- 10 Marks
FM – L2 – Q111 – Management of receivables and payables
Question
(A). A business entity offers its customers trade credit of 90 days. It is considering whether to offer a settlement discount of 2% for payment within seven days.
Required
Calculate the cost of offering the discount, as an annual interest cost.
(B). Entity K has monthly sales of GH₵100,000. A factor has offered to take over the administration of Entity K’s trade receivables, on a non-recourse basis (or without recourse basis). It would charge a fee of 4% of the value of invoices processed. If the factor takes over this work, Entity K would save monthly administration costs of GH₵2,000 and would avoid its bad debts, which are 0.75% of sales.
Entity K has been informed by the factor that the average collection period (the time between issuing an invoice and receiving payment from the customer) will be reduced from 2 months to 1 month.
The factor will also provide finance by lending 80% of the value of unpaid invoices, charging interest at an annual rate of 8% on the cash that it lends. At the moment, Entity K finances its trade receivables with bank overdraft finance at 9% per year interest.
Required
Calculate the net effect on annual profits of Entity K if the factor took over the administration of the trade receivables and provided finance on the terms described above.
Answer
(B). Annual sales = GH₵100,000 × 12 months = GH₵1,200,000.
Average trade receivables without the factor = GH₵1,200,000 × 2 months / 12 months = GH₵200,000.
Average trade receivables with the factor = GH₵1,200,000 × 1 month / 12 months = GH₵100,000.
Annual costs
| GH₵ | GH₵ | |
|---|---|---|
| Without the factor | ||
| Administration (12 × GH₵2,000) | 24,000 | |
| Bad debts (0.75% × GH₵1,200,000) | 9,000 | |
| Interest cost of finance (9% × GH₵200,000) | 18,000 | 51,000 |
| With the factor | ||
| Fees (4% × GH₵1,200,000) | 48,000 | |
| Interest cost of finance | ||
| Factor finance (8% × 80% × GH₵100,000) | 6,400 | |
| Overdraft finance (9% × 20% × GH₵100,000) | 1,800 | 56,200 |
| Net extra cost of the factor per year | 5,200 |
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