Question

The credit terms of a firm currently is “net 30”. It is considering to change it to “net 60”. This will have the effect of increase in firm’s sales. As the firm will not relax credit standards, the bad debt losses are expected to remain at same percentage, that is, 3% of sales. Incremental production, selling and collection costs are 80% of sales and expected to remain constant over the range of anticipated sales increases. The relevant opportunity cost for receivables is 15%. Current credit sales are Rs. 300 crore and current level of receivables is Rs 30 crore. If credit terms are changed, the current sale is expected to change to Rs 360 crore and firm’s receivables level will also increase. The firm’s financial manager estimates that new level of credit terms will cause firm’s collection period to increase by 30 days.
(i) Determine the present collection period and the collection period after the proposed change in credit terms.
(ii) What level of receivables is implied by the new collection period?
(iii) Determine the increased investment in receivables if new credit terms are adopted.
(iv) Are new credit terms desirable?

Answer 1

(i) Present Collection Period:

Current Credit Sales=300 Crores

Current level of receivables=30 Crores

Collection Period =365/(Receivable Turnover)

Receivable Turnover =(Sales/Level of receivables)

Current Receivable Turnover =300/30=10

Present Collection Period=365/10=36.5 days

Collection Period after Change in Credit Term:

=36.5+30=66.5 days

(ii) Receivable level implied by new collection period:

Collection Period =66.5=365/(360/Receivables)

360/Receivables=365/66.5=5.488722

Receivable Implied by new collection period=360/5.488722=65.59 Crores

(iii) Increased investment in receivables =65.59-30=35.59 crores

(iv)Cost of increase in receivable=35.59*15%=5.34 Crores

Benefit:

Increase in Sales =360-300=60 crores

Incremental Cost =80%*60=48 Crores

Net Benefit =(60-48)=12 Crores

Net Benefit is higher than the cost of increased receivables

New Credit terms are desirable