7.4 Receivable Management Flashcards
A retail company analyst is comparing North Company to South Company. The analyst notes that receivables for both companies’ private label credit cards have significantly increased balances in the current year. North’s customers’ monthly payment averaged 15% of their balances, while South’s customers’ monthly payment averaged 22% of their balances. What should the analyst conclude?
A. North’s customers may be having a hard time paying down their credit card debt than South’s customers.
B. South Company has likely increased its prices higher than North Company.
C. Both North Company and South Company have increased their prices in the current period; however, South Company has a higher gross margin than North Company.
D. North Company sells more high-volume, low-margin goods than South Company.
A. North’s customers may be having a hard time paying down their credit card debt than South’s customers.
Define the cash conversion cycle and describe how it relates to the operating cycle.
The cash conversion cycle is the time that passes, on average, between the firm’s payment for a purchase of inventory and the collection of cash from a customer on the sale of that inventory. The cash cycle is part of the operating cycle. The operating cycle is the cash cycle plus the time between purchases and payment.
An aging of accounts receivable measures the
A. Ability of the firm to meet short-term obligations.
B. Average length of time that receivables have been outstanding.
C. Percentage of sales that have been collected after a given time period.
D. Amount of receivables that have been outstanding for given lengths of time.
D. Amount of receivables that have been outstanding for given lengths of time.
The purpose of an aging of receivables is to classify receivables by due date. Those that are current (not past due) are listed in one column, those less than 30 days past due in another column, etc. The amount in each category can then be multiplied by an estimated bad debt percentage that is based on a company’s credit experience and other factors. The theory is that the oldest receivables are the least likely to be collectible. Aging the receivables and estimating the uncollectible amounts is one method of arriving at the appropriate balance sheet valuation of the accounts receivable account.
A company believes that its collection costs could be reduced through modification of collection procedures. This action is expected to result in a lengthening of the average collection period from 28 days to 34 days; however, there will be no change in uncollectible accounts. The company’s budgeted credit sales for the coming year are $27,000,000, and short-term interest rates are expected to average 8%. To make the changes in collection procedures cost beneficial, the minimum savings in collection costs (using a 360-day year) for the coming year would have to be
A. $30,000
B. $36,000
C. $180,000
D. $360,000
B. $36,000
If the change is adopted, the company’s average balance in receivables will increase by $450,000 {$27,000,000 × [(34 days – 28 days) ÷ 360 days]}. The minimum savings that the company must experience to justify the change is therefore $36,000 ($450,000 × 8%).
Which one of the following statements is most likely to be true if a seller extends credit to a purchaser for a period of time longer than the purchaser’s operating cycle? The seller
A. Will have a lower level of accounts receivable than those companies whose credit period is shorter than the purchaser’s operating cycle.
B. Is, in effect, financing more than just the purchaser’s inventory needs.
C. Can be certain that the purchaser will be able to convert the inventory into cash before payment is due.
D. Has no need for a stated discount rate or credit period.
B. Is, in effect, financing more than just the purchaser’s inventory needs.
The normal operating cycle is the period from the acquisition of inventory to the collection of the account receivable. If trade credit is for a period longer than the normal operating cycle, the seller must be financing more than just the purchase of inventory.
The average collection period for a firm measures the number of days
A. After a typical credit sale is made until the firm receives the payment.
B. For a typical check to “clear” through the banking system.
C. Beyond the end of the credit period before a typical customer payment is received.
D. Before a typical account becomes delinquent.
A. After a typical credit sale is made until the firm receives the payment.
The average collection period measures the number of days between the date of sale and the date of collection. It should be related to a firm’s credit terms. For example, a firm that allows terms of 2/15, net 30, should have an average collection period of somewhere between 15 and 30 days.
A company is considering a change in its credit terms from n/30 to 2/10, n/30. The company’s budgeted sales for the coming year are $24,000,000, of which 90% are expected to be made on credit. If the new credit terms are adopted, the company estimates that discounts will be taken on 50% of the credit sales; however, uncollectible accounts will be unchanged. The new credit terms will result in expected discounts taken in the coming year of
A. $216,000
B. $240,000
C. $432,000
D. $480,000
A. $216,000
The company can calculate expected discounts taken under the new credit policy as follows:
Total sales 24,000,000 x percentage on credit 90% = $21,600,000 credit sales
Credit sales 21,600,000 x subject to discount 50% = $10,800,000
Subject to discount 10,800,000 x discount percentage 2% = expected discounts taken $216,000
Powell Industries deals with customers throughout the country and is attempting to more efficiently collect its accounts receivable. A major bank has offered to develop and operate a lockbox system for Powell at a cost of $90,000 per year. Powell averages 300 receipts per day at an average of $2,500 each. Its short-term interest cost is 8% per year. Using a 360-day year, what reduction in average collection time would be needed in order to justify the lockbox system?
A. 1.20 days.
B. 1.50 days.
C. 0.67 days.
D. 1.25 days.
B. 1.50 days.
The amount Powell could potentially earn by investing its cash collections is calculated as follows:
Average amount per transaction $2,500
Times: payment per day x 300
= Daily Collections $750,000
Times: Money market rate x 8%
= Potential return on daily collections $60,000
The reduction in average collection time that justifies the lockbox system is the ratio of its cost to the potential return ($90,000 / $60,000 = 1.5 days)
A firm sells to retail stores on credit terms of 2/10, net 30. Daily sales average 150 units at a price of $300 each. All sales are on credit and 60% of customers take the discount and pay on day 10 while the rest of the customers pay on day 30. The amount of the firm’s accounts receivable that is paid within the discount period is
A. $810,000
B. $1,350,000
C. $990,000
D. $900,000
A. $810,000
The firm has daily sales of $45,000 consisting of 150 units at $300 each. For 30 days, sales total $1,350,000. Of these sales, 40%, or $540,000 ($1,350,000 x 40%), will be uncollected because customers do not take their discounts. The remaining $810,000 ($1,350,000 x 60%) will be paid within the discount period.
The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified the four sources of funds given below.
(1) Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.
(2) Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
(3) Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)
(4) Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year in all of your calculations.
The cost of Alternative (1) to Frame Supply Company is
A. 8.5%
B. 10.0%
C. 13.2%
D. 16.0%
D. 16.0%
The first step is to calculate the amount the firm will receive from the factoring transaction:
Amount of receivables $125,000
Times: Advance percentage x 80%
Amount received = $100,000
This amount is the basis for the calculation of interest expense:
Amount advanced $100,000
Times: Annual finance charge x 10%
Annual interest expense = $10,000
The next step is to calculate the annual factor fee:
Amount of receivables $125,000
Times: Factor fee percentage x 2%
Monthly factor fee = $2,500
Times: Months x 12
Annual factor fee = $ 30,000
The annual net cost of this factoring transaction is calculated as follows:
Annual interest expense $10,000
Annual factor fee 30,000
Less: annual savings (24,000)
Annual net cost $ 16,000
As with all financing arrangements, the effective rate is the ratio of the amount the firm must pay to the amount the firm get use of:
Effective rate = Net Cost ÷ Usable funds
= $16,000 ÷ $100,000
= 16.0%
A maker of bowling gloves is investigating the possibility of liberalizing its credit policy. Currently, payment is made on a cash-on-delivery basis. Under a new program, sales would increase by $80,000. The company has a gross profit margin of 40%. The estimated credit loss rate on the incremental sales would be 6%. Ignoring the cost of money, what would be the return on sales before taxes for the new sales?
A. 34.0%
B. 36.2%
C. 40.0%
D. 42.5%
A. 34.0%
The increase in estimated gross profit is $32,000 ($80,000 × 40%). The incremental credit loss is $4,800 ($80,000 × 6%). Accordingly, the estimated net increase in operating income is $27,200 ($32,000 – $4,800). The before-tax return on sales is 34% ($27,200 ÷ $80,000).
Hest Computers believes that its collection costs could be reduced through modification of collection procedures. This action is expected to result in a lengthening of the average collection period from 30 to 35 days; however, there will be no change in uncollectible accounts, or in total credit sales. Furthermore, the variable cost ratio is 60%, the opportunity cost of a longer collection period is assumed to be negligible, the company’s budgeted credit sales for the coming year are $45,000,000, and the required rate of return is 6%. To justify changes in collection procedures, the minimum annual reduction of costs (using a 360-day year and ignoring taxes) must be
A. $125,000
B. $37,500
C. $375,000
D. $22,500
D. $22,500
If the change is adopted, Hest’s average balance in receivables will increase by $625,000 {$45,000,000 [(35 days – 30 days ) ÷ 360 days]}. The company’s additional required investment in receivables is therefore $375,000 ($625,000 × 60% variable cost ratio), and the incremental pretax cost of this investment is $22,500 ($375,000 × 6%). Accordingly, the collection costs must be reduced by a pretax minimum of $22,500 to offset the cost of the increased investment in receivables.
A company can increase annual sales by $150,000 if it sells to a new, riskier group of customers. The uncollectible accounts expense is expected to be 16% of sales, and collection costs will be 4%. The company’s manufacturing and selling expenses are 75% of sales, and its effective tax rate is 38%. If the company accepts this opportunity, its after-tax income will increase by
A. $4,650
B. $2,850
C. $7,500
D. $8,370
A. $4,650
The company’s manufacturing and selling costs exclusive of bad debt equals 75% of sales. Hence, the gross profit on the $150,000 increase in sales will be $37,500 ($150,000 x 25%). The increase in after-tax profit is calculated as follows:
Increase in gross profit: $37,500
Less: Uncollectible accounts ($150,000 x 16%): 24,000
Less: Collection costs ($150,000 x 4%): 6,000
= Increase in pre-tax income $7500
Less: income tax expense ($7,500 x 38%): $2,850
= Increase in after-tax income $4,650.
Which of the following represents a firm’s average gross receivable balance?
I. Days’ sales in receivables x Accounts receivable turnover.
II. Average daily sales x Average collection period.
III. Net sales ÷ Average gross receivables.
A. I and II only.
B. II only.
C. II and III only.
D. I only.
B. II only.
A firm’s average gross receivable balance can be calculated by multiplying average daily sales by the average collection period (days’ sales outstanding). Alternatively, annual credit sales can be divided by the accounts-receivable turnover (Net credit sales ÷ Average accounts receivable) to obtain the average balance in receivables.
A company’s budgeted sales for the coming year are expected to be $50,000,000, of which 75% are expected to be credit sales at terms of n/30. The company estimates that a proposed relaxation of credit standards will increase credit sales by 25% and increase the average collection period from 20 days to 30 days. Based on a 360-day year, the proposed relaxation of credit standards will result in an expected increase in the average accounts receivable balance of
A. $1,822,917
B. $2,083,333
C. $520,833
D. $3,906,250
A. $1,822,917
Projected credit sales for the year under the old credit policy were $37,500,000 ($50,000,000 x 75%), resulting in an average balance in receivables of $2,083,333 [$37,500,000 x (20 days / 360 days)]. Under the new policy, credit sales will be $46,875,000 ($37,500,000 x 1.25), resulting in an average receivable balance of $3,906,250 [$46,875,000 x (30 days / 360 days)]. Hence, the expected increase in the balance is $1,822,917 ($3,906,250 - $3,083,333).
The following information regards a change in credit policy. The company has a required rate of return of 10% and variable cost ratio of 60%.
Old credit policy:
sales: $3,600,000
Average collection period: 30 days
New credit policy:
Sales: $3,960,000
Average collection period: 36 days
The pre-tax cost of carrying the additional investment in receivables, using a 360-day year, would be
A. $8,160
B. $960
C. $9,600
D. $5,760
D. $5,760
The projected average balance in receivables under the old policy was $300,000 [$3,600,000 x (30 days / 360 days)]. Under the new policy, the average balance will be $396,000 [$3,960,000 x (36 days / 360 days). Hence, the average balance is $96,000 higher under the new policy. The pre-tax cost of carrying the additional investment in receivables can be calculated as follows:
Increased investment in receivables - gross $96,000
x variable cost ratio 60%
= increased investment in receivables - net $57,600
x opportunity cost of funds x 10%
= incremental cost of new credit plan = $5,760
A firm that often factors its accounts receivable has an agreement with its finance company that requires the firm to maintain a 6% reserve and charges a 1.4% commission on the amount of the receivables. The net proceeds would be further reduced by an annual interest charge of 15% on the monies advanced. Assuming a 360-day year, what amount of cash (rounded to the nearest dollar) will the firm receive from the finance company at the time a $100,000 account that is due in 60 days is turned over to the finance company?
A. $96,135
B. $92,600
C. $90,285
D. $85,000
C. $90,825
The first step is to calculate the gross proceeds the firm will receive from the factoring transaction:
Amount of receivable $100,000
-) reserve ($100,000 x 6%) (6,000)
-) Factor Fee ($100,000 x 1.4%) (1,400)
= Gross proceeds $92,600
This amount must be reduced by the interest charged on the gross proceeds:
Gross proceeds $92,600
x) Annual finance charge 15%
= Annualized interest expense $13,890
x) portion of year (60 days / 360 days) x 16.7%
= Interest Expense $2,315
The actual cash the firm will receive from this factoring transaction is thus calculated as follows:
Gross proceeds $92,600
-) Interest Expense (2,315)
= Net proceeds $90,285
