Question

BLC Ltd. has revenue of £500 million and sells all of its goods on credit to a variety of different wholesale customers. At the moment the company offers a standard credit period of 30 days. However, 70% of its customers (by revenue) take an average of 70 days to pay, while the other 30% of customers (by revenue) pay within 30 days. The company is considering offering a 2% discount for payment within 30 days and estimates that 80% of customers (by revenue) will take up this offer (including those that already pay within 30 days). The Managing Director has asked the credit controller if the cost of this new policy would be worth offering. The company has a £80 million overdraft facility that it regularly uses to the full limit due to the lateness of payment and the cost of this overdraft facility is 15% per annum. The credit controller also estimates that bad debt level of 2% of revenue would be halved to 1% of revenue as a result of this new policy. Required Calculate the approximate equivalent annual percentage cost of a discount of 2%, which reduces the time taken by credit customers to pay from 70 days to 30 days. Calculate the value of trade receivables under the existing scheme and the proposed scheme at the year-end. Evaluate the benefits and costs of the scheme and explain with reasons whether the company should go ahead and offer the discount. You should also consider other factors in this decision. (Hint: You need to work out the cost of the discount compared to the interest on the overdraft saved and bad debt reduction.)

Answer 1

The total revenue of BLC Ltd is £500 million.

Existing scheme :- 70% pay within 70 days while the rest 30% pay within 30 days

70% of £500 comes to £350 million while 30% comes to £150 million.

So average trade receivables at year end would be as follows :-

=350*70/360 => £68.05 million where 350 is the total sales for 70 days and 360 means total days in a year which can alternatively be taken as 365 days where value arrived would have been £67.12 million.

=150*30/360 => £12.5 million where 150 is the total sales for 30 days and 360 means total days in a year which can alternatively be taken as 365 days where value arrived would have been £12.32 million.

so trade receivables under existing scheme would be :-

= £68.05 + £12.5 = £80.55 million(360 days in a year)

= £67.12 + £12.32 = £79.45 million(365 days in a year)

Similarly, for £500 million where 80% ,i.e, £400 million is received within 30 days while the rest £100 million is received within 70 days the trade receivables at year end would be as follows :-

=100*70/360 => £19.44 million where 100 is the total sales for 70 days and 360 means total days in a year which can alternatively be taken as 365 days where value arrived would have been £19.17 million.

=400*30/360 => £33.33 million where 400 is the total sales for 30 days and 360 means total days in a year which can alternatively be taken as 365 days where value arrived would have been £32.87 million.

so trade receivables under existing scheme would be :-

= £19.44 + £33.33 = £52.77 million(360 days in a year)

= £19.17 + £32.87 = £52.05 million(365 days in a year)

Bad debt level at existing scheme :- 2% of £500 million = £10 million

Bad debt level at proposed scheme :- 1% of £500 million = £5 million

Company is considering 2% discount to reduce the credit period. The above discount comes to :-

80% are proposed to take up the scheme and pay within 30 days. 80% of £500 million comes to £400 million.

2% discount on £400 million comes to £8 million.

Their is no discount being offered by the company in the existing scheme.

Average number of days calculation for overdraft interest calculation :-

Existing scheme :- 70% of 70 days comes to 49 days while 30% of 30 days comes to 9 days so total average credit period comes to 58 days.

Proposed Scheme :- 80% of 30 days comes to 24 days while 20% of 70 days comes to 14 days so total average credit period comes to 48 days.

SO the total number of days for which debtors (trade receivables) are outstanding have reduced from 58 days to 48 days.

Overdraft Facility Interest Amount :- £80 million @ 15% interest per annum comes to £12 million for the year as a whole.

For Existing Scheme Interest :- £12 million * 58 days/ 365 days => £1.90 million

For Proposed Scheme Interest :- £12 million * 48 days/ 365 days => £1.57 million

So interest on overdraft saved = £1.90 million - £ 1.57 million => £0.33 million

So, the amount of bad debt saved is £5 million (£10 million - £5 million)

Extra discount that is offered is £8 million.

So the extra cost that would be incurred by the company :- £8 million - £5 million - £0.33million => £2.67million

So implementing the new policy would cost an extra £2.67 million to the company.

The company can go ahead in implementing considering that amount will be received soon and hence more working capital will be available and also reduce chances of other losses as well as administrative cost will reduce.