Question

Some financial information is extracted from financial statements of Global Co. as follows:

	2020	2019
	£000	£000
Sales	21,000	17,500
Current assets	5,000	3,500
Current liabilities	3,800	1,900
Overdraft	1,500	200
Non-current liabilities	6,300	6,000
Operating profit margin	24%	30%
Inventory days	70	60
Receivable days	50	70
Payable days	100	90
Quick ratio	0.6:1	0.7:1

The credit controller of the company considers a new credit policy introduced in 2020 has effectively reduced the receivable days, which provides customers a 1% discount if they make full payment within 30 days. Further review of the policy indicates that the policy also reduced bad debts by £800,000 a year and the cost of financing receivables was covered by a short-term loan at the interest rate of 20% pa.

Required:
a) Is there any sign(s) of overtrading for Global? Explain with appropriate

ratio(s)/figure(s).

b) Calculate the appropriate equivalent annual percentage cost of a discount of 1 per cent, which reduces the time taken by credit customers to pay from 70 days to 50

days.

c) Assuming in 2020 customers either paid in 30 days to receive the discount or still paid in 70 days as they used to, what is the percentage of customers, by value, paid

in 30 days? Calculate the net benefit/cost of the policy.

Answer 1

Answer to Question No.a :
Overtrading happens when a business expands too quickly without having the financial
resources to support such a quick expansion.
If suitable sources of finance are not obtained, overtrading can lead to Business Failure.
Global business is over trading due to the following reasons :
1. Increase in sales from $17,500 to $21,000 but reduction in Operating
profit margin from 30% to 24% compared to previous year.
2. Increase in Current Liabilities & Overdraft loans.
3. Payable ratio increased from 90 days to 100 days.
There is a clear evidence that the business is over trading and there is a liquidity problem.
Ratios to explain liquidity position :
		formula			2020	2019
1. Current Ratio :	Current Assets/ Current Liabilities	1.32	1.84
2. Quick Ratio					0.60	0.70
3. Operation Profit					24%	30%
Answer to Question No.b :
Equivalent annual discount :		(1*(70-50)/(70-30))	0.50
Answer to Question No.C :
If all the customers paid in 30 days
Trade Receivables			£ 5,000.00
Discount if paid in 30 days @ 1%	£        50.00
Reduction in Bad debts		£     800.00
Net Benefit of the policy		£     750.00