REL/CFO European Working Capital Survey, www.relconsult.com.

The average OCC of large European businesses

Figure 11.9

Bank overdrafts

Bank overdrafts are simply bank current accounts that have a negative balance Theyare a type of bank loan and can be a useful tool in managing the business’s cash flowrequirements

Real World 11.12shows how Indesit, a large white-goods manufacturer, managed toimprove its cash flows through better working capital management

Trade credit arises from the fact that most businesses buy their goods and servicerequirements on credit In effect, suppliers are lending the business money, interest-free, on a short-term basis Trade payables are the other side of the coin from tradereceivables One business’s trade payable is another one’s trade receivable, in respect

of a particular transaction Trade payables are an important source of finance for most businesses They have been described as a ‘spontaneous’ source, as they tend

to increase in line with the increase in the level of activity achieved by a business.Trade credit is widely regarded as a ‘free’ source of finance and, therefore, a good thing for a business to use There may be real costs, however, associated with takingtrade credit

Managing trade payables

MANAGING TRADE PAYABLES 439

REAL WORLD 11.12 Dash for cash

Despite an impressive working capital track record, a 50% plunge in profit at Indesit in

2005 led to the creation of a new three-year plan that meant an even stronger emphasis

on cash generation Operating cash flow was added to the incentive scheme for seniorand middle managers, who subsequently released more cash from Indesit’s already leanprocesses by ‘attacking the areas that were somehow neglected’, Crenna [the chief finan-cial officer] says

Hidden in the dark corners of the accounts-receivable department in the UK’s sales service operation, for example, were a host of delinquent, albeit small, payments –

after-in some cases overdue by a year or more ‘If you don’t put a specific focus on thesereceivables, it’s very easy for them to become neglected,’ Crenna says ‘In theory, nobodyworries about collecting £20 In reality, we were sitting on a huge amount of receivables,though each individual bill was for a small amount.’

More trapped cash was found in the company’s spare-parts inventory The inventory isworth around A30m today compared with around A40m three years ago ‘This was a goodresult that came just from paying the same level of attention to spare parts as to finishedproducts,’ Crenna says In general, Indesit has been able to improve working capital performance through ‘fine-tuning rather than launching epic projects’ Over the past twoyears, according to REL, Indesit has released A115m from its working capital processes

Source: Karaian, J., ‘Dash for Cash’, CFO Europe Magazine, 8 July 2008, www.CFO.com.

First, customers who take credit may not be as well treated as those who pay diately For example, when goods are in short supply, credit customers may receivelower priority when allocating the goods available In addition, credit customers may

imme-be less favoured in terms of delivery dates or the provision of technical support services.Sometimes, the goods or services provided may be more costly if credit is required.However, in most industries, trade credit is the norm As a result, the above costs willnot apply except, perhaps, to customers that abuse the credit facilities A business thatpurchases supplies on credit will normally have to incur additional administration andaccounting costs in dealing with the scrutiny and payment of invoices, maintainingand updating payables accounts, and so on

These points are not meant to imply that taking credit represents a net cost to a business There are, of course, real benefits that can accrue Provided that trade credit

is not abused, it can represent a form of interest-free loan It can be a much more convenient method of paying for goods and services than paying by cash, and during

a period of inflation there will be an economic gain by paying later rather than soonerfor goods and services purchased For most businesses, these benefits will exceed thecosts involved

In some cases, delaying payment can be a sign of financial problems One suchexample is given in Real World 11.13

Taking advantage of cash discounts

Where a supplier offers a discount for prompt payment, the business should give ful consideration to the possibility of paying within the discount period An examplemay be useful to illustrate the cost of forgoing possible discounts

care-REAL WORLD 11.13 NHS waiting times

The National Health Service is delaying paying bills and cutting orders for supplies as it tries to balance its books, according to the trade associations whose members supply the service with everything from scanners to diagnostic tests.

Ray Hodgkinson, director-general of the British Healthcare Trades Association, said that while the picture was highly variable ‘some of our members are having real trouble getting money out of NHS trusts’.

Most had standing orders that said bills should be paid within 30 days, Mr Hodgkinson said.

‘But some are not paying for 60 or 90 days and even longer They are in breach of their standing orders and for a lot of our members who are small businesses this is creating problems with cash flow There is no doubt there is slow payment on a significant scale.’

Doris-Ann Williams, director-general of the British In-Vitro Diagnostics Association, whose members provide diagnostics supplies and tests, said: ‘We are starting to see invoices not being paid and orders not being closed until the start of the new financial year [in April].

‘All sorts of measures are being taken to try not to spend money in this financial year.’

Having seen orders dry up and bills not paid this time last year as the NHS headed for a plus financial deficit, she added that this was ‘starting to seem like an annual event’.

£500m-Source: NHS paying bills late in struggle to balance books, say suppliers, ft.com (Timmins, N.), © The Financial Times Limited,

13 February 2007.

FT

Controlling trade payables

To help monitor the level of trade credit taken, management can calculate the average settlement period for trade payables This ratio is:

Average settlement period for trade payables == ×× 365

Once again, this provides an average figure, which could be misleading A moreinformative approach would be to produce an ageing schedule for payables This would look much the same as the ageing schedule for receivables described earlier

in Example 11.3

We saw earlier that delaying payment to suppliers may create problems for a business

Real World 11.14 , however, describes how cash-strapped businesses may delay payments

and still retain the support of its suppliers

Average trade payables Credit purchases

MANAGING TRADE PAYABLES 441

Hassan Ltd takes 70 days to pay for goods from its supplier To encourage promptpayment, the supplier has offered the business a 2 per cent discount if paymentfor goods is made within 30 days

Hassan Ltd is not sure whether it is worth taking the discount offered

If the discount is taken, payment could be made on the last day of the discountperiod (that is, the 30th day) However, if the discount is not taken, payment will

be made after 70 days This means that, by not taking the discount, the businesswill receive an extra 40 (that is, 70 − 30) days’ credit The cost of this extra credit

to the business will be the 2 per cent discount forgone If we annualise the cost ofthis discount forgone, we have:

365/40 × 2% = 18.3%*

We can see that the annual cost of forgoing the discount is very high, and so

it may be profitable for the business to pay the supplier within the discountperiod, even if it means that it will have to borrow to enable it to do so

* This is an approximate annual rate For the more mathematically minded, the precise rate is

([(1 + 2/98) 9.125 ] − 1) × 100% = 20.2%

Example 11.4

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REAL WORLD 11.14 Credit stretch

According to Gavin Swindell, European managing director of REL, a research and sulting firm, there are ‘win-win’ ways of extending credit terms He states:

con-‘A lot of businesses aren’t worried about getting paid in 40 or 45 days, but are more interested in the certainty of payment on a specific date.’

Jas Sahota, a partner in Deloitte’s UK restructuring practice, says that three-month extensions are common, ‘as long as the supplier can see that there is a plan’ In times of stress, he says, it’s

‘

Real World 11.14 continued

important to negotiate with only a handful of the most important partners – squeezing suppliers large and small only generates grief and distracts employees with lots of calls.

More fundamentally, the benefits of pulling the payables lever in isolation is ‘questionable’, notes Andrew Ashby, director of the working capital practice at KPMG in London, ‘especially as the impact on the receivables balance is typically a lot more than the payables balance’.

Improving collections, such as achieving longer payment terms, relies on the strength of tionships built over time, notes Robert Hecht, a London-based managing director of turnaround consultancy AlixPartners ‘You can’t wait for a crisis, and then expect suppliers to step up and be your best friends.’

rela-Source: Karaian, J., ‘Dash for Cash’, CFO Europe Magazine, 8 July 2008, www.CFO.com.

The main points of this chapter may be summarised as follows

Working capital

l Working capital is the difference between current assets and current liabilities

l That is,working capital = inventories + receivables + cash − payables − bank overdrafts

l An investment in working capital cannot be avoided in practice – typically largeamounts are involved

l There are also costs of not holding sufficient inventories, which include:

– Loss of sales and customer goodwill

– Production dislocation

– Loss of flexibility – cannot take advantage of opportunities

– Reorder costs – low inventories imply more frequent ordering

l Practical points on inventories management include:

– Identify optimum order size – models can help with this

– Set inventories reorder levels

– Use forecasts

– Keep reliable inventories records

– Use accounting ratios (for example, inventories turnover period ratio)

– Establish systems for security of inventories and authorisation

– Consider just-in-time (JIT) inventories management

SUMMARY

– Lost purchasing power.

– Costs of assessing customer creditworthiness

– Administration cost

– Bad debts

– Cash discounts (for prompt payment)

l The costs of denying credit include:

– Loss of customer goodwill

l Practical points on receivables management:

– Establish a policy

– Assess and monitor customer creditworthiness

– Establish effective administration of receivables

– Establish a policy on bad debts

– Consider cash discounts

– Use financial ratios (for example, average settlement period for trade receivables ratio).– Use ageing summaries

Cash

l The costs of holding cash include:

– Lost interest

– Lost purchasing power

l The costs of holding insufficient cash include:

– Loss of supplier goodwill if unable to meet commitments on time

– Loss of opportunities

– Inability to claim cash discounts

– Costs of borrowing (should an obligation need to be met at short notice)

l Practical points on cash management:

– Establish a policy

– Plan cash flows

– Make judicious use of bank overdraft finance – it can be cheap and flexible

– Use short-term cash surpluses profitably

– Bank frequently

– Operating cash cycle (for a wholesaler) = length of time from buying inventories

to receiving cash from receivables less payables’ payment period (in days)

– Transmit cash promptly

l An objective of working capital management is to limit the length of the operatingcash cycle (OCC), subject to any risks that this may cause

Trade payables

l The costs of taking credit include:

– Higher price than purchases for immediate cash settlement

– Administrative costs

– Restrictions imposed by seller

If you would like to explore the topics covered in this chapter in more depth, we recommend the following books:

McLaney, E., Business Finance: Theory and Practice, 8th edn, Financial Times Prentice Hall, 2009,

Economic order quantity (EOQ) p 419

Materials requirement planning (MRP) system p 422

Just-in-time (JIT) inventories management p 422

Operating cash cycle (OCC) p 434

Average settlement period for trade payables p 441

Key terms

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l The costs of not taking credit include:

– Lost interest-free borrowing

– Lost purchasing power

– Inconvenience – paying at the time of purchase can be inconvenient

l Practical points on payables management:

– Establish a policy

– Exploit free credit as far as possible

– Use accounting ratios (for example, average settlement period for trade payablesratio)

Answers to these questions can be found in Appendix C at the back of the book.

Tariq is the credit manager of Heltex plc He is concerned that the pattern of monthly cashreceipts from credit sales shows that credit collection is poor compared with budget Heltex’ssales director believes that Tariq is to blame for this situation, but Tariq insists that he is not.Why might Tariq not be to blame for the deterioration in the credit collection period?

How might each of the following affect the level of inventories held by a business?

(a) An increase in the number of production bottlenecks experienced by the business

(b) A rise in the level of interest rates

(c) A decision to offer customers a narrower range of products in the future

(d) A switch of suppliers from an overseas business to a local business

(e) A deterioration in the quality and reliability of bought-in components

What are the reasons for holding inventories? Are these reasons different from the reasons forholding cash?

Identify the costs of holding:

(a) too little cash;

(b) too much cash

11.4 11.3

11.2 11.1

Exercises 11.4 to 11.8 are more advanced than 11.1 to 11.3 Those with coloured numbers have an answer in Appendix D at the back of the book If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney

Hercules Wholesalers Ltd has been particularly concerned with its liquidity position in recentmonths The most recent income statement and statement of financial position (balance sheet)

of the business are as follows:

Income statement for the year ended 31 December last year

Statement of financial position as at 31 December last year

The trade receivables and payables were maintained at a constant level throughout the year

Required:

(a) Explain why Hercules Wholesalers Ltd is concerned about its liquidity position

(b) Calculate the operating cash cycle for Hercules Wholesalers Ltd based on the informationabove (Assume a 360-day year.)

(c) State what steps may be taken to improve the operating cash cycle of the business.International Electric plc at present offers its customers 30 days’ credit Half the customers, byvalue, pay on time The other half take an average of 70 days to pay The business is consider-ing offering a cash discount of 2 per cent to its customers for payment within 30 days

The credit controller anticipates that half of the customers who now take an average of

70 days to pay (that is, a quarter of all customers) will pay in 30 days The other half (the finalquarter) will still take an average of 70 days to pay The scheme will also reduce bad debts by

£300,000 a year

Annual sales revenue of £365m is made evenly throughout the year At present the businesshas a large overdraft (£60m) with its bank at an interest cost of 12 per cent a year

Required:

(a) Calculate the approximate equivalent annual percentage cost of a discount of 2 per cent,

which reduces the time taken by credit customers to pay from 70 days to 30 days (Hint:

This part can be answered without reference to the narrative above.)(b) Calculate the value of trade receivables outstanding under both the old and new schemes.(c) How much will the scheme cost the business in discounts?

(d) Should the business go ahead with the scheme? State what other factors, if any, should betaken into account

(e) Outline the controls and procedures that a business should adopt to manage the level of itstrade receivables

11.2

The managing director of Sparkrite Ltd, a trading business, has just received summary sets offinancial statements for last year and this year:

Sparkrite Ltd Income statements for years ended 30 September last year and this year

Last year This year

Statements of financial position (balance sheets) as at

30 September last year and this year

Last year This year

The finance director has expressed concern at the increase in inventories and trade ables levels

2 trade receivables levels

Your superior, the general manager of Plastics Manufacturers Limited, has recently been ing to the chief buyer of Plastic Toys Limited, which manufactures a wide range of toys foryoung children At present, Plastic Toys is considering changing its supplier of plastic granulesand has offered to buy its entire requirement of 2,000 kg a month from you at the going marketrate, provided that you will grant it three months’ credit on its purchases The following infor-mation is available:

talk-11.4 11.3

EXERCISES 447

1 Plastic granules sell for £10 a kg, variable costs are £7 a kg, and fixed costs £2 a kg.

2 Your own business is financially strong, and has sales revenue of £15 million a year For theforeseeable future it will have surplus capacity, and it is actively looking for new outlets

3 Extracts from Plastic Toys’ financial statements:

Year 1 Year 2 Year 3

(b) Describe the accounting controls that you would use to monitor the level of your business’strade receivables

(c) Advise your general manager on the acceptability of the proposal You should give your

rea-sons and do any calculations you consider necessary (Hint : To answer this question you

must weigh the costs of administration and cash discounts against the savings in bad debtsand interest charges.)

Mayo Computers Ltd has annual sales of £20m Bad debts amount to £0.1m a year All salesmade by the business are on credit and, at present, credit terms are negotiable by the customer

On average, the settlement period for trade receivables is 60 days Trade receivables arefinanced by an overdraft bearing a 14 per cent rate of interest per year The business is currentlyreviewing its credit policies to see whether more efficient and profitable methods could beemployed Only one proposal has so far been put forward concerning the management of tradecredit

The credit control department has proposed that customers should be given a 2.5 per centdiscount if they pay within 30 days For those who do not pay within this period, a maximum of

50 days’ credit should be given The credit department believes that 60 per cent of customerswill take advantage of the discount by paying at the end of the discount period The remainderwill pay at the end of 50 days The credit department believes that bad debts can be effectivelyeliminated by adopting the above policies and by employing stricter credit investigation pro-cedures, which will cost an additional £20,000 a year The credit department is confident thatthese new policies will not result in any reduction in sales revenue

Required:

Calculate the net annual cost (savings) to the business of abandoning its existing credit policies

and adopting the proposals of the credit control department (Hint: To answer this question you

must weigh the costs of administration and cash discounts against the savings in bad debts andinterest charges.)

11.5

Boswell Enterprises Ltd is reviewing its trade credit policy The business, which sells all of itsgoods on credit, has estimated that sales revenue for the forthcoming year will be £3m underthe existing policy Credit customers representing 30 per cent of trade receivables are expected

to pay one month after being invoiced and 70 per cent are expected to pay two months afterbeing invoiced These estimates are in line with previous years’ figures

At present, no cash discounts are offered to customers However, to encourage prompt payment, the business is considering giving a 2.5 per cent cash discount to credit customerswho pay in one month or less Given this incentive, the business expects credit customersaccounting for 60 per cent of trade receivables to pay one month after being invoiced and those accounting for 40 per cent of trade receivables to pay two months after being invoiced.The business believes that the introduction of a cash discount policy will prove attractive tosome customers and will lead to a 5 per cent increase in total sales revenue

Irrespective of the trade credit policy adopted, the gross profit margin of the business will be

20 per cent for the forthcoming year and three months’ inventories will be held Fixed monthlyexpenses of £15,000 and variable expenses (excluding discounts) equivalent to 10 per cent ofsales revenue will be incurred and will be paid one month in arrears Trade payables will be paid

in arrears and will be equal to two months’ cost of sales The business will hold a fixed cash ance of £140,000 throughout the year, whichever trade credit policy is adopted Ignore taxation

bal-Required:

(a) Calculate the investment in working capital at the end of the forthcoming year under:

(i) the existing policy;

(ii) the proposed policy

(b) Calculate the expected profit for the forthcoming year under:

(i) the existing policy;

(ii) the proposed policy

(c) Advise the business as to whether it should implement the proposed policy

(Hint: The investment in working capital will be made up of inventories, trade receivables and cash, less trade payables and any unpaid expenses at the year end.)

Delphi plc has recently decided to enter the expanding market for minidisc players The business will manufacture the players and sell them to small TV and hi-fi specialists, medium-sized music stores and large retail chain stores The new product will be launched next Februaryand predicted sales revenue for the product from each customer group for February and theexpected rate of growth for subsequent months are as follows:

Customer type February Monthly compound Credit period

sales revenue sales revenue growth

The business is concerned about the financing implications of launching the new product, as

it is already experiencing liquidity problems In addition, it is concerned that the credit controldepartment will find it difficult to cope This is a new market for the business and there are likely

to be many new customers who will have to be investigated for creditworthiness

Workings should be in £000’s and calculations made to one decimal place only

Required:

(a) Prepare an ageing schedule of the monthly trade receivables balance relating to the newproduct for each of the first four months of the new product’s life, and comment on the

11.7 11.6

EXERCISES 449

results The schedule should analyse the trade receivables outstanding according to customer type It should also indicate, for each customer type, the relevant percentage outstanding in relation to the total amount outstanding for each month.

(b) Identify and discuss the factors that should be taken into account when evaluating the creditworthiness of the new business customers

Goliath plc is a retail business operating in Ireland The most recent financial statements of thebusiness are as follows:

Income statement for the year to 31 May

£000 £000

Cost of salesOpening inventories 550.0

2,000.0Closing inventories (560.0) (1,440.0 )

Statement of financial position as at 31 May

£000 £000

Non-current assets

Property, plant and equipment

Machinery and equipment at cost 424.4Accumulated depreciation (140.8 ) 283.6Motor vehicles at cost 308.4

All sales and purchases are made on credit

11.8