Question

. The Company is considering a change in its credit standards. The company sells currently 10 000 units of Technotron. The sales price is 40€. The variable cost is 60% of the sales price. The relaxation of credit standards should result in 15% sales increase. However, the average credit collection period increases to 80 days from current 30 days. It is also expected that bad debt loss would also increase from 2% to 5% of the sales. The company finances its current assets with short-term loans that carry 8% of interest.

Try to evaluate if a change in credit standards has a positive effect on the profits of the company or not. In order to do so, you will have to compare additional profits with increase in bad debt expense and financing costs of additional receivables.

Discuss, what are the positive and negative aspects of relaxation of credit standards (in general).

Answer 1

Current Scenario.

Sales- 10,000

Sale Price- 40€

Total Sales= 10,000*40€= 400,000€

Variable Cost- 60%

Average Collection period is 80 Days.

Therefore We need to calculate Receivable Turnover Ratio to find out Debtors.

Formula 1- Receivable turnover Ratio = Sales/Debtors

Formula 2- Average Collection Period = 360 / Receivable Turnover Ratio

Therefore using formula 2

Receivable Turnover Ratio= 360/30 = 12

Therefore using Formula 1 now

Debtors= 400,000/12 = 33,333€

Since the company Finances its Current Assets with Short Term Debt. therefore Debt in Present Scenario = 33,333€

Taking the Relaxation into Consideration.

Sales is expected to Increase by 15%

Therefore Sales (Relaxed Scenario)= 400,000 + 400,000*15%= 460,000

Receivable Days is expected to go to 80 Days.

There applying the same method as we did earlier and finding Debtors:

Therefore We need to calculate Receivable Turnover Ratio to find out Debtors.

Formula 1- Receivable turnover Ratio = Sales/Debtors

Formula 2- Average Collection Period = 360 / Receivable Turnover Ratio

Therefore using formula 2

Receivable Turnover Ratio= 360/80 = 4.5

Therefore using Formula 1 now

Debtors= 460,000/4.5 = 102,222€

Since the above amount is serviced with short term debt therefore debt = 102,222€

Additional Debt= 102,222-33,333= 68,889€.

Therefore Additional Interest = 68,889* 8%= 5511€ - (A)

Bad Debt is expected to increase from 2% to 5% i.e an increase of 3% of sales.

Therefore Additional Bad Debt = 460,000* 5% - 400,000* 2% = 15000€ (B)

Additional profit which we will get from Additional Sales=

Additional Sales - (Additional Sales * Variable Cost %)

(460,000 - 400,000)- (460,000-400,000)*60%= 24000€ (C)

Therefore Total Additional Profit/Loss= Additional Profit - Additional Finance Cost - Additional Bad Debt ( C - A - B )

Additional Profit / Loss = 24,000 - 15000 - 5511 = 3489€

The company has made an additional profit of 3489€.

The positives of Relaxation of credit Standards are :

It allows you to increase your sales which ultimately affects the profits.

The Gross Profit margins are high which help us to cover the interest cost and bad debts

We are able to access a larger customer base

The negatives of Relaxing Credit standards are :

The Cash Conversion Cycle gets longer, i.e we receive back Cash after a longer period of time.

Because of the above mentioned point we have to have access to extra funds.

We have to pay extra interest cost on the extra funds which can eventually be a burden.

It also makes us more levered which means we are more vulnerable

Because the number of customers go up we are at a risk of having higher bad debts.