Question

Alabama Company makes and sells electric fans. Its manufacturing factory in Mainland China utilizes around 90% of its production capacity. Its Hong Kong selling office distributes the electric fans only to local wholesalers. Traditionally, the company’s sales have been in the following categories: 25% cash sales; and around 75% sales on account (due in 60 days). Uncollectible accounts expense was approximately 1% of net sales. With these policies, Alabama earned a modest profit, and monthly cash receipts exceeded monthly cash payments by a comfortable margin.

In the recent management meeting, the Sales Manager proposes a new credit policy, i.e. Alabama will offer 360-day payment terms to all customers. The Sales Manager expects that both the sales and profit will be doubled (so called “Double Excellence”).

Although the new proposal may improve the profit level, the Financial Controller raises the concerns of cash flow problem. Alabama will take a longer time to convert its investment in accounts receivable into cash by granting longer credit terms to all customers.

REQUIRED:

1. 1) Suggest TWO ways that Alabama may be able to generate the cash it needs to pay its bills when the “Double Excellence” is implemented. What are the expected financial impacts if Alabama adopts your suggestion?

2. 2) Suggest TWO factors (besides cashflow issue) to Alabama’s management for the evaluation of the plan. Explain.

Answer 1

1. The first way to generate the cash required to pay bills after implementation of the "Double Excellence" policy can be ad-hoc or temporary Cash Credit Limit on Accounts Receivable. Such a limit will serve as a bridge to fill the cash requirements.

The second way can be raising funds by issue of short term notes payable which will mature in a year period. It will also serve a bridge to serve a smooth flow of operations.

2. The first factor while evaluating the "Double Excellence" policy is that we should keep in mind the increased risk of default by customers i.e. Bad Debts. The percentage of Bad Debt always increases with an increase in the time allowed to customers for making payments.

The second-factor for evaluating the proposal is that we should consider the cost of funds raised to bridge the gap of cash inflows. If the ad-hoc cash credit limit is taken then we should consider its interest cost for the year. On the other hand, if short term notes are issued then we should consider interest on short term notes for the year.

(We have to consider the opportunity cost of an increase in the amount blocked in accounts receivable also.)