ACC 100 Study Guide - Final Guide: Current Asset, Accounts Receivable, Current Liability

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12 Apr 2016

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Most customers with a good reputaion in the business community and a good credit raing are ofered credit terms when they buy goods or services from suppliers. If a business is relaively new and does not have a strong reputaion or a solid credit history they may not get credit terms right away. They may purchase cod (cash on delivery). They may have to build a relaionship and prove they are a reliable payer before they are given credit terms. Not all the customers receive the same credit terms. Credit terms depend on the relaionship between the seller and the buyer. A seller may give 3/10, n/15 to one customer but give another customer 1/15, n/45. The seller decides what terms they will give to each of their customers. Remember, as a business owner, if you don"t sell on credit one of your compeitors will. Selling on credit is likely to be necessary in order to remain compeiive.

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Upscale Toddlers, Inc., manufactures childrenâs clothing,including such accessories as socks and belts. The company has beenin business since 1955, mainly supplying private label merchandiseto large department stores. In 1990, however, the company startedproducing its own line of childrenâs clothing under the brandnameâYuppiewear.â An increasing number of two-income families has beenaccompanied by an increasing demand for high-status childrenâsclothing, and Toddlers was the first in its field to recognize thistrend.
When Toddlersâ sales were primarily for private labels, the firmâsfinancial manager did not have to worry much about its overallcredit policy. Most of its sales were negotiated directly withdepartment store buyers, and the resulting contracts containedspecific credit terms. The new line, however, represents asignificant change. It is sold through numerous wholesalers understandard credit terms, so credit policy per se has becomeimportant. Elizabeth Hardin, the assistant treasurer, has beenassigned the task of reviewing the companyâs current credit policyand recommending any desirable changes.
Toddlersâ current credit terms are 2/10, net 30. Thus, wholesalersbuying from Toddlers receive a 2 percent discount off the grosspurchase price if they pay within ten days, while customers who donot take the discount must pay the full amount within thirty days.The company does check the financial strength of potentialcustomers, but its standards for granting credit are not high.Similarly, it does have procedures for collecting past-dueaccounts, but its collections policy could best be described aspassive. Gross sales to wholesalers average about $15 million ayear, and 50 percent of the paying wholesalers take the discountand pay, on average, on Day 10. Another 30 percent of the payersgenerally pay the full amount on Day 30, while 20 percent tend tostretch Toddlersâ terms and do not actually pay, on average, untilDay 40. Two percent of Toddlersâ gross sales to wholesalers end upas bad debt losses.
Nathan Langly, the treasurer and Hardinâs boss, is convinced thatthe firm should tighten up its credit policy. According to Langly,good customers will pay on time regardless of the terms, and theones who would complain about a tighter policy are probably notgood customers. Hardin must make an analysis and then recommend acourse of action. For political reasons, she has decided to focuson a tighter policy, under which a 4 percent discount would beoffered to customers who pay cash on delivery (COD) and twenty daysof credit would be offered to customers who elect not to take thediscount. Also, under the new policy stricter credit standardswould be applied, and a tougher collection policy would beenforced. This policy has been dubbed 4/COD, net 20.
Langly likes this policy. He believes that increasing the discountwould both bring in new customers and also encourage more ofToddlersâ existing customers to take the discount. As a result, hebelieves that sales to wholesalers would increase from $15 millionto $16.5 million annually, that 60 percent of the paying customerswould take the discount, that 30 percent of the payers would pay onDay 20, that 10 percent would pay late on Day 30, and that bad debtlosses

would be reduced to 1 percent of gross sales. Langlyâs is notthe only position, though. Arnold Quayle, the sales manager, hasargued for an easier credit policy. Quayle thinks that the proposedchange would result in a drastic loss of sales and profits.
Toddlersâ variable cost-to-sales ratio is 80 percent; its pre-taxcost of carrying receivables is 12 percent; and the company canexpand without any problems (or any cost increases) because it cansubcontract production that it cannot handle in-house. Further,Langly is convinced that neither the variable cost ratio nor thecost of capital would change as a result of a credit policy change.Arnold Quayle, however, thinks that the variable cost ratio mightincrease significantly if sales rise so much that the company isforced to use outside suppliers. Also, after discussions with thecost accounting staff, Quayle thinks that the variable cost ratiomight rise as high as 90 percent this coming year, even without anincrease in sales, due to higher labor costs under a contract nowbeing negotiated. Everyone agrees that there is little chance thatcosts will decline, regardless of the credit policy decision.Toddlersâ federal-plus-state tax rate is 40 percent.
Now Hardin must conduct an analysis to estimate the effect of theproposed credit policy change on Toddlersâ profitability. She andLangly are very much concerned about the analysis, both because ofits importance to the company and also because of its âpoliticalimplicationsâ. The sales and production people have been lobbyingagainst any credit tightening because they do not want to take achance on losing sales and having to cut production, and alsobecause they question the assumptions Langly wants to use.Therefore, Hardin knows that her report will be critically reviewedand a thorough analysis is required. She is especially concernedabout being prepared for follow-up questions that other people,such as those in sales and production, might ask when the report isbeing reviewed. The report should consider all relevant factors,including an analysis of both the current and proposed creditpolicies and a recommendation as to what Toddlers should do.
Hardin has requested that you assist with the report. She is notcertain what risks are involved with a credit policy change or ifsuch risks can even be assessed and incorporated in the analysis.Meanwhile, Langly has expressed concern that if the firm changesits credit policy, Toddlersâ competitors may react by makingsimilar changes in their terms. Thus, Toddlers would have a newcredit policy without any change in sales.
As with every report presented to management, there probably willbe a number of questions regarding the assumptions used in theanalysis. Specifically, Hardin expects both the sales andproduction managers to question the assumptions, so she would liketo know which variables are most critical in the sense thatprofitability is very sensitive to them. No one has yet determinedjust how far off the assumptions could be before the change to atighter credit policy would be incorrect. Also, if she could,Hardin would like to have a better basis for the assumptions usedin her report - as it stands, all she has to rely on is Langly'sjudgment, which is contrary to that of two other senior executives.However, she is not sure whether any additional actions could betaken to improve the accuracy of the forecasts.
Langly gave you a portion of a letter he recently received fromIvana Tinkle, a member of Toddler's board of directors. Ivana whoalso sits on the Board of Face Cosmetics, Inc., has been involvedin numerous credit policy decisions. The decisions made by Facewere always successful from a profitability standpoint. Thus, Ivanasuggests that Toddlers use the same algebraic approach used byFace, in addition to constructing projected profit statements.Pages two and three of Ivana's letter are set forth in Exhibit 1.Ivana is a very influential member of the board, so be prepared toaddress her suggestion.
Working with Langly, she prepared the following set of questionsfor use as a guide in drafting her report. Put yourself in herposition and answer the following questions. As you answer eachquestion, think about follow-up questions that other people, suchas those in sales and production, might ask when the report isbeing reviewed.

s an alternative to constructing profit statements, an algebraicapproach has been developed that focuses directly on the change inprofits. To use this approach, it is first necessary to define thefollowing symbols:
S0 = SN =
V =
1 â V =
k = DSO0 = DSON =B0 = BN = P0 = PN =D0 = DN = T =
current gross sales new gross sales after the change in creditpolicy. Note that SN can be greater than or less than S0. variablecosts as a percentage of gross sales. V includes production costs,inventory carrying costs, the cost of administering the creditdepartment, and all other variable costs except bad debt losses,receivables carrying costs, and the cost of giving discounts.contribution margin, or the proportion of gross sales that goestoward covering fixed costs and increasing profits cost of financing the firmâs receivables current days sales outstanding newaverage days sales outstanding after change in credit policycurrent bad debt losses as a proportion of current gross sales newbad debt losses as a proportion of new gross sales proportion ofcurrent-collected gross sales that are discount sales proportion ofnew-collected gross sales that are discount sales current discountoffered discount offered under new policy tax rate
Calculate values for the incremental change in the firmâsinvestment in receivables, ÎI, and the incremental change inafter-tax profits, DP, as follows:
Formula for ÎI if Sales Increase: ÎI = V[(DSON - DSO0)(S0/360)] +V[(DSON)(SN - S0)/360].
Formula for ÎI if Sales Decrease: ÎI = V[(DSON - DSO0)(SN/360)] +V[(DSO0)(SN - S0)/360].
Formula for ÎP: ÎP = (1 - T)(SN - S0)(1 - V) - kÎI -(BNSN - B0S0)
- [DNSNPN(1 - BN) - D0S0P0(1 - B0)].
Note that, in the profit equation, the first term {(1 - T)(SN -S0)(1 - V)} is the incremental after-tax gross profit, the secondterm {kÎI} is the incremental cost of carrying receivables, thethird term {BNSN-B0S0} is the incremental bad debt losses, and thelast term {DNSNPN(1 - BN) - D0S0P0(1 - B0)} is the incremental costof discounts taken based on the percent of discounts taken bypaying customers.
Use the equations presented here to estimate the change i profitsassociated with the new policy. I hope this provides you withenough information. I will be out of the country on business forthree months and will not be available to answer any furtherquestions on this approach.
Sincerely, Ivana Tinkle

Question 1, What are the four variables that make up a firmâscredit policy? How likely (and how quickly) are competitors torespond to a change in each variable, and is their response likelyto be the same for a change toward tightness as one towardlooseness?

2.What is Toddlersâ dollar cost of carrying receivables underthe current policy? What would be the expected cost under the newpolicy? (Use a 360 day year.)

3.Hardin expects both the sales and production managers toquestion her assumptions, so she would like to know which variablesare most critical in the sense that profitability is very sensitiveto them. Then, she would like to know just how far off herassumption could be before the change to a tighter credit policywould be incorrect. If you are using the spreadsheet model, do somesensitivity analyses, changing one variable at a time while leavingthe others at their base case values. Which variables are mostimportant in terms of their effects on profits, and how large anerror could there be in the assumptions which you regard as beingmost critical before the decision should be reversed?

May 1		Issued Check No. 3410 to S&P Management Co. in payment ofthe May rent, $3,200. (Use two lines to record the transaction.Charge 80% of the rent to Rent Expense-Selling Space and thebalance to Rent Expense-Office Space.)
2		Sold merchandise on credit to Hensel Company, Invoice No. 8785,for $7,000 (cost is $5,000).
2		Issued a $150 credit memorandum to Knox Co., for defective(worthless) merchandise sold on April 28 and returned for credit.The total selling price (gross) was $4,700.
3		Received a $800 credit memorandum from Peyton Products for thereturn of merchandise purchased on April 29.
4		Purchased the following on credit from Gear Supply Co.:merchandise, $36,872; store supplies, $591; and office supplies,$82. Invoice dated May 4, terms n/10 EOM.
5		Received payment from Knox Co., for the balance from the April28 sale less the May 2 return and the discount.
8		Issued Check No. 3411 to Peyton Products to pay for the $6,300of merchandise purchased on April 29 less the May 3 return and a 2%discount.
9		Sold store supplies to themerchant next door at their cost of $387 cash.
10		Purchased $4,900 of office equipment on credit from Gear SupplyCo., invoice dated May 10, terms n/10 EOM.
11		Received payment from HenselCompany for the May 2 sale less the discount.
11		Purchased $9,500 of merchandise from Garcia, Inc., invoice datedMay 10, terms 2/10, n/30.
12		Received an $900 credit memorandum from Gear Supply Co. for thereturn of defective office equipment received on May 10.
15		Issued Check No. 3412, payable to Payroll, in payment of salessalaries, $4,820, and office salaries, $3,550. Cashed the check andpaid the employees.
15		Cash sales for the first half of the month are $59,420 (cost is$46,500). (Cash sales are recorded daily but are recorded onlytwice here to reduce repetitive entries.)
15		Post to the customer and creditor accounts. Also post individualitems that are not included in column totals at the end of themonth to the general ledger accounts. (Such items are posted dailybut are posted only twice each month because they are few innumber.)
16		Sold merchandise on credit to Hensel Company, Invoice No. 8786,for $4,800 (cost is $2,700).
17		Purchased $13,600 of merchandise from Fink Corp., invoice datedMay 14, terms 2/10, n/60.
19		Issued Check No. 3413 to Garcia, Inc., in payment of its May 10invoice less the discount.
22		Sold merchandise to Lee Services, Invoice No. 8787, for $7,800(cost is $5,940), terms 2/10, n/60.
23		Issued Check No. 3414 to Fink Corp. in payment of its May 14invoice less the discount.
24		Purchased the following on credit from Gear Supply Co.:merchandise, $8,820; store supplies, $690; and office supplies,$273. Invoice dated May 24, terms n/10 EOM.
25		Purchased $3,400 of merchandise from Peyton Products, invoicedated May 23, terms 2/10, n/30.
26		Sold merchandise on credit to Crane Corp., Invoice No. 8788, for$14,400 (cost is $8,420).
26		Issued Check No. 3415 to Perennial Power in payment of the Mayelectric bill, $1,275.
29		The owner of Colo Company, Jenny Colo, used Check No. 3416 towithdraw $6,500 cash from the business for personal use.
30		Received payment from Lee Services for the May 22 sale less thediscount.
30		Issued Check No. 3417, payable to Payroll, in payment of salessalaries, $4,820, and office salaries, $3,550. Cashed the check andpaid the employees.
31		Cash sales for the last half of the month are $66,800 (cost is$42,200).
31		Post to the customer and creditor accounts. Also post individualitems that are not included in column totals at the end of themonth to the general ledger accounts. Foot and crossfoot thejournals and make the month-end postings. uses a sales journal, a purchases journal, a cash receiptsjournal, a cash disbursements journal and a general journal.

Small business management class.

Please answer the two questions from the article belowplease.

Q1)Which one of the techniques to increase cash inflows is bestillustrated in the article? Explain how you know. ?

Q2)Which one of the techniques to decrease cash outflows is bestillustrated in the article? Explain how you know. ?

The article:

The financial crisis on Wall Street is quickly spiraling down tosmall businesses, making it extremely difficult for them to securefrom large banks the credit they need to start and maintain theiroperations.

Some businesses that currently have good relationships withbanks are getting more scrutiny and higher interest rates -- suchas 15% or more. Riskier borrowers are being denied creditaltogether.

Aside from falling back on friends or family -- or charging upyet another credit card -- here's a look at five alternatives forgetting extra cash to run a business in this economy.

-- Peer-to-Peer Lending Sites

Several Web sites now facilitate loans between individuals whodon't know each other. Typically, the prospective borrowers createprofiles that include how much they need to borrow, what the moneywill be used for and some credit history.

Other individuals can browse the loan requests and make offersthat include payment terms and interest rates. Prospective lendersalso get a risk assessment of the borrower generated by the Website based on the borrower's credit history.

Some "peer-to-peer" lending sites include LendingClub.com,Prosper.com, RaiseCapital.com and Zopa.com.

On Prosper.com, for instance, 25% of borrowers are individualsrunning or looking to start businesses, says Chief Executive ChrisLarsen. The site facilitates loans between individuals from $1,000to $25,000, and interest rates on those loans right now range from6% for those with the strongest credit ratings to about 30%.

Prosper, which has 800,000 registered users, is seeing moreentrepreneurs with good credit scores signing up. "We're certainlyseeing a steady increase of the quality of borrower coming to oursite," Mr. Larsen says. About 55% of the loans being funded are forborrowers with credit scores above 720, he adds, while only about5% are for those categorized as "subprime" borrowers.

-- Community Banks, Credit Unions

While big banks are being battered by all the financial turmoilon Wall Street, many local banks and credit unions are far morestable.

In fact, community banks continue to expand, although some havesuffered losses on securities issued by troubled mortgage giantsFannie Mae and Freddie Mac, says Camden Fine, chief executive ofthe Independent Community Bankers of America, an industryassociation in Washington.

Still, he says, even the community banks are more hesitant tolend to companies that lack rock-solid balance sheets.

-- Factoring, Asset-Based Loans

Though certainly not a cheap route to capital, some banks andnon- bank financing companies offer financing that is backed by abusiness's assets or accounts receivable.

So-called factoring, where a lender might, say, outright give aborrower 80 cents on the dollar for the company's accountsreceivable, can be a good option for businesses like manufacturersthat are owed a lot of money by customers and that have no betterlending option right now, says Raphael Amit, an entrepreneurshipprofessor at the University of Pennsylvania's Wharton School.

Interest rates on such financing can sometimes run 15% orhigher, so it's best to only resort to this approach when there'sno lower-cost option.

So-called asset-based loans -- loans in which assets such asinventory, equipment or real estate are used as collateral -- canbe good options for companies with lots of assets. But again, ratestend to run much higher than on traditional bank loans. The loanamounts are often capped at a percentage of the assessed value ofthe assets, such as 65%.

Also, even loans backed by assets can be difficult to get forcompanies with less-than-stellar credit ratings. Mark Sunshine,president of First Capital, a West Palm Beach, Fla., financecompany, says he's seeing more demand for loans based on accountsreceivable or assets, but isn't necessarily doing much morebusiness. "There's a reason local banks won't lend them money," hesays of riskier small companies. He says he's sticking to companieswith lots of assets to use as collateral.

-- Negotiating With Customers or Suppliers

Another smart strategy for helping cash flow -- perhaps even ifyou do have access to loans -- is striking better payment termswith customers and suppliers, Prof. Amit says. Especially whenbusiness relationships are strong and long-lasting, many companiesare willing to help each other out in tough economies.

A business that usually gives customers 30 to 60 days to pay thebills, for instance, might require customers to pay upon receipt ofgoods. A supplier, on the other hand, might be willing to extendlengthier payment terms to a business customer if it feels thecustomer is trustworthy and vital to its own business. Somesuppliers also will lend money to their longstanding, most valuedcustomers.

-- Changing Behaviors

Hard times call for small businesses to be nimble andentrepreneurial. Many businesses are using the tough economy toscrutinize their business practices and find creative ways tocreate better cash flow.

Some turn to leasing instead of buying equipment they need.

Others are identifying areas of the business that will tend tobe more lucrative in today's economy and shifting their resourcesin those directions.

ACC 100 Study Guide - Final Guide: Current Asset, Accounts Receivable, Current Liability

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