tutorial 2 - credit management

given data

• current sales = 75 mil.

• current credit terms = “4/20, net 40“

  • 25% of customers take the discount and pay after 20 days

  • the remaining 75% pay in 60 days

  • bad debts = 3% of sales

• variable costs = 75% of sales

• cost of capital = 10%

proposed plans

• plan 1 [relaxed credit terms]:

  • new credit terms = “6/30, net 65“

  • projected sales increase = 20%

    • new sales = 90 mil.

  • discount take up = 30% pay in 30 days

  • non discount customers = pay in 90 days

  • bad debts = 4%

• plan 2 [stricter credit terms]:

  • new credit terms = “4/10, net 30“

  • projected sales decrease = 5%

    • new sales = 71.25 mil

  • discount take up = 10% pay in 10 days

  • non discount customers = pay in 50 days

  • bad debts = 3%

st.1 - calculate profits

profit = sales x [1 - variable cost]

• current profit:

  • 75 mil x [1 - 75%] = 18.75 mil

• plan 1 profit:

  • 90 x [1 - 75%] = 22.5

  • change in profit = 22.5 - 18.75 = 3.75

• plan 2 profit:

  • 71.25 x [1 - 75%] = 17.8125

  • change in profit = 17.8125 - 18.75 = -0.9375

st.2 - calculate bad debts

bad debts = sales x bad debt percentage

• current bad debts:

  • 75 × 3% = 2.25

• plan 1 bad debts:

  • 90 × 4% = 3.6

  • change in bad debt = 3.6 - 2.25 = 1.35

• plan 2 bad debts:

  • 71.25 × 3% = 2.1375

  • change in bad debt = 2.1375 - 2.25 = -0.1125

st.3 - calculate cost of discounts

cost of discount = sales x discount percentage x proportion of customers using discount

• current COD:

  • 75 × 4% x 25% = 0.75

• plan 1 COD:

  • 90 × 6% x 30% = 1.62

  • change in COD = 1.62 - 0.75 = 0.87

• plan 2 COD:

  • 71.25 × 4% x 10% = 0.285

  • change in COD = 0.285 - 0.75 = -0.465

st.4 - calculate average accounts receivable

using the weighted average collection period:

debtors = [discount customers x (discount days/365)] + [non discount customers x (non discount days/365)]

• current debtors:

  • discount customers = [(75 × 25%) x (20/365)] = 1.027397

  • non discount customers = [(75 × 75%) x (60/365)] = 9.246575

• plan 1 debtors:

  • DC = [(90 × 30%) x (30/365)] = 2.219178

  • NDC = [(90 × 70%) x (90/365)] = 15.534247

  • change in discount debtors = 2.219178 - 1.027397 = 1.191781

  • change in NDC = 15.534247 - 9.246575 = 6.287671

  • total change in debtors = 6.287671 + 1.191781 = 7.479452

• plan 2 debtors:

  • DC = [(71.25 × 10%) x (10/365)] = 0.195205

  • NDC = [(71.25 × 90%) x (50/365)] = 8.784247

  • change in DC = 0.195205 - 1.027397 = -0.832192

  • change in NDC = 8.784247 - 9.246575 = -0.462329

  • total change in debtors = -1.294521

st.5 - calculate financing cost

cost of capital increase = total increase in debtors x cost of capital

• plan 1:

  • 7.479452 × 10% = 0.747945

• plan 2:

  • -1.294521 × 10% = -0.129452

st.6 - evaluate net benefit

net benefit = profit change - inc. in bad debt - inc. in discount cost - cost of financing

• plan 1:

  • 3.75 - 1.35 - 0.87 - 0.747945 = 0.782055

• plan 2:

  • -0.9375 + 0.1125 + 0.465 + 0.129452 = -0.230548

  • remember, subtracting with a negative no. turns into a plus

conclusion

• plan 1 is financial better [+ 782,055]

• plan 2 results in a net loss [- 230,548]

• adopt plan 1, as it yields a net positive benefit

b. discuss the ways by which a company might aim to improve its collection of cash from trade debtors.

• set clear credit terms - define payment terms, due dates, and penalties for late payments upfront

• offer early payment discounts - encourage faster payments by providing small discounts

• conduct credit risk analysis - assess customers’ credit worthiness using credit ratings, internal scoring, and financial history

• invoice promptly and accurately - send clear error free invoices immediately after delivery to avoid disputes and delays

• implement a strong collection policy - use structured follow ups [reminders, legal action] to recover overdue payments

• use automated payment reminders - set up email/SMS alerts before and after due dates to prompt timely payments

• encourage electronic payments - offer multiple online payment methods to speed up collections

• use factoring or invoice discounting - sell invoices to a third party or get upfront cash for receivables to improve liquidity

• charge late payment fees - discourage delays by imposing penalties for overdue payments, as stated in credit terms

• regularly review accounts receivable - monitor outstanding balances, aging reports, and high risk customers to take early action