Assess The Financial Impact Of Proposals To Improve Credit S
Assess the financial impact of proposals to improve credit sales profitability
You have been asked to assess the expected financial impact of each of the following proposals to improve the profitability of credit sales made by your company. Each proposal is independent of the other. Answer all questions. Showing your work may earn you partial credit.
Proposal #1: Extending trade credit to previously denied customers, increasing sales by $150,000 annually, with associated costs and risks detailed. Calculate the incremental income after taxes, return on sales, additional accounts receivable investment, incremental return on new investment, and evaluate if the proposal meets a 20% required rate of return.
Proposal #2: Establishing regional collection centers to reduce collection time by 2 days, thus freeing up cash and potentially saving interest costs. Assess the potential cash freed, annual interest savings, and whether the proposal is financially justified given its annual cost of $5200.
Paper For Above instruction
Introduction
The profitability of credit sales is a critical aspect of a company's financial health, influencing cash flow, liquidity, and overall profitability. Companies often explore proposals to enhance credit management and collections to maximize financial returns. This analysis evaluates two such proposals: extending credit to previously denied customers (Proposal #1) and establishing regional collection centers to improve collection efficiency (Proposal #2). Each proposal's financial implications are assessed through detailed calculations, considering costs, benefits, and strategic alignment with the company's required rate of return.
Proposal #1: Extending Trade Credit to Poor-Risk Customers
This proposal aims to increase sales by $150,000 annually by extending credit to previously denied customers, presenting an opportunity for additional revenue but also incurring risks and costs. The key variables include uncollectible accounts, collection costs, production and selling costs, and tax rate.
Incremental Income After Taxes
The gross increase in sales is $150,000. Of these, 7% are projected to be uncollectible, amounting to $10,500 ($150,000 × 0.07). Therefore, the net sales that are potentially collectible are $139,500 ($150,000 - $10,500).
Collection costs are 3% of sales, amounting to $4,500 ($150,000 × 0.03), regardless of actual collection success. Production and selling costs are 80% of sales, totaling $120,000 ($150,000 × 0.80). The pre-tax profit attributable to the incremental sales can be approximated by subtracting these relevant expenses from gross sales:
- Gross sales: $150,000
- Less uncollectible (bad debt): $10,500
- Less collection costs: $4,500
- Less production/selling costs: $120,000
However, for better accuracy, the profit calculation should consider only the collectible portion:
\[
\text{Incremental pre-tax profit} = \text{Sales} - \text{Uncollectible} - \text{Collection costs} - \text{Production & selling costs}
\]
Calculating:
\[
\text{Expected net sales} = 150,000 - 10,500 = 139,500
\]
\[
\text{Variable costs} (production and selling) = 0.80 \times 150,000 = 120,000
\]
Pre-tax income:
\[
= 139,500 - 4,500 - 120,000 = 15,000
\]
Taxes are 40%:
\[
\text{Taxes} = 0.40 \times 15,000 = 6,000
\]
Net after-tax income:
\[
= 15,000 - 6,000 = 9,000
\]
Thus, the incremental income after taxes is $9,000.
2. Incremental Return on Sales
Return on sales (ROS) is calculated as net income divided by sales:
\[
\text{ROS} = \frac{\text{Net income after taxes}}{\text{Sales}} = \frac{9,000}{150,000} = 0.06 \text{ or } 6\%
\]
This indicates that the new credit extension yields a 6% return on sales.
3. Additional Investment in Accounts Receivable
The receivable turnover ratio is 3:1, implying that the average receivables are roughly one-third of annual credit sales:
\[
\text{Additional accounts receivable} = \frac{\text{Sales}}{\text{Receivable turnover}} = \frac{150,000}{3} = 50,000
\]
Therefore, the incremental investment in accounts receivable is $50,000.
4. Incremental Return on New Investment
The return on new accounts receivable is calculated as:
\[
\text{Return} = \frac{\text{Net income after taxes}}{\text{Additional accounts receivable}} = \frac{9,000}{50,000} = 0.18 \text{ or } 18\%
\]
This exceeds the typical cost of capital, indicating a favorable investment.
5. Investment Decision Based on 20% Required Rate of Return
Since the calculated return on new investment is 18%, which is below the company's minimum hurdle rate of 20%, the proposal does not meet the required threshold and should not be accepted based solely on financial metrics.
Proposal #2: Establishing Regional Collection Centers
This proposal focuses on improving cash inflow by reducing collection time, thereby freeing up cash and reducing interest expense. Given the current average collections of $60,000 per day, a 2-day reduction can generate significant savings.
1. Dollar Amount of Cash Freed Up
Total collections per day are $60,000; a 2-day reduction in collection time results in:
\[
\$60,000 \times 2 = \$120,000
\]
Thus, the system would free up $120,000 in cash.
2. Interest Savings
Assuming all freed cash is used to pay down debt with a 6% interest rate:
\[
\text{Annual interest savings} = 120,000 \times 0.06 = \$7,200
\]
The company can save $7,200 annually in interest payments.
3. Financial Justification
The total annual cost of the new collection system is $5,200. Comparing this to the annual interest savings:
\[
\$7,200 - \$5,200 = \$2,000 \text{ net benefit}
\]
The positive net benefit indicates that the system is financially advantageous.
Conclusion
The analysis demonstrates that extending credit to previously denied customers (Proposal #1) is not financially justifiable given the company's required rate of return, despite generating positive net income and a strong return on investment. Conversely, establishing regional collection centers (Proposal #2) offers clear financial benefits through interest savings that outweigh the costs, making it a recommended initiative.
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