Question

Joe owns a small company that is experiencing cash flow problems. Although his competitors require payment for services within 30 days, Joe provides his customers up to 90 days with no interest. Joe works with reputable companies, provides top-quality services, and rarely encounters dissatisfied customers. His annual revenue this year will be about $1,500,000 and he expects a net income of $110,000 this year. The long collection period appears to have created the cash flow problem. The business has a $100,000 accounts receivable balance and the company needs more cash to pay current bills. He has recently negotiated a line of credit agreement with a local credit union that should solve the company’s cash flow problems. The line of credit requires that the company pledge the accounts receivable as collateral and provides for a 12% interest rate based on the company’s credit rating. The credit union offers line of credit interest rates between 5% and 18%, based on a company’s credit rating and their opinion of a company’s last two to three years financial statements. The credit union agreed to loan 70% of the receivables balance. Joe is satisfied with this arrangement because he estimates he needs approximately $45,000 to cover this month’s accounts payable. On the day they were first going to use the line, Joe heard from a business associate that the company’s largest customer might declare bankruptcy. The customer owed the business $40,000. Joe is now concerned about the impact this would have on his line of credit. Joe uses the direct write-off method to recognize uncollectible accounts expense. Recognizing the uncollectible accounts expense would affect his income statement, he knows that the bank might further reduce the available credit by reducing the percentage of receivables allowed under their agreement. Joe will have to attest to the quality of the receivables at the end of the month to show that the terms of the agreement are being met.

1. Given their current accounts receivable balance, how much of the credit line can Joe access? Based on the facts presented, is this a material amount? Why or why not?

Answer 1

Joe's Company has an Accounts Receivable balance of $ 100,000.

The loan amount that can be availed from the Credit Union @ 70% of the Accounts Receivable balance is $70,000

The write -off of the Accounts Receivable due to likely bankruptcy of the customer $40,000.

The revised Accounts Receivable Balance ($100,000-40,000) is $60,000.

1.The Loan Amount which Joe can access (assuming the same 70%) will be ($60,000*70%) , $42,000.

2.The Accounts Payable for the month is $45,000. There is a shortfall of $3,000.. Since the Company is expected to make profit even after writing off of $40,000 and   providing for interest on loan@12%, the shorfall of $3,000 is not material.

Joe can further assert with the Credit union that it is not certain that the customer will become bankrupt since it was heard only from a business associate and the customer has not declared bankruptcy.