Question

On September 1, 2017, Gelato Corp. sold goods to Bo-Chin Corporation, a new customer. Before shipping the goods, Gelato’s credit and collections department conducted a procedural credit check and determined that Bo-Chin is a high-credit-risk customer. As a result, Gelato did not provide Bo-Chin with open credit by recording the sale as an account receivable. Instead, Gelato required Bo-Chin to provide a non–interest-bearing promissory note for $35,000 face value, to be repaid in one year. Bo-Chin has a credit rating that requires it to pay 12% interest on borrowed funds. Gelato pays 10% interest on a loan recently obtained from its local bank. Gelato has a December 31 year end.

What else could Gelato have done to decrease collection risk related to the sale to Bo-Chin?

Answer 1

Hi there! Here is the answer to your question. Hope it helps.

As Bo-chin is a high credit risk customer, giving it a long repayment period is very risky. Gelato asked Bo-chin to issue promisory note with one-year repayment time. Other than this, there could have been some other ways to reduce collection risk, which are:-

1. Ask Bo-chin to issue Letter of credit from its bank in favour of Gelato. It is a normal business practice, where the buyer's bank gives guarantee for the payment of amount due, at agreed time, to the seller, for the invoice value. Here, the credit risk transfers to the buyer's banker and seller's dues are secured.

2. Ask Bo-chin for upfront payment, offering cash discount of 2%. As given in the question, there is a difference of 2% between the interest charged by banker of Bo-chin and banker of Gelato. So, even if Gelato offers 2% cash discount, it is not losing as it would not have to pay its banker for the working capital loan, which it would have borrowed or needs to borrow to supply the order.

As Bo-chin is a new customer, Gelato should not disclose to Bo-chin about the high credit risk it entails, but make it understand that restrictions would be slowly lifted as they both develop relations and make a long-term association.