7.4 Receivable Management Flashcards
(29 cards)
A retail company analyst is comparing North Company to South Company. The analyst notes that receivables for both companies’ private label credit cards have significantly increased balances in the current year. North’s customers’ monthly payment averaged 15% of their balances, while South’s customers’ monthly payment averaged 22% of their balances. What should the analyst conclude?
A. North’s customers may be having a hard time paying down their credit card debt than South’s customers.
B. South Company has likely increased its prices higher than North Company.
C. Both North Company and South Company have increased their prices in the current period; however, South Company has a higher gross margin than North Company.
D. North Company sells more high-volume, low-margin goods than South Company.
A. North’s customers may be having a hard time paying down their credit card debt than South’s customers.
Define the cash conversion cycle and describe how it relates to the operating cycle.
The cash conversion cycle is the time that passes, on average, between the firm’s payment for a purchase of inventory and the collection of cash from a customer on the sale of that inventory. The cash cycle is part of the operating cycle. The operating cycle is the cash cycle plus the time between purchases and payment.
An aging of accounts receivable measures the
A. Ability of the firm to meet short-term obligations.
B. Average length of time that receivables have been outstanding.
C. Percentage of sales that have been collected after a given time period.
D. Amount of receivables that have been outstanding for given lengths of time.
D. Amount of receivables that have been outstanding for given lengths of time.
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.
A company believes that its collection costs could be reduced through modification of collection procedures. This action is expected to result in a lengthening of the average collection period from 28 days to 34 days; however, there will be no change in uncollectible accounts. The company’s budgeted credit sales for the coming year are $27,000,000, and short-term interest rates are expected to average 8%. To make the changes in collection procedures cost beneficial, the minimum savings in collection costs (using a 360-day year) for the coming year would have to be
A. $30,000
B. $36,000
C. $180,000
D. $360,000
B. $36,000
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 the company must experience to justify the change is therefore $36,000 ($450,000 × 8%).
Which one of the following statements is most likely to be true if a seller extends credit to a purchaser for a period of time longer than the purchaser’s operating cycle? The seller
A. Will have a lower level of accounts receivable than those companies whose credit period is shorter than the purchaser’s operating cycle.
B. Is, in effect, financing more than just the purchaser’s inventory needs.
C. Can be certain that the purchaser will be able to convert the inventory into cash before payment is due.
D. Has no need for a stated discount rate or credit period.
B. Is, in effect, financing more than just the purchaser’s inventory needs.
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 for a firm measures the number of days
A. After a typical credit sale is made until the firm receives the payment.
B. For a typical check to “clear” through the banking system.
C. Beyond the end of the credit period before a typical customer payment is received.
D. Before a typical account becomes delinquent.
A. After a typical credit sale is made until the firm receives the payment.
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 company is considering a change in its credit terms from n/30 to 2/10, n/30. The company’s budgeted sales for the coming year are $24,000,000, of which 90% are expected to be made on credit. If the new credit terms are adopted, the company estimates that discounts will be taken on 50% of the credit sales; however, uncollectible accounts will be unchanged. The new credit terms will result in expected discounts taken in the coming year of
A. $216,000
B. $240,000
C. $432,000
D. $480,000
A. $216,000
The company can calculate expected discounts taken under the new credit policy as follows:
Total sales 24,000,000 x percentage on credit 90% = $21,600,000 credit sales
Credit sales 21,600,000 x subject to discount 50% = $10,800,000
Subject to discount 10,800,000 x discount percentage 2% = expected discounts taken $216,000
Powell Industries deals with customers throughout the country and is attempting to more efficiently collect its accounts receivable. A major bank has offered to develop and operate a lockbox system for Powell at a cost of $90,000 per year. Powell averages 300 receipts per day at an average of $2,500 each. Its short-term interest cost is 8% per year. Using a 360-day year, what reduction in average collection time would be needed in order to justify the lockbox system?
A. 1.20 days.
B. 1.50 days.
C. 0.67 days.
D. 1.25 days.
B. 1.50 days.
The amount Powell could potentially earn by investing its cash collections is calculated as follows:
Average amount per transaction $2,500
Times: payment per day x 300
= Daily Collections $750,000
Times: Money market rate x 8%
= Potential return on daily collections $60,000
The reduction in average collection time that justifies the lockbox system is the ratio of its cost to the potential return ($90,000 / $60,000 = 1.5 days)
A firm sells to retail stores on credit terms of 2/10, net 30. Daily sales average 150 units at a price of $300 each. All sales are on credit and 60% of customers take the discount and pay on day 10 while the rest of the customers pay on day 30. The amount of the firm’s accounts receivable that is paid within the discount period is
A. $810,000
B. $1,350,000
C. $990,000
D. $900,000
A. $810,000
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 x 40%), will be uncollected because customers do not take their discounts. The remaining $810,000 ($1,350,000 x 60%) will be paid within the discount period.
The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified the four sources of funds given below.
(1) Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.
(2) Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
(3) Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)
(4) Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year in all of your calculations.
The cost of Alternative (1) to Frame Supply Company is
A. 8.5%
B. 10.0%
C. 13.2%
D. 16.0%
D. 16.0%
The first step is to calculate the amount the firm will receive from the factoring transaction:
Amount of receivables $125,000
Times: Advance percentage x 80%
Amount received = $100,000
This amount is the basis for the calculation of interest expense:
Amount advanced $100,000
Times: Annual finance charge x 10%
Annual interest expense = $10,000
The next step is to calculate the annual factor fee:
Amount of receivables $125,000
Times: Factor fee percentage x 2%
Monthly factor fee = $2,500
Times: Months x 12
Annual factor fee = $ 30,000
The annual net cost of this factoring transaction is calculated as follows:
Annual interest expense $10,000
Annual factor fee 30,000
Less: annual savings (24,000)
Annual net cost $ 16,000
As with all financing arrangements, the effective rate is the ratio of the amount the firm must pay to the amount the firm get use of:
Effective rate = Net Cost ÷ Usable funds
= $16,000 ÷ $100,000
= 16.0%
A maker of bowling gloves is investigating the possibility of liberalizing its credit policy. Currently, payment is made on a cash-on-delivery basis. Under a new program, sales would increase by $80,000. The company has a gross profit margin of 40%. The estimated credit loss rate on the incremental sales would be 6%. Ignoring the cost of money, what would be the return on sales before taxes for the new sales?
A. 34.0%
B. 36.2%
C. 40.0%
D. 42.5%
A. 34.0%
The increase in estimated gross profit is $32,000 ($80,000 × 40%). The incremental credit 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).
Hest Computers believes that its collection costs could be reduced through modification of collection procedures. This action is expected to result in a lengthening of the average collection period from 30 to 35 days; however, there will be no change in uncollectible accounts, or in total credit sales. Furthermore, the variable cost ratio is 60%, the opportunity cost of a longer collection period is assumed to be negligible, the company’s budgeted credit sales for the coming year are $45,000,000, and the required rate of return is 6%. To justify changes in collection procedures, the minimum annual reduction of costs (using a 360-day year and ignoring taxes) must be
A. $125,000
B. $37,500
C. $375,000
D. $22,500
D. $22,500
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.
A company can increase annual sales by $150,000 if it sells to a new, riskier group of customers. The uncollectible accounts expense is expected to be 16% of sales, and collection costs will be 4%. The company’s manufacturing and selling expenses are 75% of sales, and its effective tax rate is 38%. If the company accepts this opportunity, its after-tax income will increase by
A. $4,650
B. $2,850
C. $7,500
D. $8,370
A. $4,650
The company’s manufacturing and selling costs exclusive of bad debt equals 75% of sales. Hence, the gross profit on the $150,000 increase in sales will be $37,500 ($150,000 x 25%). The increase in after-tax profit is calculated as follows:
Increase in gross profit: $37,500
Less: Uncollectible accounts ($150,000 x 16%): 24,000
Less: Collection costs ($150,000 x 4%): 6,000
= Increase in pre-tax income $7500
Less: income tax expense ($7,500 x 38%): $2,850
= Increase in after-tax income $4,650.
Which of the following represents a firm’s average gross receivable balance?
I. Days’ sales in receivables x Accounts receivable turnover.
II. Average daily sales x Average collection period.
III. Net sales ÷ Average gross receivables.
A. I and II only.
B. II only.
C. II and III only.
D. I only.
B. II only.
A firm’s average gross receivable balance can be calculated by multiplying average daily sales by the average collection period (days’ sales outstanding). Alternatively, annual credit sales can be divided by the accounts-receivable turnover (Net credit sales ÷ Average accounts receivable) to obtain the average balance in receivables.
A company’s budgeted sales for the coming year are expected to be $50,000,000, of which 75% are expected to be credit sales at terms of n/30. The company estimates that a proposed relaxation of credit standards will increase credit sales by 25% and increase the average collection period from 20 days to 30 days. Based on a 360-day year, the proposed relaxation of credit standards will result in an expected increase in the average accounts receivable balance of
A. $1,822,917
B. $2,083,333
C. $520,833
D. $3,906,250
A. $1,822,917
Projected credit sales for the year under the old credit policy were $37,500,000 ($50,000,000 x 75%), resulting in an average balance in receivables of $2,083,333 [$37,500,000 x (20 days / 360 days)]. Under the new policy, credit sales will be $46,875,000 ($37,500,000 x 1.25), resulting in an average receivable balance of $3,906,250 [$46,875,000 x (30 days / 360 days)]. Hence, the expected increase in the balance is $1,822,917 ($3,906,250 - $3,083,333).
The following information regards a change in credit policy. The company has a required rate of return of 10% and variable cost ratio of 60%.
Old credit policy:
sales: $3,600,000
Average collection period: 30 days
New credit policy:
Sales: $3,960,000
Average collection period: 36 days
The pre-tax cost of carrying the additional investment in receivables, using a 360-day year, would be
A. $8,160
B. $960
C. $9,600
D. $5,760
D. $5,760
The projected average balance in receivables under the old policy was $300,000 [$3,600,000 x (30 days / 360 days)]. Under the new policy, the average balance will be $396,000 [$3,960,000 x (36 days / 360 days). Hence, the average balance is $96,000 higher under the new policy. The pre-tax cost of carrying the additional investment in receivables can be calculated as follows:
Increased investment in receivables - gross $96,000
x variable cost ratio 60%
= increased investment in receivables - net $57,600
x opportunity cost of funds x 10%
= incremental cost of new credit plan = $5,760
A firm that often factors its accounts receivable has an agreement with its finance company that requires the firm to maintain a 6% reserve and charges a 1.4% commission on the amount of the receivables. The net proceeds would be further reduced by an annual interest charge of 15% on the monies advanced. Assuming a 360-day year, what amount of cash (rounded to the nearest dollar) will the firm receive from the finance company at the time a $100,000 account that is due in 60 days is turned over to the finance company?
A. $96,135
B. $92,600
C. $90,285
D. $85,000
C. $90,825
The first step is to calculate the gross proceeds the firm will receive from the factoring transaction:
Amount of receivable $100,000
-) reserve ($100,000 x 6%) (6,000)
-) Factor Fee ($100,000 x 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
x) Annual finance charge 15%
= Annualized interest expense $13,890
x) portion of year (60 days / 360 days) x 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
-) Interest Expense (2,315)
= Net proceeds $90,285
A firm averages $4,000 in sales per day and is paid, on average, within 30 days of the sale. After they receive their invoice, 55% of the customers pay by check, while the remaining 45% pay by credit card. Approximately how much would the company show in accounts receivable on its balance sheet on any given date?
A. $48,000
B. $4,000
C. $54,000
D. $120,000
D. $120,000
The average balance of receivables is $120,000 ($4,000 x 30 days). Whether customers pay by credit card or check, collection requires 30 days.
A company is reviewing its trade credit policy with respect to the small retailers to which it sells. Four plans have been studied and the results are as follows:
Plan A
Annual revenue: $200,000
Credit Loss: $1,000
Collection Cost: $1,000
Accounts Receivable: $20,000
Inventory: $40,000
Plan B
Annual revenue: $250,000
Credit Loss: $3,000
Collection Cost: 2,000
Accounts Receivable: 40,000
Inventory: 50,000
Plan C
Annual revenue: 300,000
Credit Loss: 6,000
Collection Cost: 5,000
Accounts Receivable: 60,000
Inventory: 60,000
Plan D
Annual revenue: 350,000
Credit Loss: 12,000
Collection Cost: 8,000
Accounts Receivable: 80,000
Inventory: 70,000
The information shows how various annual expenses, such as credit losses and the cost of collections, change as sales change. The average balance of accounts receivable and inventory have also been projected. The cost of the product to the company is 80% of the selling price, after-tax cost of capital is 15%, and the effective income tax rate is 30%. What is the optimal plan for the company to implement?
A. Plan B.
B. Plan D.
C. Plan A.
D. Plan C.
A. Plan B.
The following schedule represents the after tax profit for each plan:
Plan A
Annual revenue: $200,000 x GP percentage (20%)
= GP $40,000
-) Credit Loss: $1,000
-) Collection Cost: $1,000
= Gross incremental profit: $38,000
-) Income taxes (30%) 11,400
= After tax profit 26,600
Plan B
Annual revenue: $250,000 x GP percentage (20%)
= GP $50,000
-) Credit Loss: $3,000
-) Collection Cost: $2,000
= Gross incremental profit: $45,000
-) Income taxes (30%) 13,500
= After tax profit 31,500
Plan C
Annual revenue: $300,000 x GP percentage (20%)
= GP $60,000
-) Credit Loss: $6,000
-) Collection Cost: $5,000
= Gross incremental profit: $49,000
-) Income taxes (30%) 14,700
= After tax profit 34,300
Plan D
Annual revenue: $350,000 x GP percentage (20%)
= GP $70,000
-) Credit Loss: $12,000
-) Collection Cost: $8,000
= Gross incremental profit: $50,000
-) Income taxes (30%) 15,000
= After tax profit 35,000
The following schedule presents the investment in current assets for each plan:
Plan A:
Accounts Receivable: $20,000
+) Inventory: $40,000
= Capital invested $60,000
x) Cost of capital 15%
= Dollar cost of capital $9,000
Plan B:
Accounts Receivable: $40,000
+) Inventory: $50,000
= Capital invested $90,000
x) Cost of capital 15%
= Dollar cost of capital $13,500
Plan C:
Accounts Receivable: $60,000
+) Inventory: $60,000
= Capital invested $120,000
x) Cost of capital 15%
= Dollar cost of capital $18,000
Plan D:
Accounts Receivable: $80,000
+) Inventory: $70,000
= Capital invested $150,000
x) Cost of capital 15%
= Dollar cost of capital $22,500
The difference between after-tax profit and cost of capital is the net incremental profit. Plan B’s is the highest:
Plan A
After tax profit: $26,600
-) Dollar cost of capital 9,000
= Net incremental profit $17,600
Plan B
After tax profit: $31,500
-) Dollar cost of capital 13,500
= Net incremental profit $18,000
Plan C
After tax profit: $34,300
-) Dollar cost of capital 18,000
= Net incremental profit $16,300
Plan D
After tax profit: $35,000
-) Dollar cost of capital 22,500
= Net incremental profit $12,500
A corporation has been advised by its accountant that the following four sales volumes can be achieved along with the following receivable payment patterns and credit losses, depending on the company’s credit policy (in thousands).
I. Sales volume: $520
30 days: $300
60 days: $100
90 days: $100
120 days: $0
Credit losses: $20
II. Sales volume: 630
30 days: $200
60 days: $200
90 days: $100
120 days: $100
Credit losses: $30
III. Sales volume: 770
30 days: $200
60 days: $100
90 days: $200
120 days: $200
Credit losses: $70
IV. Sales volume: 900
30 days: $100
60 days: $200
90 days: $200
120 days: $300
Credit losses: $100
Assuming that the firm’s cost of capital is 20% and that all payments are made on the first possible day of the aging month, which sales volume will maximize profit?
A. IV.
B. II.
C. I.
D. III.
A. IV.
The optimal credit strategy is one that maximizes sales while minimizing credit loss expense and collection time. Although IV has the highest credit loss expense and collects less money earlier, it results in the highest amount of sales, enough to offset the increased cost of credit losses and collection time. The total income from each policy is found by subtracting the imputed financing charge for each month of uncollectible receivables and credit loss expense from the total sales, in this case totaling $775, determined as follows: $900 - ($200 x 20% / 12) - ($200 x 2 x 20% / 12) - ($300 x 20% /12 x 3) - $100 = $775.
An established firm sells computer hardware, software, and services. The firm is considering a change in its credit policy. It has been determined that such a change would not change the payment patterns of the current customers. To determine whether such a change would be beneficial, the firm has identified the proposed new credit terms, the expected additional sales, the expected contribution margin on the sales, the expected bad debt losses, and the investment in additional receivables and the period of the investment. What additional information, if any, does the firm require to determine the profitability of the proposed new policy as compared to the current credit policy?
A. The new credit standards.
B. No additional information is needed.
C. The credit standards that presently exist.
D. The opportunity cost of funds.
D. The opportunity cost of funds.
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.
The following information regards a change in credit policy. The company has a required rate of return of 11% and a variable cost ratio of 50%.
Sales
Old Credit Policy: $4,600,000
New Credit Policy: $4,960,000
Average collection period
Old Credit Policy: 30 days
New Credit Policy: 35 days
The pre-tax cost of carrying the additional investment in receivables, assuming a 360-day year, is
A. $13,778
B. $5,439
C. $10,878
D. $98,890
B. $5,439
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
A company with $4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase credit sales by $720,000. The company’s average collection period for new customers is expected to be 75 days, and the payment behavior of the existing customers is not expected to change. Variable costs are 80% of sales. The firm’s opportunity cost is 20% before taxes. Assuming a 360-day year, what is the company’s benefit (loss) on the planned change in credit terms?
A. $0
B. $144,000
C. $120,000
D. $28,800
C. $120,000
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
The sales manager feels confident that, if the credit policy were changed, sales would increase and, consequently, the company would utilize excess capacity. The two credit proposals being considered are as follows:
Proposal A / Proposal B
Increase in sales $500,000 / $600,000
Contribution margin 20% / 20%
Credit loss percentage 5% / 5%
Increase in operating profits $ 75,000 / $ 90,000
Desired return on sales 15% / 15%
Currently, payment terms are net 30. The proposed payment terms for Proposal A and Proposal B are net 45 and net 90, respectively. An analysis to compare these two proposals for the change in credit policy would include all of the following factors except the
A. Impact on the current customer base of extending terms to only certain customers.
B. Cost of funds.
C. Current credit loss experience.
D. Bank loan covenants on days’ sales outstanding.
C. Current credit loss experience.
All factors should be considered that differ between the two policies. Factors that do not differ, such as the current credit loss experience, are not relevant. The company must estimate the expected credit losses under each new policy.
