Worked Example On The Effect Of Sales Expansion On The Working Capital

Earlier article shows the effect of sales expansion on the working capital of a company.

Below is an additional worked example of the impact of sales expansion in the event the company extend its credit term.

Worked Example: Company ABC Ltd has a current sales of $2.6 million. It wants to increase its sales by relaxing its credit policy. The current credit term is 45 days and the proposed terms of credit is 60 days. However the company believes that bad debts will increase from 1.5% to 2% of sales and sales should increase by 10%. The variable operating costs are 72% of the sales. The corporate tax rate is 35% and that the company requires an after-tax return of 15% on its investment. Question: Should Company ABC Ltd extend its credit policy from 45 days to 60 days?

Suggested Solution $ $ Sales Increase (10 % of $2.6m) 260,000 Contribution margin (100-72%=28%) 72,800 Less: Bad debts 1.5% x$2.6m 39,000 2.0% x($2.6×1.1=$2.86m) 58,000 Incremental bad debts (19,000) Operating profit before tax 53,800 Operating profit after tax 34,970 Increase in receivables investment =(New sales/360 days x 60 days) deduct (Old sales/360 days x 45 days) $476,660-$325,000 151,660 Expected rate of return =Operating profits after tax/Increase in receivables investment 34,970/151,660 =23.06% Less: Original rate of return 15% Incremental rate of return 8.06% Yes, it is to the advantage of Company ABC Ltd to extend its credit policy as it achieve a higher rate of return of 8.06%

The Effect of Sales Expansion On Working Capital

This article looks in particular the effect of Sales Expansion On Working Capital.

Managing Accounts Receivables has a critical impact on the company’s working capital. In fact, credit sales normally form a very large portion of the sales re: about 15% to 25% of a firm’s assets. To increase sales, top management will resort to increasing/extending the credit period to the customers. Examination question often ask candidates to assess the viability of such sales expansion in terms of increase in credit period.

Append below showed how we compute the viability when a firm relax or extend its credit period to boost its sales.

HOW TO COMPUTE THE FINANCIAL VIABILITY/IMPACT OF A FIRM WHEN THERE IS AN INCREASE IN ACCOUNTS RECEIVABLE. Step: (1) Compute the additional profit from the increase in sales from the extension of credit terms to its customers (2) Compute the cost of additional investment in accounts receivable (3) Compute the cost of additional bad debts. (4) Finally, sum up step (1) to step (3) to see whether there is a net gain to the firm · Additional profit from in increase in sales minus(-) · additional cost of additional investment in accounts receivable + · Additional cost of additional bad debts SIMPLE ILLUSTRATION Company ABC has a yearly sale volume of $12 million. The cost of goods is 80% of annual sales. Top management wants to increase sales by 10% by extending its credit terms from 30 days to 45 days. Bad debts is estimated to increase from 1% to 2% of yearly sales. Company ABC’s cost of tying up funds in accounts receivable is 10%. Required: Should Company ABC relax or extend its credit terms from 30 to 45 days? Suggested Solution: Step 1: Compute the additional profit from increase in sales · Additional sales =($12 million x 10%) =$1.2 million · Assuming there is no increase in fixed costs, profit/contribution from additional sales =$1.2 million x 20% =$240,000 Step 2: Compute the additional cost of additional investment in accounts receivables · Original investment in accounts receivable · 30/360 x $12 million=$1 million · 45/360 x $12 x 1.1 = $1.65 million · Additional investment of accounts receivable =$1.65m -$1.0 m = $650,000 · Cost = 10%(cost of fund) x $650,000 =$65,00 Step 3: Compute additional cost of bad debts ( 1% to 2% of sales) · (2% x$12m x1.1=$264,000)-(1% x$12m=$120,000) =$144,000 The result of the relaxation or extension of its credit period from 30 days to 45 days: · $240,000-($65,000+$144,000) =$31,000 net gain

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