Question

Upon graduation from NAU with your business degree, you took a job as a Management Consultant. Fogler River Supply, Inc. (FRS) has hired your consulting firm to analyze their credit management and evaluate their credit policy. Jill Fogler, a finance graduate, owns a river rafting supply business with her brother, Joe, who majored in Recreation Services Management. The firm sells primarily to rafting tour companies. Sales are slow during the cold winter months, rise during the spring and summer, and then fall off again in the fall when river flows decline and the weather turns cold. The Foglers are concerned about the firm’s current credit policy. The terms of sale are net 30, but they expect only 55% of the customers (by dollar value) to pay the full amount on day 30, while the other 45% pay, on average, on Day 50. Gross sales are currently $350,000 per year. Of the gross sales, 2% end up as bad debt losses. Monthly sales for the first six months of 2017 are provided in the table below.

Table 1 – 2017 Monthly Sales (first six months) January February March April May June $20,000 $25,000 $35,000 $40,000 $40,000 $35,000

FRS is considering a change in credit policy. The change would entail 1) changing the credit terms to 2/10, net 30, 2) employing stricter credit standards before granting credit, and 3) enforcing collections with greater vigor than in the past. Thus, cash customers and those paying within 10 days would receive a 2% discount, but all others would have to the pay the full amount within 30 days. The owners believe the discount would both attract additional customers and encourage some existing customers to purchase more from the firm – after all, the discount amounts to a price reduction. The net expected result is for sales to increase to $375,000, for 35% of the paying customers to take the discount and pay on the 10 th day, for 45% to pay the full amount on day 30, for 15% to pay late on day 35, and for bad debt losses to fall from 2% to 1.5% of gross sales. The firm’s operating (variable) cost ratio will remain unchanged at 65%, and its cost for financing (notes payable or required return on investments) will remain unchanged at 5%. The company would have to purchase some new inventory to cover the additional sales. Inventory turnover averages 4 times per year, and CGS is 55% of sales. The most recent income statement with relevant information is given below.

Table 2 - 2017 Income Statement Gross Sales $350,000 Less: discounts 0 Net Sales $350,000 Variable Costs (65%) 227,500 Profit before credit costs and taxes (CM) $122,500 Credit related costs: A/R Carrying costs Inventory Investment cost Bad Debt Losses Profit before taxes Taxes (26%) Net Income

Case requirements: 1. To provide some insight for Jill and her brother describe the four variables that make up a firm’s credit policy, and explain how each of them affects sales and DSO considering a stricter (tighter) credit policy. 2. FRS would like you to determine and explain the primary factors that influence the level of receivables outstanding. Additionally, they would like to know what factors influence the dollar cost of carrying the receivables. 3. Refer to the monthly sales in Table 1 on the previous page and the current customer payment patterns to answer the following questions. a. What were FRS’s receivables balances at the end of Quarters 1 and 2 for 2017? b. Assume 90 days per calendar quarter. What were the average daily sales (ADS) and days sales outstanding (DSO) for the each of the first two quarters of 2017? What were the ADS and DSO for the first six months of 2017? c. Does the DSO indicate that the firm’s customers have changed their payment behavior from the first quarter to the second quarter of 2017? Is DSO a good management tool in this situation? Why or why not? d. Would the aging schedule or uncollected balances schedule properly measure customer payment patterns? Based on your answer, construct the schedule that measures payment patterns and explain to the Foglers what the schedule indicates about their customers’ payment patterns from one quarter to the next. 4. Determine the incremental after tax profit associated with the change in credit terms being considered. In other words, what is the difference in profit from old to new credit terms? Use a 26% tax rate. (Hint: Construct income statements under each policy, consider the four variables that affect profitability with a credit policy change, and focus on the expected change.) Based on the findings, should the company make the change? 5. Suppose the firm makes the change, but its competitors react by making similar changes to their own credit terms, with the net result being that gross sales remain at the current $350,000 level. If this were to happen, no additional inventory purchases would be necessary. What would be the impact on the firm’s after tax profitability? Based on the findings, should the company make the change? 6. Given your sensitivity analysis of FRS’s credit policy change, will you recommend that the company make the change to the new credit policy or continue using their existing credit policy? Justify your answer

Answer 1

1)The 4 variables that make up the firm's credit policy are :--

cash discount, collection effort, credit period, credit standard. The cash discount motivates the debtors to return the amount to the concerned firm in quick time. The collection effort of the firm is also responsible for less collection period from debtors.The credit period & the credit standard similarly are responsible. These variables affect the sales, bad debt loss, discounts taken by customers & collection expenses.

If there is a tight credit policy cash inflow from debtors increase and hence Day Sales Outstanding (DSO) reduces. Similarly cash inflow increases more manufacturing activity and more Sales.

2) Primary factors that influence the level of receivables outstanding: The debtors are not keen to release payments to the firm within the average collection period schedule. The lenient credit policy lets the company collections lag behind. The factors that influence the cost of carrying receivables are Day Sales Outstanding, Credit Sales and innterest rate.

3a) Accounts receivable balance in quarter 1 = 90 * Average credit sales/receivable collection period= 240000 Accounts receivable balance in quarter 2 = 90*115000/30 = 345000 3b) ADS qtr 1 = 80000/90=889 ; ADS qtr 2 = 115000/90 = 1278. DSO qtr 1 = 90*80000/240000 = 30; DSO qtr 2 = 90*115000/345000=30

Ans 3c) No. ; Ans 3d) Yes

4) Old situation : Sales = 350000; Bad debt losses = - 7000; Variable cost= 65% of 350000 = 227500 ; Hence Sales - V = Gross Profit = 122500. GP - bad debt = 115500. Tax = .26 * 115500 = 30030; Hence Profit After Tax (PAT) = 85470

New situation :Sales - V = 375000 - 243750=106250 ; bad debt loss = 5625; EBIT = 106250-5625=100625 hence PAT = 74462.4; Tax rate = 26%