Question 10.SE.6: Boswell Enterprises Ltd is reviewing its trade credit policy...
Boswell Enterprises Ltd is reviewing its trade credit policy. The business, which sells all of its goods on credit, has estimated that sales revenue for the forthcoming year will be £3 million under the existing policy. Credit customers representing 30 per cent of trade receivables are expected to pay one month after being invoiced and 70 per cent are expected to pay two months after being invoiced. These estimates are in line with previous years’ figures.
At present, no cash discounts are offered to customers. However, to encourage prompt pay-ment, the business is considering giving a 2^{1/2} per cent cash discount to credit customers who pay in one month or less. Given this incentive, the business expects that credit customers accounting for 60 per cent of trade receivables will pay one month after being invoiced and that those accounting for 40 per cent of trade receivables will pay two months after being invoiced. The business believes that the introduction of a cash discount policy will prove attractive to some customers and will lead to a 5 per cent increase in total sales revenue.
Irrespective of the trade credit policy adopted, the gross profit margin of the business will be 20 per cent for the forthcoming year and three months’ inventories will be held. Fixed monthly expenses of £15,000, and variable expenses (excluding discounts) equivalent to 10 per cent of sales revenue, will be incurred and will be paid one month in arrears. Trade payables will be paid in arrears and will be equal to two months’ cost of sales. The business will hold a fixed cash bal-ance of£140,000 throughout the year, whichever trade credit policy is adopted. Ignore taxation.
Required:
(a) Calculate the investment in working capital at the end of the forthcoming year under both the existing policy and the proposed policy.
(b) Calculate the expected profit for the forthcoming year under both the existing policy and the proposed policy.
(c) Advise the business as to whether it should implement the proposed policy.
(Hint: The investment in working capital will be made up of inventories, trade receivables and cash, less trade payables and any unpaid expenses at the year end.)
Boswell Enterprises Ltd
(a)
| \underline{Current policy} | \underline{New policy } | |||
| £000 | £000 | £000 | £000 | |
| Trade receivables | ||||
| ((£3m × 1/12 × 30%) + (£3m × 2/12 × 70%)) | 425.0 | |||
| ((£3.15m × 1/12 × 60%) + (£3.15m × 2/12 × 40%)) | 367.5 | |||
| Inventories | ||||
| ((£3m − (£3m × 20%)) × 3/12) | 600.0 | |||
| ((£3.15m − (£3.15m × 20%)) × 3/12) | 630.0 | |||
| Cash (fixed) | \underline{140.0} | \underline{140.0} | ||
| 1,165.00 | 1,137.50 | |||
| Trade payables | ||||
| ((£3m − (£3m × 20%)) × 2/12) | (400.0) | |||
| ((£3.15m − (£3.15m × 20%)) × 2/12) | (420.0) | |||
| Accrued variable expenses | ||||
| (£3m × 1/12 × 10%) | (25.0) | |||
| (£3.15m × 1/12 × 10%) | (26.3) | |||
| Accrued fixed expenses | \underline{ (15.0 )} | \underline{ (440.0 )} | \underline{ (15.0 )} | \underline{ (461.3 )} |
| Investment in working capital | \underline{725.0} | \underline{676.2} | ||
(b)
| \underline{Current policy} | \underline{New policy } | |||
| £000 | £000 | £000 | £000 | |
| Sales revenue | 3,000.0 | 3,150.0 | ||
| Cost of goods sold | (\underline{ 2,400.0 }) | (\underline{ 2,520.0 }) | ||
| Gross profit (20%) | 600.0 | 630.0 | ||
| Variable expenses (10%) | \underline{ (300.0 )} | \underline{ (315.0 )} | ||
| Fixed expenses | \underline{ (180.0 )} | \underline{ (180.0 )} | ||
| Discounts (£3.15m × 60% × 2.5%) | \underline{-} | \underline{( 480.0 ) } | \underline{ (47.3 ) } | \underline{ (542.3) } |
| Profit for the year | \underline{120.0} | \underline{87.7} | ||
(c) We can see that the investment in working capital will be slightly lower under the pro-posed policy than under the current policy. However, profits will be substantially lower as a result of offering discounts. The increase in sales revenue resulting from the dis-counts will not be sufficient to offset the additional cost of making the discounts to customers. It seems that the business should, therefore, stick with its current policy.