Ch 28: Accounts Receivable Management & Factoring

CHAPTER 28 ACCOUNTS RECEIVABLE MANAGEMENT AND FACTORING

Problem 1 Current policy A. Credit period B. Annual sales (Rs lakh) C. Inc. sales (Rs lakh), [B - 3,000] D. Cost of sales (Rs lakh), [B/10 x 8+600] E. Receivable invst. at cost (Rs cr), [D/360 x A] F. Inc. receivable invst. at cost (Rs cr), [E - 167] G. Inc. contribution (Rs lakh), [B x (10-6)/10] H. Expected rate of return (%), [G/F] I. Required rate of return (%) Note: Cost of sales includes variable cost plus fixed cost. None of the new policies is desirable since the required rate of return is higher than the expected rate of return. Cost calculations: Average cost (Rs) Unit variable cost (Rs) Price (Rs) Total cost of sales (Rs lakh) Total variable cost (Rs lakh) Total fixed cost (Rs lakh) Problem 2 Current sales (Rs cr) Current level of receivable (Rs cr) Bad debts losses (%) Incremental cost(%) Current collection period (days) New collection period (days) New levels of sales (Rs cr) New levels of receivable (Rs cr) Incremental receivable invst. (Rs cr) Contribution from addl. sales (Rs cr) Bad debts on addl. sales (Rs cr) Net contribution (Rs cr) Rate of return (%) Required rate of return (%) Net surplus return (%) 300 30 3% 80% 36 66 360 66 36 12 1.8 10.2 28.3% 15% 13.3% 25 3,000 2,400 167 Policy X 40 3,012 12 2,407 267 101 4.8 4.8% 12% Policy Y 50 3,027 27 2,416 336 169 10.8 6.4% 12% Policy Z 60 3,047 47 2,428 405 238 18.8 7.9% 12%

8 6 10 2,400 1,800 600

(30/300) x 360 36 + 30 (360/360) x 66 66 - 30 60 x 0.20 60 x 0.03 12 - 1.8 10.2/(66-30) 28.3% 15.0%

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 3 Policy Policy Policy Policy A B C D A. Collection period (days) 40 45 55 70 B. Incremental sales (Rs) 300,000 400,000 500,000 600,000 C. Inc. invst. in receivable (Rs cr), [D x 0.20] 33,333 50,000 76,389 116,667 D. Inc. contribution (Rs cr), [D x (1 - 0.85)] x (1 - .35) 29,250 39,000 48,750 58,500 E. Expected return (%), D/E 88% 78% 64% 50% F. Required rate of return (%) 20% 25% 32% 40% Assuming that there are no other costs (bad debt, collection charges etc.) involved, the company will benefit if it liberalises credit period to 70 days. Problem 4 Policy Policy Policy 2 3 4 A. Credit period (days) 45 60 75 90 B. Annual sales (Rs cr) 64 64.5 65.3 66.5 C. Cost of sales (Rs cr), [B x 0.8 + 6] 57.20 57.60 58.24 59.20 D. Inc. sales (Rs cr), [C - 54] 4 4.5 5.3 6.5 E. Level of receivable (Rs cr), [C/360 x A] 4.50 7.15 9.60 12.13 14.80 F. Inc. receivable invst. (Rs cr), [E - 4.50] 2.65 5.10 7.63 10.30 G. Inc. contribution (Rs cr), [D x 0.20] 0.80 0.90 1.06 1.30 H. Bad-debt loss (%) 1.5% 1.5% 1.7% 2.0% 2.5% I. Bad-debt loss (Rs cr), [D x H] 0.06 0.08 0.11 0.16 J. Inc. expected profit (Rs cr), [G - I] 0.74 0.82 0.95 1.14 K. Expected return (%), [J/F] 27.9% 16.1% 12.5% 11.0% L. Required rate of return (%) 18% 18% 18% 18% The firm should shift to credit policy 1. Other policies are not desirable since the expected rates are lower than the required rates of return. Cost calculation: Sales (Rs cr) Total cost (Rs cr), [0.90 x 60] Variable cost (Rs cr), [0.80 x 60] Fixed cost (Rs cr), [54 - 48] Problem 5 Required rate of return (%) Credit sales (Rs cr) Current collection period (days) Current level of receivable (Rs cr),[120/360x60] New collection period (days) New level of receivable (Rs cr), [120/360x40] Discount rate (%) Cost of cash discount (Rs cr), [120 x 0.6 x 0.02] Decrease in receivable invst. (Rs cr),[13.33-20] Expected return (%), [-1.44/-6.67] Required rate of return (%) Net gain (%) 15 120 60 20 40 13.33 0.02 -1.44 -6.67 21.6% 15.0% 6.6% Current policy 30 60 54.00 Policy 1

60 54 48 6

Ch 28: Accounts Receivable Management & Factoring

Problem 6

A. Current sales B. New credit period C. New collection period D. Bad-debt losses E. Increased sales F. Variable cost G. Tax rate H. Required rate of return I. Incremental sales J. Contribution from incr. sales, I (1 - 0.70) K. Bad-debt losses on incr. sales (I D) L. Profit before tax, J - K M. Less: tax, L G N. Profit after tax, L - M O. Incr. receivable investment (at selling price) P. Expected return, N/O Q. Net gain (%), P - H

(Rs) 7,200,000 45 45 3% 360,000 70% 35% 15% 360,000 108,000 10,800 97,200 34,020 63,180 345,000 18.3% 3.3%

Incremental investment in receivable includes 15 days increase collection period for existing sales. Investment in receivables = 7,200,000 (45-30)/360 + 360,000 45/360 = Rs 345,000. Problem 7

Current sales Increase in sales New level of sales Current collection period (days) Current level of receivables New level of receivables Cash discount Discount period (days) Percentage customers taking discount Bad debt losses Variable cost Corporate tax rate Opportunity cost of capital A. Increased sales B. Contribution from increased sales, A (1-0.70) C. Bad debt loss, A 2% D. Cost of cash discount: 740,000 0.02 0.5 E. After-tax profit, (B - C -D)(1-0.5) F. Decrease receivable investment, 41,111 - 60,000 G. Expected return, E/F H. Net gain %, 10% -G

(Rs) 720,000 20,000 740,000 30 60,000 41,111 2% 10 50% 2% 70% 50% 10% 20,000 6,000 400 7400 -900 -18,889 4.8% 5.2%

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

The investment in receivables is the difference between new level of receivables and the current level of receivables. Since the average collection period for 50 per cent sales is 10 days and for remaining 50 per cent 30 days, the new level of receivables is calculated as follows: New level of receivables = 740,000 0.50 10/360 + 740,000 0.50 30/360 = Rs 41,111 Decrease in receivables investment = 41,111 60, 000 = - Rs 18,889 In decline in after-tax profit is Rs 900 which translates to 4.8 per cent loss of return while the company can earn 10 per cent on its investment. Hence, there is a gain of 5.2 per cent, or -900 0.10 -18,889 = + Rs 989. Problem 8 (Rs crore) Slowpaying accounts 4.40 3.74 0.11 0.07 0.06 0.09 0.04 4.12 0.28

Good Total 22.00 18.70 0.57 0.35 0.31 0.09 0.04 20.06 1.94 0.44 0.18 0.22 0.84 1.10 5.0% accounts 17.60 14.96 0.46 0.28 0.25

A. Sales B. Variable costs: a. Cost of goods sold, [0.85xA] b. Selling, [0.026xA] c. Administration, [0.016xA] d. Warehousing, [0.014xA] e. Bad debts. [0.004x22] f. Collection charges, [0.002x22] C. Total variable costs, [a +b + c + d + e +f] D. Contribution, [A-C] E. Fixed costs: g. Selling, [0.02x22] h. Administration, [0.008x22] i. Warehousing, [0.01x22] F. Total fixed costs, [g + h + i] G. Profit before tax, [D-F] H. Pre-tax profit margin (%), [G/A] Consequences of not selling to slow-paying customers: Lost contribution (excluding bad debts and collection charges), [4.4 x 0.094] Less bad debt and collection charges avoided Net loss Decrease in receivable investment Expected return (%)

15.95 1.65 0.44 0.18 0.22 0.84 0.82 4.7%

0.28 6.4%

0.41 0.13 0.28 0.885 31.8%

If the company does not sell to slow-paying customers, it shall avoid the outstanding receivable balance of Rs 0.885 crore (Rs 88.5 lakh).

Ch 28: Accounts Receivable Management & Factoring

Problem 9 Current policy 60 45 60% 1% 0.50% 0.36 0.18 0.54 7.50 18% Alternate policy 1 60 20 80% 2% 1% 0.96 0.48 1.44 0.90 3.33 4.17 21.6% 18% Alternate policy 2 60 14 95% 3% 1.50% 1.71 0.86 2.57 2.03 2.33 5.17 39.2% 18%

A. Sales (Rs cr) B. Collection period (CP) C. Percentage taking discount D. Discount rate (%) E. Default percentage F. Cost of discount (Rs cr), [A x C x D] G. Cost of default (Rs cr), [A x C x E] H. Total loss (Rs cr), [F + G] I. Incremental loss, [H - 0.54] J. Receivable invst. (Rs cr), [(A/360) x B] K. Inc. receivable invst. (Rs cr), [J - 7.50] L. Expected return (%), [I/J] M. Required rate of return (%) Problem 10 Annual sales (Rs cr) Credit sales, 80% (Rs cr) Average collection period (days) Level of receivable (Rs cr): (160/360) x 80 Factoring commission (Rs cr): 1.75% x 35.56 Reserve (Rs): 10% x 35.56 Available advance (Rs cr): 35.56 - 3.56- 0.62 Upfront interest on advance (Rs cr): (16.5% x 31.38)/360/80 Net available advance (Rs cr): 31.38 - 1.15 Annual cost of factoring: Commission: 0.62 x (360/80) Interest on advance: 1.15 x (360/80) Total Savings from factoring (Rs cr): Bad debt avoided: 0.9% x 160 Cost of administration avoided Total Net cost of factoring Effective cost of factoring: 6.34/30.23 (%)

200 160 80 35.56 0.62 3.56 31.38 1.15 30.23

2.80 5.18 7.98 1.44 0.20 1.64 6.34 21.0%

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

CASES Case 28.1: Relax Pharmaceutical Limited The case can be used to answer the following questions: (1) How to determine the investment in receivable? Increment investment in receivable means additional investment (on new and current sales) caused by a change in the credit policy. This investment may be measured in terms of selling price or cost just the variable cost or total cost (including both variable and fixed). (2) What are marginal accounts? What is their cost and contribution? Generally fixed costs will not change whether a firm sells or does not sell to marginal accounts because all fixed costs are expected to be recovered from sales to good accounts. Relaxing credit terms may increase sales to marginal accounts. There will be trade-off between the increased revenue and the increased cost. (3) What does a credit policy involve? How does change in a credit policy affect a firms sales revenue and profitability? (4) How can debtors (or receivable be monitored)? Collection period or aging schedule will not be useful when sales show periodic fluctuations. In this situation collection experience matrix is an appropriate approach. This case helps to explain most of issues with regard to a firms credit policy. The calculations are shown below. Current Situation Sales to good customers (Rs million) Sales to marginal customers (Rs million) Current sales (Rs million) Average collection period - good cusomers (days) Average collection period - marginal cusomers (days) Credit sales per day - good customers (Rs million) Investment in receivables- good customers (Rs million) Credit sales per day - marginal cuistomers (Rs million) Investment in receivables - marginal customers (Rs million) Total investment in receivables at selling price (Rs million) Contribution from marginal accounts Avoidable variable cost (excluding 1/4th collection costs of good customers) Contribution ratio Contribution loss from marginal customers (Rs million) Tax (35% rate assumed) After-tax contribution loss (Rs million) Investment in receivables - marginal customers (Rs million) Rate of return Required rate of return Marginal accounts are proftable. They should continue. Proposed policy (without cash discount) Credit period (days) New sales (Rs million) Credit 900 180 1,080 Cash 120 0 120 Total 1,020 180 1,200 60 70 2.5 150 0.5 35 185

900/360 2.5 60 180/360 0.5 70

180 x 13.03%

86.97% 13.03% 23.45 8.21 15.25 35 43.6% 15%

70 1,440

Incremental sales to good customers Incremental sales to marginal customers (Rs million) Incremental sales (Rs million) Average collection period - good cusomers (days) Average collection period - marginal cusomers (days)

Credit 60 180 240

Cash 0 0 0

Total 60 180 240 75 90

Ch 28: Accounts Receivable Management & Factoring

Bad-debt losses from sale to marginal customers Collection costs (marginal accounts) Collection charges (marginal accounts) (Rs million) Contribution ratio Contribution from incremntal sales (rs million) Incremental bad-debt losses and collection costs (Rs million) Net contribution (Rs million) After-tax contribution (Rs million) Investment in receivables- good customers (Rs million) Investment in receivables - marginal customers (Rs million) Total investment in receivables (Rs million) Rate of return Required rate of return It's not desirable to change the credit terms. Proposed policy (with cash discount) Credit period (days) New sales (Rs million) (900 + 60)/360*75 (180 + 180)/360*90

0.0550 0.0009 0.05 13.03% 31.27 10.11 21.16 13.75 200 90 290 4.7% 15%

70 1,440 Credit 60 180 240 (900 + 60)*0.3 Cash 0 0 0 Total 60 180 240 2% 288 5.76 75 90 0.0550 0.0009 0.05

Incremental sales to good customers Incremental sales to marginal customers (Rs million) Incremental sales (Rs million) Cash discount Sales to customers availing cash discount (Rs million) Cash discount (Rs million) Average collection period - good customers (days) Average collection period - marginal customers (days) Bad-debt losses from sale to marginal customers Collection costs (marginal accounts) Collection charges (marginal accounts) (Rs million)

Contribution ratio Contribution from incremental sales (Rs million) Incremental bad-debt losses and collection costs (Rs million) Incremental cash discount (Rs million) Net contribution (Rs million) After-tax contribution (Rs million)

13.03% 31.27 10.11 5.76 15.40 10.01

I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Investment in receivables- good customers (Rs million) Investment in receivables - marginal customers (Rs million) Total investment in receivables (Rs million) Rate of return Required rate of return It's not desirable to change the credit terms.

0.3*(900 + 60)/360*75 (180 + 180)/360*90

164 90 254 3.9% 15%