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Tutorial on Receivables Management

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Instruction: Show your solutions in the space provided after each situation:

Tutorial 1: Kari-Kidd Corporation currently gives credit terms of “net 30 days.” It has $60 million in credit sales,
and its average collection period is 45 days. To stimulate demand, the company may give credit terms of “net 60
days.” If it does instigate these terms, sales are expected to increase by 15%. After the change, the average
collection period is expected to be 75 days, with no difference in payment habits between old and new customers.
Variable costs are $0.80 for every $1.00 of sales, and the company’s before-tax required rate of return on
investment in receivables is 20 percent. Should the company extend its credit period? (Assume a 360-day year.)

Tutorial 2: Matlock Gauge Company makes wind and current gauges for pleasure boats. The gauges are sold
throughout the Southeast to boat dealers, and the average order size is $50. The company sells to all registered
dealers without a credit analysis. Terms are “net 45 days,” and the average collection period is 60 days, which is
regarded as satisfactory. Sue Ford, vice president of finance, is now uneasy about the increasing number of bad-
debt losses on new orders. With credit ratings from local and regional credit agencies, she feels she would be able
to classify new orders into one of three risk categories. Past experience shows the following:

Order Category
Low Risk Medium Risk High Risk
Bad-debt loss 3% 7% 24%
Category orders to total orders 30% 50% 20%

The cost of producing and shipping the gauges and of carrying the receivables is 78% of sales. The cost of
obtaining credit information and of evaluating it is $4 per order. Surprisingly, there does not appear to be any
association between the risk category and the collection period; the average for each of the three risk categories
is around 60 days. Based on this information, should the company obtain credit information on new orders instead
of selling to all new accounts without credit analysis? Why?

Tutorial 3: To increase sales from their present annual $24 million, Kim Chi Company, a wholesaler, may try more
liberal credit standards. Currently, the firm has an average collection period of 30 days. It believes that, with
increasingly liberal credit standards, the following will result:

Credit Policy
A B C D
Increase in sales from previous level (in millions) $2.8 $1.8 $1.2 $.6
Average collection period for incremental sales (days) 45 60 90 144

The prices of its products average $20 per unit, and variable costs average $18 per unit. No bad-debt losses are
expected. If the company has a pre-tax opportunity cost of funds of 30%, which credit policy should be pursued?
Why? (Assume a 360-day year.)

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Tutorial 4: Upon reflection, Kim Chi Company has estimated that the following pattern of bad-debt losses will
prevail if it initiates more liberal credit terms:

Credit Policy
A B C D
Bad debt losses on incremental sales 3% 6% 10% 15%

Given the other assumptions in previous number, which credit policy should be pursued? Why?

Tutorial 5: Recalculate previous number, assuming the following pattern of bad-debt losses:

Credit Policy
A B C D
Bad debt losses on incremental sales 1.5% 3.0% 5.0% 7.5%

Which policy now would be best? Why?

Tutorial 6: The Acme Aglet Corporation has a 12% opportunity cost of funds and currently sells on terms of “net/10,
EOM.” (This means that goods shipped before the end of the month must be paid for by the tenth of the following
month.) The firm has sales of $10 million a year, which are 80% on credit and spread evenly over the year. The
average collection period is currently 60 days. If Acme offered terms of “2/10, net 30,” customers representing 60%
of its credit sales would take the discount, and the average collection period would be reduced to 40 days. Should
Acme change its terms from “net/10, EOM” to “2/10, net 30”? Why?

Tutorial 7: Porras Pottery Products, Inc., spends $220,000 per annum on its collection department. The company
has $12 million in credit sales, its average collection period is 2.5 months, and the percentage of bad-debt losses
is 4%. The company believes that, if it were to double its collection personnel, it could bring down the average
collection period to 2 months and bad-debt losses to 3%. The added cost is $180,000, bringing total collection
expenditures to $400,000 annually. Is the increased effort worthwhile if the before-tax opportunity cost of funds is
20%? If it is 10%?

Tutorial 8: The Pottsville Manufacturing Corporation is considering extending trade credit to the San Jose
Company. Examination of the records of San Jose has produced the following financial statements:

San Jose Company balance sheets (in millions)


ASSETS 20X1 20X2 20X3
Current assets
Cash $ 1.5 $ 1.6 $ 1.6
Receivables 1.3 1.8 2.5
Inventories (at lower of cost or market) 1.3 2.6 4.0
Other 0.4 0.5 0.4
Total current assets $ 4.5 $ 6.5 $ 8.5
Fixed assets
Building (net) 2.0 1.9 1.8
Machinery and equipment (net) 7.0 6.5 6.0
Total fixed assets $ 9.0 $ 8.4 $ 7.8
Other assets 1.0 0.8 0.6
Total assets $14.5 $15.7 $16.9
LIABILITIES
Current liabilities
Notes payable $ 2.1 $ 3.1 $ 3.8
Trade payables 0.2 0.4 0.9
Other payables 0.2 0.2 0.2
Total current liabilities $ 2.5 $ 3.7 $ 4.9
Term loan 4.0 3.0 2.0

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Total liabilities $ 6.5 $ 6.7 $ 6.9
Net worth
Preferred stock 1.0 1.0 1.0
Common stock 5.0 5.0 5.0
Retained earnings 2.0 3.0 4.0
Total liabilities and net worth $14.5 $15.7 $16.9

San Jose Company income statements (in millions)


20X1 20X2 20X3
Net credit sales $15.0 $15.8 $16.2
Cost of goods sold 11.3 12.1 13.0
Gross profit $ 3.7 $ 3.7 $ 3.2
Operating expenses 1.1 1.2 1.0
Net profit before taxes $ 2.6 $ 2.5 $ 2.2
Tax 1.3 1.2 1.2
Profit after taxes $ 1.3 $ 1.3 $ 1.0
Dividends 0.3 0.3 0.0
To retained earnings $ 1.0 $ 1.0 $ 1.0

The San Jose Company has a Dun & Bradstreet rating of 4A2. Inquiries into its banking disclosed balances
generally in the low millions. Five suppliers to San Jose revealed that the firm takes its discounts from the three
suppliers offering “2/10, net 30” terms, though it is about 15 days slow in paying the two firms offering terms of “net
30.”

Analyze the San Jose Company’s application for credit. What positive factors are present? What negative factors
are present?