Therefore, the services of credit agency are worthwhile because it will result in increase in profit from

Rs. 6,56,250 to Rs. 6,75,000.

Illustration 20.8

ABC Ltd. Is examining the question of relaxing its credit policy.It sells at present 20,000 units at a price
of Rs. 100 per unit,the variable cost per unit is Rs. 88 and average cost per unit at the current sales
volume is Rs. 92. All the sales are on credit, the average collection period being 36 days.

A relaxed credit policy is expected to increase sales by 10% and the average age of receivables to 60
days. Assuming 15% return,should the firm relax its credit policy?

Solution:

EVALUATION OF PROPOSALS

Present Plan Proposed Plan

(20,000 units) (22,000 units)

Sales Rs. 20,00,000 Rs.22,00,000

-Variable costs (Rs. 88 per unit) 17,60,000 19,36,000
-Fixed costs (20,000 units *Rs.4) 80,000 80,000
Net Profit 1,60,000 1,84,000
Investment cost 27,600 50,400
Income 1,32,400 1,33,600

The firm should relax its credit policy as it increases the profit by Rs. 1,200.

Working Notes :

The investment costs have been calculated as follows :

Present Plan Proposed Plan

Cost of sales(Variable + Fixed cost) Rs. 18,40,000 Rs. 20,16,000
Average daily sale (360 days a year) 5,111 5,600
Credit period 36 days 60 days
Therefore,average debtors 1,84,000 3,36,00
Interest @15% 27,600 50,400

Illustration 20.9

As a part of the strategy to increase sales and profits,the sales manager of a company proposes to sell
goods to a group of new customers with 10% risk of non-payment. This group would require one and a
half months credit and is likely to increase sales by Rs. 1,00,000 per annum.Production and selling
expenses amount to 80% of sales and the income-tax rate is 50%.The company’s minimum required rate
of return (after tax) is 25%.

Should the sales manager’s proposal be accepted?

Also find the degree of risk of non-payment that the company should be willing to assume if the
required rate of return (after tax) were (i) 30%, (ii) 40%, and (iii) 60%.

Solution :

Additional sales from new customers per annum Rs.1,00,000

-Risk of non-payment @ 10% 10,000

Net Turnover 90,000

-Production and selling expenses (80% of sales) 80,000

Profit of Tax 10,000

-Income tax @ 50% 5,000

Prfit after Tax 5,000

Average Investment in Debtors : The credit period being 1½ months ,there will be turnover of debtor
of 8 times considering 12 months.

Thus, average debtors will be Rs.1,00,000/8 = Rs. 12,500

Cost of goods sold being 80% of sales, the average investment in debtors would be 80% of Rs.
12,500 i.e., Rs. 10,000

Thus rate of return (being PAT of Rs. 5,000) = Rs. 5,000 100/10,000 =50%

This rate being higher than 25% ,the proposal should be accepted.

Acceptable degree of risk of non-payment for different required rate of returns(after tax).

30% 40% 60%

Average investment in debtors Rs.10,000 Rs.10,000 Rs.10,000
Required Profit after tax 3,000 4,000 6,000
Profit before tax (Grossed up by 50%) 6,000 8,000 12,000
Production and selling expenses 80,000 80,000 80,000
Required sales to achieve desired 86,000 88,000 92,000
return 1,00,00 1,00,00 1,00,00
Additional sales
So acceptable degree of risk of non- 14,000 12,000 8,000
payment 14 12 8
Acceptable degree of risk (in %)
Illustration 20.10

A company currently has an annual turnover of Rs. 10,00,000 and an average collection period
of 45 days. The company wants to experiment with a more liberal credit policy on the ground
that increase in collection will generate additional sales.

From the following information ,kindly indicate which of the policies you would like the company
to adopt:

Credit Policy Increase in credit Increase in sales % of Default

period
I 15 days Rs. 50,000 2%
II 30 days Rs. 80,000 3%
III 40 days Rs. 1,00,000 4%
IV 60 days Rs. 1,25,000 6%

The selling price of the product is Rs. 5, and the variable cost per unit is Rs.3. The current bad
debts loss is 1% and the required rate of return on investment is 20%.

A year can be taken to comprise of 360 days.

Solution :

As the information given in this problem is in terms of incremental credit period and incremental
sales , the evaluation to different credit policies may b made on incremental basis as follows:

COST OF ADDITIONAL INVESTMENT IN DEBTORS

Present Credit Policies (Proposed)

Policy
I II III IV

Sales 10,00,000 10,50,000 10,80,000 11,00,000 11,25,000

Average Debtors 1,25,000 1,75,000 2,25,000 2,59,722 3,28,125

Additional Debtors 50,000 1,00,000 1,34,722 2,03,125

-Contribution@40% 20,000 40,000 53,889 81,250

Average 30,000 60,000 80,833 1,21,875

investment in
Debtors

Cost @ 20% 6,000 12,000 16,167 24,375

Average debtors have been calculated as : Total sales Receivables turnover . So, for th credit
policy I, the total sales are Rs. 10,50,000, and the receivables turnover is 8 (i.e., 360 cy I, the
total sales are Rs. 10,50,000, and the receivables turnover is 8 (i.e., 360 45).Hence the
average debtors are Rs.10,50,000 8 = Rs. 1,75,000.For the other proposals also,the average
debtors have been calculated in the same manner.

EVALUATION OF DIFFERENT CREDIT POLICIES

Present Credit Policies (Proposed)

Policy

I II III IV

Sales 10,00,000 10,50,000 10,80,000 11,00,000 11,25,000

Additional sales (Proposed) ---- 50,000 80,000 1,00,000 1,25,000

Variable cost (60% of sales) 30,000 48,000 60,000 75,000

Incremental Contribution (A) 20,000 32,000 40,000 50,000

% of default on sales 1% 2% 3% 4% 6%

Bad debts 10,000 21,000 34,200 44,000 67,500

Incremental bad debts (B) 11,000 22,400 34,000 57,500

Cost of financing (calculated

as above) (C)
6,000 12,000 16,167 24,375
Total Incremental Cost
(B+C) 17,000 34,400 50,167 81,875

Increase in Profit [A-(B+C)] 3,000 -2400 -10,167 -31,875

Recommendation - First proposal of credit up to 60 days is acceptable as it is expected to

result in increase in profit by Rs. 3,000 over and above the minimum required profit of 20%.
Illustration 20.11

Easy Limited specializes in the manufacture of a computer component. The component is

currently sold for Rs. 1,000 and its variable cost is Rs. 800. For the year ended 31.12.99 the
company sold on an average 400 components per month.

At present, the company grants one month credit to its customers. The company is thinking of
extending the same to two months on account of which the followingis expected :

Increase in sales 25%

Increase in stock Rs. 2,00,000

Increase in creditors Rs.1,00,000

You are to advise the company on whether or not to extend the credit terms if :

(a) Old customers avail the the extended credit period of two months and
(b) Existing customers do not the credit terms but only the new customers avail the same.
Assume in this case the entire increase in sales is attributable to the new customers.

The company expects a minimum return of 40% on the investment.

Solution :

In this case, the contribution is 20% i.e.,(Rs. 1,000 –Rs. 800) on Rs. 1,000

Increase of sales by 25% on Rs. 48,00,000 (Rs. 1,000 400 12 months) =Rs.
12,00,000 = Rs. 2,40,000

Old Customers Only new

 customers

Contribution on Additional sales Rs. Rs. 2,40,000

2,40,000
Present average receivable (1/12 -----
Of Rs. 48,00,000) 2,00,000
4,00,000 (1/6 of Rs.
Revised average receivable 12,00,000)
10,00,000 2,00,000
(1/6 40,000
of Rs.60,00,000) 1,60,000
2,00,000
Increased receivable 3,60,000
6,00,000 1,00,000
- Contrbution @ 20% 2,60,000
1,20,000 1,04,000
Investment in receivable 2,40,000
4,80,000 1,36,000
+ Increase in stock
2,00,000
6,80,000
-Increase in creditors
1,00,000
Additional working capital
5,80,000
Desired Return on additional WC @ 40%
2,32,000
Contribution on additional sales
2,40,000
Net contribution
8,000

Though both schemes are acceptable, but margin is better in second scheme.

Illustration 20.12

Star Limited, manufacturers o f Colour TV sets, are considering the liberalization of existing credit terms
to three of their large customers A,B and C. The credit period and likely quantity of TV sets that will be
lifted by the customers are as follows:

(QUANTITY LIFTED OF TV SETS)

Credit Period (Days) A B C

0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500

The selling price per TV set is Rs.9,000. The expected contribution is 20% of the selling price. The cost of
carrying debtors averages 20%per annum. You are required:

(a) Determine the credit period to be allowed to each customer

(Assume 360 days in a year for calculation purposes)

(b) What other problems the company might face in allowing the credit period as determined in (a)
above?

Solution :

Determination of the Credit Period to be allowed to each customer

In case of customer ‘A’, there is no increase in sales as far as the credit period is concerned. Apparently
‘A’ enjoys good liquidity and the demand for TV sets in his area is limited. Hence,there is no point in
allowing credit period to ‘A’. However , in case of customers ‘B’ and ‘C’, the credit period can be
determined by trading off between profitability of additional sales and the cost of carrying additional
debtors as a result of relaxation of credit period. It may be noted that the present level of credit period
allowed to customer B and C are not given.So, liberalization of credit terms to them means extending
further credit beyond present level which may be 0 or 30 or 60 days. The incremental analysis,
therefore, in this case, shall compare any credit period with the immediate preceding credit period term

Profitability of additional sales on account of relaxing credit period to B&C

Customer B Customer C
Credit period (days) 0 30 60 90 0 30 60 90

Sales(unit) 1,000 1,500 2,000 2,500 - - 1,000 1,500

Sales 90 135 180 225 - - 90 135
Contribution @ 20% 18 27 36 45 - - 18 27
Incremental Cont.(A) - 9 9 9 - - 18 9
Average Debtors - 11.25 30 56.25 - - 15 33.75
(Credit Period X sales/360)
Average Debtors @ 80% cost - 9 24 45 - - 12 27.00
Incremental Debtors - 9 15 21 - - 12 15
Cost Of Carrying Incremental - 1.8 3 4.2 - - 2.4 3
Debtors at 20% (B)

Excess Incremental - 7.2 6 4.8 - - 15.6 6

Contribution over Cost Of
Carrying Incremental
Debtors (A-B)

It is seen from the above computations that incremental contribution exceeds incremental cost of
carrying additional debtors at each extension of credit period. Therefore, credit period to B and C should
be 90 days.

(b)Other problem to be faced by the company in allowing the credit period as determined in (a)
above:

When the company allows 90 days credit to customers B and C and no credit to customer A, it might
face the following problems:

(i) Customer A is lifting 1,000 TV sets without any credit facility whereas the same quantity of
TV sets is lifted by customer C with 60 days credit period. A would, therefore, protest
against granting that he should also be allowed a credit period of 60 days. Alternatively he
may ask for some cash discount.

(ii) At 90 days credit period, customer B would lift 2,500 TV sets whereas customer C would lift
1,500 TV sets. As such customers C would demand either a further relaxation in credit
period, say beyond 90 days, or some cash discount.

Illustration 20.13

Primer Steel Limited has a present annual Sales turnover of Rs. 40,00,000. The unit sale price is
Rs. 20. The variable costs are Rs. 12 per unit and fixed costs amount to Rs. 5,00,000 per annum.
The present credit period of one month is proposed to be extended to either 2 or 3 months
whichever will be more profitable. The following additional information is available:

ON THE BASIS OF CREDIT PERIOD OF

1 month 2 months 3 months

Increase in sales by - 10% 30%
% of Bad debts to sales 1 2 5

Fixed cost will increase by Rs. 75,000 when sales will increase by 305. The company requires a pre-tax
return on investment at 20%.

Evaluate the profitability of the proposals and recommend best credit period for the company.
Solution:

EVALUATION OF PROFITABILITY UNDER DIFFERENT CREDIT PERIODS

One Month Two months Three months

Sales Rs. 40,00,000 Rs. 44,00,000 Rs. 52,00,000
Bad debt to sales 40,000 88,000 2,60,000
Net Sales 39,60,000 43,12,000 49,40,000
Net Incremental -- 3,52,000 9,80,000
Sales(A)
Variable cost @ Rs.12 24,00,000 26,40,000 31,20,000
Fixed Cost 5,00,000 5,00,000 5,75,000
Cost of sales 29,00,000 31,40,000 36,95,000
Net incremental Cost -- 2,400,000 7,95,000
(B)
Average Debtors at cost 2,41,667 5,23,333 9,23,750
Increase in Average -- 2,81,667 6,82,083
Debtors
Cost of Incremental -- 56,333 1,36,417
Debtors@ 20%(C)
Total Incremental -- 2,69,333 9,31,417
Cost(B+C)
Net increase in Profit -- 55,667 48,583
[A-(B+C)]

The change of credit period form one month to two months is expected to increase the profit by Rs.
55,667 which is more than Rs. 48,583. So the firm may change policy from th present credit period of
one month to two months.

Illustration 20.14

Agro Products Ltd., is considering the following credit policy alternatives:

Existing Policy Option I Option II

Credit policy(days) 30 14 60
Sales(Rs. Lakhs) 10.00 9.60 12.00
Bad debt(% of sales) 5 3.33 6
Cost of 0.20 0.12 0.25
administration(Rs. Lacs)
Average effective 45 21 75
collection period(days)
The average effective period differs from the credit period as all debtors do not strictly adhere to the
condition stipulated. The company achieves a contribution of 40% on sales and the firm requires a 20%
per annum return on investment. You are required to suggest which credit period is more suitable to the
company. Also calculate the average debtors and the desired return on these debtors.

Solution:

I.Evaluation of Credit Policy : (Rs. In lakh)

Details Existing Option I Option II

Sales 10.00 9.60 12.00
-40% Contribution 4.00 3.84 4.80
-Bad debt 0.50 0.32 0.72
-Cost of administration
Net Contribution
Incremental
Profit/Loss(A) - -0.10 0.53

II. Calculation of Average investment in Debtors and Returns Thereon:

Details Existing Option I Option II

Average Debtors (Sales 1.230 0.550 2.470
X Credit period)/365
-40% Contribution
0.020 0.007 0.050
-Cost of administration (45 days) (21 days) (75 days)
(Proportionately) 0.718 0.323 1.430
Investment in Debtors
Required 20% Return 0.144 0.065 0.286
on Investment (B) - 0.035 0.244
Available Incremental
Profit/Loss(A-B)
Recommendation: Option II should be adopted as it is expected to contribute more profit than Option I.

Illustration 20.15

A company offers standard credit terms of 60 days net. Its cost of short term borrowings is 16% per
annum. Determine whether a 2.5% discount should be offered for payment within 7 days to customers
who would normally pay after (i) 60 days, (ii) 80 days, and (iii)105 days.

Solution:

The cost of using a discount to obtain funds and improve liquidity should be compared with alternative
sources of finance. If the cost of short term borrowings is 16% ,then cost of discount offer must be less
than this, otherwise discount need not be offered. A customer who is paying after 60,80 or 105 days
involves a cost @ 16% per annum for the respective period. If the firm offers a discount @2.5% for
payment within 7 days, then it means that 97.5% of the funds will be available for 53 days ,73 days and

98 days respectively. The percentage cost of getting funds for respective periods is Rs. 2.50/Rs.97.5.

However, the annual percentage cost of the discount in each case is :

The discount should be offered to customers who would have paid after 20 or 105 days, and not to
those who would have paid after 60 days. The reason being that the cost of funds is 16% and the
customers who would have paid after 60 days would inflict a cost of 17.7% if the discount terms are
offered to them.

Illustration 20.16

Casio Esale Ltd. Presently gives credit terms of net 30 days. It has Rs.6 crores in sales, and its average
collection period is 45 days. To stimulate demand,the company may give terms of net 60 days. If it doess
instigate these terms. Sales are expected to increase by 15 per cent . After the change,the average
Collection period is expected to be 75 days, with on different in payment habit between old and new
customer. Variable coast are 80%, and the company’s require rate of return on investment in receivable
is 20 per cent should the company extend its credit period? (Assume a 360 days year).

Solution:

Present and proposed credit policies can be compared as follows:

Present Proposed
Total sales Rs. 6,00,000 Rs. 6,90,00,000
-Variable Cost @ 80% 4,80,00,000 5,52,00,000
Contribution(A) 1,20,00,000 1,38,00,000
Average Collection Period 45 days 75 days
Average Debtors at Cost Rs.60,00,000 Rs. 1,15,00,000
Required Return on Investment Rs.12,00,000 23,00,000
@ 20% (B) Rs.1,08,00,000 Rs.1,15,00,000
Net surplus (A-B)

As the net surplus would increase fro Rs. 1.08 crores to Rs1.15 crores, the company may offer new credit
terms to its customers.

Illustration 20.17
Big Apple Trading Ltd. Purchases raw material on credit term of 2/10, net 30. A review of the company’s
record by the owner revealed that payments are usually made 20 days after purchases are received.

When asked why the firm did not take advantage of its discount, the accountant, replied that it coast
only 2 per cent for these fund, whereas a bank loan would coast the company 12 per cent.

(a) What mistake is it the accountant making?

(b) What is the real coast of talking advantage of the discount?
(c) If the firm could not borrow from the bank and was forced to resort to the use of trade credi
fund, what suggestion might made that would reduce the annual interest cost?

Solution:

In the given case, the company is making the payment in 20 days while the seller is offering 2% cash
discount if payment made in 10 days. The accountant is comparing this 2% fore-gone benefit with the
bank’s annual interest rate of 12%. This is wrong. The real annual coast of not taking advantage of cash
discount is:

Annual % cost= X X365= 74.50%

In the firm could not borrow from the bank, then the firm can reduce the annual interest coast by
resorting to full credit period before making the payment.

Illustration 20.18

A company sells a product @ Rs. 30 per unit with a variable cost of Rs.20 per unit. The fixed coast
amount to Rs. 6,25,000 per annum and the total annual sale to Rs. 75,00,000. It is estimated that if the
present credit facility of one month were double, sale could be increase by Rs. 6,00,000 per annum., the
company expect a return on investment of a least 20% prior to taxation. Justify by calculation that this
course can be adopted.

There is the possibility of an additional overseas order being procured which would not affect the home
market. 10,000 extra units could be sold, but additional coast on the order would amount to Rs. 300
while the risk of a bad debt is estimated at 0.25 also credit would have to be extended to the customer
to 90 days. Should the order be accepted?

Solution:

(a) Statement showing comparative profitability

Particulars Present Position Proposal

Credit policy 1 month 2 months
 Sales(Rs. In lacs) 75 81
Selling Price (Rs. Per unit) 30 30
Selling Units 2,50,000 2,70,000
Rs. In lacs Rs. In lacs
Sales 75.00 81.00
Variable cost @ Rs. 20 per unit 50.00 54.00
Fixed Cost 6.25 6.25
Total Cost 56.25 60.25
Profit(Sales-Total Cost) 18.75 20.75

So, increase profit is Rs. 2,00,000

Average debtor (at sale value)
Average debtors (at total coast)
Extra investment in debtors
Return =10% of 5,35,417
Surplus over return
Hence, credit policy of 2 month can be adopted, as it will increase the profit by Rs. 92,917
75,00,000,/12 81,00,000*2/12
=Rs. 6,25,000 =Rs. 13,50,000
56,25,000/12 60,25,000*2/12
=Rs. 4,68,750 =Rs. 10,04,167
=10,04167-4,68,750 =Rs.5,35,417
=Rs.1,07,083
= Incremental profit-Expected Return
= 2,00,00-1,07,083
=Rs. 92, 917

(b) Overseas Order

Sales (10,00 unit @ Rs. 30 per unit) Rs. 3,00,000

-Variable cost (10,00*20) 2,00,000
1,00,000
-addition cost 300
Profit 99,700
-bad debts (0.25*3,00,000) 75,000
Incremental profit 24,700
Debtor (at total cost) = Rs. 2,00,300. (i.e. Rs.2,00,000+300)
Return @ 20% for 90 days = 90 days *20%*2,00,000=Rs. 9,878
Surplus over return = Incremental profit – Expected return
= 24,700-9,878= Rs. 14.882
Hence, the oversea order should be accepted as it expected to give an incremental profit of Rs.
14.882

Illustration 20.19
Head and solder Ltd. Sells good to give a gross profit of 30%. Presently, it has annual sales of
Rs.12,00,000 and debtors pay, on an average, after 60 days of date of invoice.1% of sales are
bad debts. The company is considering to relax the credit and collection policies to allow a credit
of 90 days to debtors. If new police is adopted, sales would increase by 10% but the bad debts
would increase to 2%. The company maintains an inventory (approximate) equal to 50 days
projected sales and suppliers are paid in 30 days after receipt to invoice. Critically evaluate the
two credit policies given that:
1. Sales are evenly distributed,
2. The opportunity cost of capital is 12%,and
3. Invoice for sales and purchases are effected on the last day of the calendar month.

Solution:-

Present Proposed
Total Sales Rs. 12,00,000 Rs. 13,20,00
Sales per month 1,00,000 Rs. 1,10,000
Bad Debt 1%/2% 1,000 2,200
Cash inflow per month 99,000 1,07,800
Cost of goods sold (70% of Rs. 70,000 Rs. 77,000
Sales)
Average Inventory(50 days at Rs. 1,16,667 Rs. 1,28,333
cost)

It is given that invoices for sales and purchases are effected at the end of calendar month. Say,
for the total sales of January, the invoices will be raised on 31 January and are received on
March 31st. In the proposed scheme, the sales of January would be corrected on April 30,and so
on. The cash flow position for different months, now own ward may be presented as follows:

Present Policy: 1 2 3 4 5

Sales Collection - - Rs. 99,000 Rs. 99,000 Rs. 99,000

Payment to - Rs.70,000 70,000 70,000 70,000
Creditors
Initial Inventory - 1,16,667 - - -
Acquired
Net - (1,86,667) 29,000 29,000 29,000
Inflows/(Outflows)
Proposed Policy:
Sales Collection - - - Rs.1,07,800 Rs.1,07,800
Payment to - Rs. 77,000 77,000 77,000 77,000
Creditors
Initial Inventory - 1,28,333 - - -
Acquired
Net - (2,05,333) (77,000) 30,800 30,800
Inflows/(Outflows)
 Difference in two - -18,667 -1,06,000 +1,800 +1,800
policies

So, in the first month from the adoption of new policy, there would be no change in cashflow.
But for the second and third months, net outflow would be Rs.18,667 and 1,06,000 respectively.
Thereafter’ the company would be Rs. 18,667 and 1,06,000 respectively thereafter, the company
would receive Rs. 1,800 per month in perpetuity. The cost of the capital of the firm is 12% p.a. or
1% per month. The PV of these inflow series is Rs. 1,80,000 i.e.,(Rs.1800/01) in the beginning of
month 4. This PV of in flows would be available to the company after outflow of Rs.18,667
(months 2) and Rs. 1,06,000 (month 3 end). The PV of Inflows is higher than the outflows, so , the
firm can adopt the proposed credit policy.

Illustration 20.20

Easy Sales Corporation currently provides 30 days of credit to its customers. Its total sales (all on
Credit ) are Rs. 6 crore. The company Examining the Possibility of increasing the credit period to
60 days. Such an extension is likely to increase the sales by Rs.80 lakhs. The company’s bad
debts to sales ratio is 5% which is likely to remain unchanged under new credit policy. Other
relevant financial data are as under:

Variable cost to sales ratio - 0.75

Tax rate - 40%
Cost of capital - 10%
Is it desirable to change the existing credit policy?

Solution:
Change In sales Rs. 80,00,000
Less: variable cost (0.75*80,00,000) 60,00,000
20,00,000
Less: Bad debts (0.05*80,00,000) 4,00,000
16,00,000
Less: Tax @40% 6,60,000
9,60,000
Less: Cost of Investment in debtors (47,50,000*.1) 4,75,000
Increase in profit 4,85,000

As the residual income due to relaxed credit period is positive, it is desirable to change the
credit policy.

Working Notes:
 Increase in investment in Debtors:
Exisiting investment (6,00,00,000 X .75 X 30/360) Rs. 37,50,000
New investment (6,80,00,000 X .75 X 30/360) 85,00,000
Increase in investment 47,50,000

Illustration 20.21

Sug Ltd. Is a regular cash customer of Quest Ltd. The former has offered to buy goods of Rs. 20,00,000 in
one year and is expected to make payments as per following schedule:

By the end of 20 days 15% of the Bill

By the end of 45 days 30% of the Bill

By the end of 90 days 25% of the Bill

By the end of 100 days 2% of the Bill

Purchases of Rs. 20,00,000 would be scattered over the year and to be made in equal quantities on the
first day of each quarter. The selling price and the profit per unit are Rs. 200 and Rs. 30 per unit. Quest
Ltd. Expects that if the offer is accepted, additional cost of RS. 35,000 p.a. would be required. The
opportunity cost of fund for Quest Ltd. May be taken as 25%. Should the offer be accepted or not?

Solution:

Expected Profit for Sale (20,00,000 4) Rs. 3,00,000

Less: Incremental cost 35,000

Incremental Profit 2,65,000

Quarterly Sales (Rs. 20,00,000 4) Rs. 5,00,000

Cost of quarterly sales is (5,00,000 200) 170 4,25,000

Cost of Credit availed by Sug Ltd: Product per Quarter

15% of Rs. 4,25,000 = Rs. 63,750 x 20 days Rs. 12,75,000

30% of Rs. 4,25,000 = 1,27,500 x 45 days 57,37,500

25% of Rs. 4,25,000 = 1,06,250 x 90 days 95,62,500

2% of Rs. 4,25,000 = 1,19,000 x 100 days Rs. 1,19,00,000

2% of Rs. 4,25,000 (Non-recovery) -

Total Funds blocked for 1 day 2,84,75,000

Interest @ 25% for 1 day for 1 Quarter Rs. 19,503

Interest for 4 quarters 78,012

Cost of Bad Debts (5,00,000x 2%x 4) 40,000

Total cost (Interest + Bad Debts) 1,18,012

Incremental Profit 2,65,000

Net Profit (265,000-1,18,012) 1,46,988

The firm should accept the offer.

Illustration 20.22

A company currently has Rs. 10,00,000 per annum of sales, all on credit terms of 60 days. The average
credit taken is, however, 80 days. It is considering offering a discount of 3% within 7 days, and it expects
that 60% of existing customers will take the discount. The remainder will be equally split between those
paying after 80 days and those paying after 100 days. The new credit terms are also expected to
generate an additional Rs 50000 of sales. Variable costs are 80% of sales price and the company’s bank
overdraft costs 14%.

The company wishes to know whether offering the discount is worthwhile if :

(a) No new sales are obtained

(b) New sales are described above ( year may be taken consisting of 365 days )

SOLUTION:

(a) If no new sales are obtained :

Cost of discount @ 3?% of (60% of Rs 10,00,000) Rs -18,000

Existing credit cost (@ 14% on 80% of sales for 80 days ) Rs 24,548

(Rs 10,00,000 x 80% x 60% x 7days x 14%) Rs 1288

(Rs 10,00,000 x 80% x 20% x 80 days x 14%) Rs 4910

(Rs 10,00,000 x 80% x 20% x 100days x 14%) Rs 6137 12335

Net saving cost 12213 12213

Net annual cost of offering the discount -5783

(b) New sales and discount offer :

Net cost as in (a) Rs -5783

New sales Rs 50000

Additional contribution (50,000 x 20%) Rs 10000

-discount (50000x 3%) 1500

-Cost of credit ( 50000 x 80% x 7days x 14%) 107

Net benefit of new sales 8387 8387

Net benefit of new credit policy (per annum) 2604

The discount should not be offered if no new sale will result but it is worthwhile if Rs50,000 per annum
additional sales are expected .

MULTIPLE CHOICE QUESTIONS

1. 5 Cs of the credit does not include

(a) Collateral,

(b) Character,

(c) Conditions,

(d) None of the above.

2. Which of the following is not an element of credit policy?

(a) Credit Terms,

(b) Collection Policy,

(c) Cash Discount Terms,

(d) Sales Price.

3. Ageing schedule incorporates the relationship between:

(a) Creditors and Days Outstanding,

(b) Debtors and Days Outstanding,

(c) Average Age of Directors,

(d) Average Age of All Employees.

4. Bad Debts cost is not borne by factor in case of:

(a) Pure Factoring,

(b) Without Recourse Factoring,

(c) With Recourse Factoring,

(d) None of the above.

5. Which of the following is not a technique of receivables management?

(a) Funds Flow Analysis,

(b) Ageing Schedule,

(c) Days sales outstanding,

(d) Collection Matrix.

6. Which of the following is not a part of credit policy?

(a) Collection Effort,

(b) Cash Discount,

(c) Credit Standard,

(d) Paying Practices of debtors.

7. Which is not a service of a factor?

(a) Administrating Sales Ledger,

(b) Advancing against Credit Sales,

(c) Assuming bad debt losses,

(d) None of the above.

8. Credit Policy of a firmshould involve a trade-off between increased:

(a) Sales and Increased Profit,

(b) Profit and Increased Costs of Receivables,

(c) Sales and Cost of goods sold,

(d) None of the above

9. Out of the following what is not true in respect of factoring?

(a) Continous Arrangement between Factor and Seller,

(b) Sale of Receivables to the factor,

(c) Factor provides cost free finance to seller,

(d) None of the above.

10. Payment to creditors is a manifestation of cash held for:

(a) Transactionery Motive,

(b) Precautionary Motive,

(c) Speculative Motive,

(d) All of the above.

11. If the closing balance of receivables is less than the opening balance for a month then which one is
true out of:

(a) Collections> Current Purchases,

(b) Collections> Current Sales,

(c) Collections> Current Purchases,

(d) Collections> Current Sales.

12. If the average balance of debtors has increased, which of the following might not show a change in
general?

(a) Total Sales,

(b) Average Payables,

(c) Current Ratio,

(d) Bad Debt loss.

13. Securitization is related to conversion of;

(a) Receivables,

(b) Stock,

(c) Investments,

(d) Creditors.

14. 80% of sales of Rs. 10,00,000 of a firm are on credit. It has a Receivable Turnover of 8. What is the
Average collection period(360 days a year) and Average Debtors of the firm?

(a) 45 days and Rs. 1,00,000,

(b) 360 days and Rs. 1,00,000,

(c) 45 days and Rs. 8,00,000

(d) 360 days and Rs. 1,25,000.

15. In response to market expectations, the credit period has been increased from 45 days to 60 days.
This would result in:

(a) Decrease in Sales,

(b) Decrease in Debtors,

(c) Increase in Bad Debts,

(d) Increase in Average Collection Period.

16. If a company sells its receivable to another party to raise funds, it is known as:

(a) Securitization,

(b) Factorin,

(c) Pledging,

(d) None of the above.

17. Cash Discount term 3/15, net 40 means:

(a) 3% Discount if payment in 15 days, otherwise full payment in 40 days,

(b) 15% Discount if payment in 3 days, otherwise full payment 40 days,

(c) 3% Interest if payment made in 40 days and 15% interest thereafter,

(d) None of the above.

18. If the sales of the firm are Rs. 60,00,000 and the average debtors are Rs. 15,00,000 then the
receivables turnover is:

(a) 4 times

(b) 25%

(c) 400%

(d) .25 times

19. If cash discount is offered to customers, then which of the following would increase?

(a) Sales

(b) Debtors

(c) Debt collection period

(d) All of the above

20. Receivables Management deals with:

(a) Receipts of raw materials

(b) Debtors collection

(c) Creditors Management

(d) Inventory Management

21. Which of the following is related to Receivables Management?

(a) Cash Budget

(b) Economic Order Qunatity

(c) Ageing schedule

(d) All of the above.

[Answers: 1. (d), 2. (d), 3. (b), 4. (c), 5. (a), 6. (d), 7. (d), 8. (b), 9. (c), 10. (a), 11. (b), 12. (b), 13. (a), 14. (a),
15. (d), 16. (b), 17. (a), 18. (a), 19. (1), 20. (b), 21. (c)]
ASSIGNMENTS

1. Write short notes on:

(a) Credit evaluation of customers.

(b) Optimal credit policy.

(c) Annualised cost of cash discount.

2. Explain the objective of credit policy of a firm.

3. What is credit policy? What are the elements of a credit policy?

4. What are the costs associated with receivables?

5. What are the costs and benefits associated wih a change in credit policy?

6. What are credit terms? Explain the role of credit terms in a credit policy.

7. State the role which receivables play in the overall financial picture of the firm?

8. What is factoring? What are the types of factoring? Explain the benefits of factoring.

9. Explain how factoring is different from bill discounting and short-term financing.

10. What are the techniques of control of receivables? Explain the “Ageing Schedule”.

11. “Average age of receivables is an important yardstick of testing the efficiency of receivables
management”. Explain.

PROBLEMS

P20.1 (a) A company sells a product @ Rs. 30 per unit with a variable cost of Rs. 20 per unit. The fixed
costs amount to Rs. 6,25,000 per annum and the total annual sales to Rs. 75 lacs. It is estimated that if
the present credit facility of one month is doubled, sales could be increased by Rs. 6,00,000 per annum,
the company expects a return on investment of at least 20% prior to taxation. Justify by calculation that
this course can be adopted.

(b) There is the possibility of an additional overseas order being procured which wold not affect the
home market. 10,000 extra units could be sold, but costs on the order would amount to Rs. 300 while
the risk of a bad debt is estimated at 0.25. Also, credit would have to be extended to the customer to 90
days. Should the order be accepted.
[Answer: (a) The credit period may be doubled as it will result in net increase is profit by Rs. 92,917. (b)
The offer may be accepted as the net return from the offer is expected to be Rs. 14,822.]

P20.2 ABC Ltd. Has currently an annual credit sales of Rs. 8,00,000. Its average age of accounts
receivables is 60days. It is contemplating a change in its credit policy that is expected to increase sales to
Rs.10,00,000 and increase the average age of accounts receivables to Rs. 72 days. The firm’s sales price
is Rs.25 per unit, the variable cost per unit is Rs. 12and average cost per unit at Rs. 8,00,000 sales
volume is Rs. 17. Assume a 360-day year, and calculate the following.

i) What are the average accounts receivable with both the present and the proposed plans?
ii) What is the cost of marginal investment, if the assumed rate of return is 15%

[Answer: Average investment is debtors in existing and proposed plan is Rs. 90667 and Rs. 128,000
respectively. So, marginal increase is (128,000-90667) = Rs. 37,333 and its cost @ 15% is rs. 5,600.]

P20.3 PQR Ltd. Is considering relaxing its credit policy and evaluating two proposed policies. Currently,
the firm has annual credit sales of Rs. 50 lacs and Accounts receivables of Rs. 12,50,000. The current
level of loss due to bad debts is Rs. 150,000. The firm is to give a return of 20% on investment in the new
(additional) accounts receivables. The company’s variable costs are 70% of the selling price. The
following further information is furnished:

Present Policy Policy option I Policy option II

Annual credit sales Rs. 50,00,000 Rs. 60,00,000 Rs. 67,50,000
Account Receivables 12,50,000 20,00,000 28,12,500
Bad debt losses 1,50,000 3,00,000 4,50,000

You are the management accountant of the firm. Advice the MD which option should be adopted.

[Answer: policy Option I may be adopted, as it is excepted to increase profit by Rs. 45,000]

P20.4 ABC Company’s present annual sales amount to Rs. 30 lacs at Rs. 12 per unit. Variable costs are
Rs. 2.50 lacs per annum. Its present credit period of the month is proposed to be extended to either 2 or
3 months, whichever appears to be more profitable.

The following estimates are made for the purpose :

Credit Policy 1 month 2 months 3 months

Increase in Sales (%) - 8 30

% of bad debts to sales 1 3 6

Fixed cost will increase by Rs. 50,000 annually after any increase in sales above 25% over the present
level. The company requires a pre tax return on investment of at least 20% for the level of risk involved.
What will be the most rewarding credit policy in case of ABC Company under the above circumstances?
Present your answer in a tabular form.

[Answer: contribution is 1/3 of sales. The present policy is the best. The proposal of 2months and 3
months credit are not justified as the return on additional investment is not 20%]

P20.5 Super Sports Co. dealing in sports goods, have an annual sales of 50,00,000 and are currently
extending 30 days credit to the dealers. It is felt that sales can pick up considerably if the dealer are
willing to carry increased stock, but the dealers have difficulty in financing their inventory. Super sports
Co. is, therefore considering a shift in credit policy.

The average collection period now is 30 days.

Costs: Variable costs 80% of sales.

Fixed cost Rs. 6 lac per annum.

Required pre tax return an investment = 20%

Credit Policy Average collection period Annual Sales(Rs. In lacs)

A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63

Determine which policy should be adopted by the company on the basis of (i) Total Profit, and (ii)
Incremental Profit.

[Answer: the credit policy B may be adopted as it is giving highest return among all the 4 proposed
policies]

P20.6 A small firm has total credit sales of Rs 80 lacs and its average collection period is 80 days. The
past experience indicates the bad-debt losses are around 1% of credit sales. The firm spends about Rs.
1,20,000 per annum on administering its credit sales. This cost includes salaries of one officer and two
clerks who handle credit checking, collection, etc., telephone and telex charges. These are avoidable
costs. A factor is prepared to buy the firm’s receivables. He will charge 2% commission. He will also pay
advance against receivable to the firm at an interest rate of 18% after withholding 10% as reserve. What
is the cost of factoring.
[Answer: Average receivables Rs.17,77,778. Factoring commission Rs. 35,55,556. Advance by factor=
15,01,866 (net of commission, reverses and interest). Annual cost of factoring (commission + interest) is
Rs. 4,41,603 and savings (Bad debts + Cost of administration) is Rs. 2,00,000. So the net cost of factoring
is Rs. 2,41,603].

P20.7 A company currently has annual sales of Rs. 5,00,000 and an average collection period of 30 days,
it is considering a more liberal credit policy. If the credit period is extended, the company excepts sales
and bad debt losses to increase in the following manner:

Credit Policy Increase in credit Period Increase in Sales(Rs.) Bad-debt % of Total sales
A 10 days 25,000 1.2
B 15 days 35,000 1.5
C 30 days 40,000 1.8
D 42 days 50,000 2.2

The selling price per unit is Rs. 2. Average cost per unit at the current level of operation is Rs. 1.20.if the
current bad- debt loss is 1% and the required rate of return investment is 20% which credit policy should
be undertaken? Ignore taxes, and assume 360 days in a year.

[Answer: the firm should extend the credit period by another 15 days only. This will give the maximum
incremental profit.]

P20.8 A firm is considering pushing up its sales by extending credit facilities to the following categories
of customer:

(a) Customers will a 10% risk of non-payment, and

(b) Customers will a 30 % risk of non-payment.

The incremental sales expected in case of category (a) are Rs. 40,000 while in case of category (b) they
are Rs. 50,000. The cost of production and selling costs are 60% of sales while the collection costs
amount to 5%of sales in case of category (a) and 10% of sales in case of category (b).

You are required to advice the firm about extending credit facilities to each of the above categories of
customers.

[Answer: the firm can extend sales to 10% risk customers and this will result in increase in income Rs.
10,00,000. But 30% risk customers should be avoided as they are not expected to contribute to profit of
the firm.]