- 15 Marks
L2 – Q110 – Trade Receivables Management
Question
Entity N is reviewing its credit policy. It is estimated that if the period of credit allowed to customers is reduced to 60 days, there will be a 25% reduction in annual sales, but bad debts would be reduced by GH¢30,000 each year. It would also be necessary to spend an extra GH¢20,000 each year on credit control. Entity N has cash flow difficulties and relies on overdraft finance, for which the interest rate is 9%.
Required
Calculate the effect of these changes on the annual profit. Base your answer on the level of sales in Year 3, and assume that purchases and inventory would be reduced in the same proportion as the reduction in sales.
| Entity N – Extracts from annual accounts | Year 3 |
|---|---|
| Inventory | GH¢ |
| Raw materials | 180,000 |
| Work in progress | 93,360 |
| Finished goods | 142,875 |
| Purchases | 720,000 |
| Cost of goods sold | 1,098,360 |
| Sales | 1,188,000 |
| Trade receivables | 297,000 |
| Trade payables | 126,000 |
Answer
Loss of sales based on Year 3 = 25% × GH¢1,188,000 = GH¢297,000
However, the cost of these sales will be avoided.
Gross profit percentage = (1,188,000 – 1,098,360) / 1,188,000 = 0.755. Gross profit is 7.55% of sales. It is assumed that the loss from the reduction in sales will be: 7.55% × GH¢297,000 = GH¢22,424
| GH¢ | |
|---|---|
| Loss of profit from fall in sales | (22,424) |
| Additional cost of credit control | (20,000) |
| Reduction in bad debts | 30,000 |
| Reduction in profit, before savings in interest | (12,424) |
Working capital changes
Reduction in inventories
Raw materials (25% × 180,000) = 45,000
Work in progress (25% × 93,360) = 23,340
Finished goods (25% × 142,875) = 35,719
Reduction in trade payables (25% × 126,000) = 31,500
Reduction in trade receivables
Current trade receivables = 297,000
Receivables after the change = (60 / 365) × 75% × GH¢1,188,000 = 146,466
Reduction in working capital = 45,000 + 23,340 + 35,719 – 31,500 + (297,000 – 146,466) = 223,093
Cost of financing working capital = 9%
Saving per year in interest from reduction (GH¢) = 9% × 223,093 = 20,078
| Net effect on annual profit | GH¢ |
|---|---|
| Reduction in profit, before savings in interest (see above) | (12,424) |
| Reduction in interest cost | 20,078 |
| Net increase in annual profit | 7,654 |
Reducing the credit period to 60 days will result in annual savings of GH¢7,654.
To achieve these savings, there would have to be a fall in sales by 25%.
Senior management might decide that the size of the savings does not justify such a large fall in annual sales, because of the longer-term consequences this might have for the business.
- Uploader: Samuel Duah