Credit Policy-Working Capital management

Gupta Bros. promoted Conditioner India Pvt. Ltd. near Delhi in 1995. They contributed an initial capital of Rs. 80 Lakhs in addition to the contributions from their near and dears. Both the brothers owned about 60 per cent of capital and solely responsible for running the business. They happen to be engineering graduates from India. They entered in to air-cooler market and developed a unique model called, cool-aid, to cater to the needs of customers located in and around Delhi namely Haryana, Rajasthan and Uttar Pradesh. They manufactured the equipment s and assembled at their factory. Both seem to have carried out a thorough research before entering into this segment and believed to be having good knowledge in marketing. PRODUCT AND MARKET The technical component cool-aid is an excellent high-tech product. The assembled segment has a unique distinction among the air-coolers for its elegant look. The efficiency of the machinery was believed to be the best in the market prevailing then. The model was reasonably priced as compared to the other available competitive models. The market price was fixed at 5,000/- per unit inclusive of all taxes. It sold 4,992 coolers in 1996, which rose to 6,140 units in 1997 and further to 7,350 units in 1998. The summarized balance sheet and profit and loss account are appended in Exhibit I and II. FINANCE OF OPERATIONS CIPL has made judicious use of equity and debt capital to finance its growth during last three years. Its debt-equity ratio was about 1:4. The lenders were not prepared to extend further loan to company unless it increases it equity capital. Neither Gupta Bros not the shareholders of the company have personal funds to invest in the business. Nor they wanted to go to public in the fear of liquidation of their stake. Both the brothers had very limited knowledge on finance and had no training in Finance. To take care of financial activities of the company s operations, they had been relying on their accountants. Their bank and other lenders have indicated to them that their management of funds was not up to the mark. Particularly the management of accounts receivable was very poor. The companies average collection period had been around 93 days. However, it had a tight control over inventory.

CREDIT POLICY The company had about 1,080 small and medium sized enterprises as dealers, spread overthe cities and main towns of Haryana, Rajasthan, Uttar Pradesh and Delhi. The companyhad a provision of extending credit of 60 days, but most of the dealers had stretched thepayments. The average collection period of the company last year, based on year-endfigures, was about staggeringly high 120 days. In addition to the salesman who also doesthe job of collection, CIPL had appointed collection / recovery officers.The totalcollection expense which includes salaries, travel, etc. amounted to 2 lakhs per year.Around 90 per cent of the firm s sales were on credit basis. Out of this 15 per cent sold tothe customers whose financial position were not very sound. In fact the total bad debtlosses which amounted to about 2 per cent of sales to these customers and three-fourth ofthe collection expenses are attributable to these accounts.

The company s sales are highlyseasonal in character esp. during summer only. Around two thirds of the sale sales takesplace during the period from January to April. The company is expecting a twenty per cent increase over the last year sales. Thecompanies cost of goods sold are 80 per cent.After consulting the marketing andaccounting staff and analyzing the status of the competition, the company decided tochange its credit policy. Given the acute competition and availability of the cheapermodels, the company did not want to change the credit period for its prompt customers.However it has decided to offer cash discount to motivate customers to pay early. Thenew credit terms would be 2/15, net 60 . A quick study of sample of customersindicated that about two third of them might like to avail cash discounts. This change inpolicy would not change the expected sales, but the average collection period of promptcustomers is likely to reduce to 80 days. The company has also decided relax its credit standards to expand its sales. This isexpected to increase sales by 10 per cent. The marginal customers, which would alsoinclude new customers, are not expected to take advantage of cash discounts and arelikely to continue to take on an average 150 days to pay. In the case of these customers,bad debt losses are expected to increase to 2.5 per cent. The company would enforcecollections with more vigor. It is expected that collection expenses would increase by Rs.50,000 per annum. The company generally requires a rate of return of 15 per cent from itsinvestments. QUESTION 1.What strategy was adopted by CIPL to increase receivables in relations togranting of credit period? 2.What are the criticalities faced by CIPL for stretch in credit period? Does itaffects the profitability of the firm, if yes how? 3.What are steps taken by CIPL to reduce the bad debt in the firm? 4. Change in credit policy offered good return to CIPL Explain.

EXHIBIT I CONDITIONER INDIA PRIVATE LIMITED (CIPL) SUMMARISED BALANCE SHEET AS ON JUNE 30 (Rupee in Lakh) 1998

Particulars ASSETS: Cash Accounts receivable Inventory Current Assets Net Fixed Assets TOTAL ASSETS LIABILITES: Creditors Accruals Bank Borrowings Current Liability Lon-term Debt Share Capita TOTAL LIABLITIES

1996

1997

3.35 40.47 20.12 63.94 100.40 164.34

5.26 72.94 42.95 121.15 124.15 245.30

7.14 107.10 70.00 184.24 142.80 327.04

10.04 3.35 10.04 23.43 45.47 95.44 164.34

14.00 4.20 44.76 62.96 67.64 114.70 245.30

17.90 5.40 63.90 87.20 109.61 130.23 327.04

EXHIBIT II CONDITIONER INDIA PRIVATE LIMITED SUMMARIZED PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING JUNE 30 (Rupee in Lakh) Particulars Sales Less: Cost of goods sold Gross Profit Less: Interest Collection Charges Bad Debt Other expenses Taxes Profit after Tax 1996 251.45 203.85 47.60 6.03 1.67 0.69 6.46 17.31 15.44 1997 306.96 243.15 63.81 14.57 1.86 0.93 8.89 18.30 19.26 1998 357.10 285.10 72.00 26.84 2.14 1.02 10.61 15.89 15.50

EXHIBIT III CONDITIONER INDIA PRIVATE LIMITED MONTHLY SALES (Rupee in Lakh) Month JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH APRIL MAY JUNE Total Actual(1997-98) 8.87 8.50 8.62 7.79 8.12 6.95 39.57 80.67 86.15 73.74 19.00 9.12 357.10 Projected(1998-99) 10.00 10.00 10.00 10.00 10.00 10.00 50.00 95.00 100.00 87.00 21.00 10.0 423.00