- 20 Marks
FM – L2 – Q118 – Working Capital Management
Question
AquaPure Ltd is a leading producer of mineral water in Zamora. The company sells all of its output to wholesalers on credit terms net 40. The company’s collection policy is somewhat relax, and so the receivables turnover days is currently 53 days. This fairly liberal credit policy has resulted in significant increases in sales revenue in recent years. However, the company has been facing cash flow problems as a significant number of customers take longer than the credit period to settle their accounts. The company typically falls on overdraft facilities from its bankers when it fails to generate adequate cash flows from operations to meet working capital requirements. The average cost of the overdraft facilities is 15% per annum.
Last week, the management team met and discussed the company’s cash flow and liquidity problems with a view to finding solutions to the problems. In that meeting, two proposals were offered to help solve the problems:
Proposal 1: Introduce early settlement discount of 1.5% on accounts that are settled within 10 days in which invoice is sent while the current credit period is maintained. It is estimated that 60% of accounts will be paid within the discount period.
Proposal 2: Switch from financing working capital requirements using the bank overdraft facilities at 15% interest to financing working capital requirements using supplier’s trade credit. Suppliers are willing to supply on credit terms 1/10, net 40. Proponents of the proposals believe that the implementation of their proposal will improve on the company’s financial situation.
Set out below are the company’s statement of profit or loss and statement of financial position for the past three years:
Statement of profit or loss for the year ended 31st December
| 20X5 (GH¢’000) | 20X6 (GH¢’000) | 20X7 (GH¢’000) | |
|---|---|---|---|
| Revenue | 40,000 | 60,000 | 122,000 |
| Cost of sales | (15,000) | (31,000) | (58,000) |
| Gross profit | 25,000 | 29,000 | 64,000 |
| Selling and administrative expenses | (11,000) | (17,500) | (24,000) |
| Operating profit | 14,000 | 11,500 | 40,000 |
Statement of financial position as at 31st December
| 20X5 (GH¢’000) | 20X6 (GH¢’000) | 20X7 (GH¢’000) | |
|---|---|---|---|
| Noncurrent assets: | |||
| Property, plant and equipment | 13,400 | 19,000 | 22,500 |
| Current assets: | |||
| Inventory | 8,000 | 15,500 | 25,500 |
| Trade receivables | 6,900 | 11,210 | 24,210 |
| Cash | 1,110 | – | – |
| Total current assets | 16,010 | 26,710 | 49,710 |
| Total assets | 29,410 | 45,710 | 72,210 |
| Equity: | |||
| Stated capital | 100 | 100 | 100 |
| Income surplus | 18,510 | 28,110 | 36,810 |
| Shareholders’ equity | 18,610 | 28,210 | 36,910 |
| Non-current liabilities: | |||
| Medium-term loan | 3,000 | 2,500 | 2,000 |
| Current liabilities: | |||
| Trade payables | 2,200 | 3,500 | 8,600 |
| Dividend payable | 5,600 | 6,400 | 7,500 |
| Bank overdraft | – | 5,100 | 17,200 |
| Total current liabilities | 7,800 | 15,000 | 33,300 |
| Total liabilities | 10,800 | 17,500 | 35,300 |
| Total equity and liabilities | 29,410 | 45,710 | 72,210 |
Required:
(a) Considering the background information and financial data provided above, would you conclude that AquaPure Ltd is experiencing overtrading? Explain with relevant computations.
(b) Appraise the proposal for early settlement discount (i.e. Proposal 1) and advise on whether it should be accepted for implementation or not. Your appraisal should focus on how the discount policy will influence the company’s profitability. Show all relevant computations.
(c) Appraise the proposal to switch from financing working capital needs using bank overdraft to using suppliers’ trade credit, and advise management accordingly. Show all relevant computations.
(d) Assuming AquaPure Ltd cannot raise additional funds from external sources such as borrowing and new share offer, suggest to management three steps they can take to ease the cash shortages the company is facing.
Answer
(B) Under current policy:
Current credit sales = GH¢122 million
Current credit period = 40 days
Receivables turnover days = 53 days
Trade receivables, 20X7 = GH¢24.210 million
Trade receivables, 20X6 = GH¢11.210 million
Under discount policy:
Credit sales = GH¢122 million (assumed to be kept at recent sales level)
Credit period = 40 days
Discount period = 10 days
Discount rate = 1.5%
Early payment probability = 60%
Financing cost = 15%
Cash discount cost = Credit sales × Discount rate × Early payment probability
Cash discount cost = GH¢122m × 1.5% × 60% = GH¢1.098m
If credit policy remains unchanged, average trade receivables would be GH¢17.715m:
Current average trade receivables = (53 / 365) × GH¢122m = GH¢17.715m
Or
Current average trade receivables = (GH¢24.210m + GH¢11.210m) / 2 = GH¢17.71m
If early settlement discount is introduced, average trade receivables would be GH¢7.353m:
New average trade receivables = ((10 / 365) × 60% × GH¢122m) + ((40 / 365) × 40% × GH¢122m)
New average trade receivables = GH¢2.005m + GH¢5.348m = GH¢7.353m
Funds that would be released every year if the early settlement discount is introduced is GH¢11.365m:
Funds to be released = GH¢17.715m – GH¢7.353m = GH¢10.362m
Interest charges that would be saved every year due to the early settlement discount is GH¢1.554:
Interest saved = GH¢10.362 × 0.15 = GH¢1.554m
Summary:
| GH¢m | |
|---|---|
| Benefit of new discount policy: Interest saved every year | 1.554 |
| Cost of new discount policy: Cash discount allowed every year | 1.098 |
| Net benefit of new discount policy | 0.456 |
Conclusion:
If the early settlement discount is introduced and 60% of accounts are settled early to take the discount, the company’s profit will increase by GH¢0.456m every year. Therefore, management should accept the early settlement discount proposal for implementation.
(C). If the company continues to finance working capital needs with bank overdraft, the annual financing cost would be 15%.
If the company finances working capital needs with suppliers trade credit the annual financing cost would be 12.3% (assuming simple interest):
Cost of trade credit = (d / (100 – d)) × (365 / t)
Discount, d = 1
Effective credit period, t = 40 – 10 = 30
Cost of trade credit = (1 / (100 – 1)) × (365 / 30) = 0.123
Conclusion:
Since the cost of financing with suppliers’ trade credit is lower than the cost of financing with the overdraft facilities, the company should discard its current working capital financing method and finance with trade credit.
Note:
Full credit should be given to candidates who estimate the cost of trade credit based on compound interest:
Cost of trade credit = {[(100 / (100 – d))^(365 / t)] – 1}
Cost of trade credit = {[(100 / (100 – 1))^(365 / 30)] – 1} = 0.13
(D). Steps management can take to ease cash shortages when the company cannot obtain additional funds from external sources include the following:
(1) Postpone capital investments.
(2) Postpone dividend payments.
(3) Accelerate collection from customers by offering incentives for early payment (e.g. early settlement discount, increase in credit limit). This will reduce funds tied up in working capital.
(4) Reduce investment in inventory to minimise funds tied up in working capital.
(5) Reverse past investment decisions by selling assets previously acquired but are surplus to the company’s needs, or producing negative or lower returns. Even assets that are needed can be sold and leased back.
(6) Negotiate with creditors for more favourable payment terms.
- Topic: Cash Management
- Uploader: Samuel Duah