its existing credit polic? Trilly Building Supplies Ltd has an annual turnover of £25 million before taking into account bad debts of £250.000. All sales made by the company are on credit and at present , credit terms are negotiable by the customer. On average, the settlement period for trade debtors is 60 days. The company is currently reviewing its credit policies to see whether more efficient and profitable methods could be employed. Two major proposals have so far been put forward concerning the management of trade credit. These are as follows:
Proposal AThe credit control department has proposed that customers should be given a 2.5% discount if they pay within 30 days. For those who do not pay within this period, a maximum of 50 days credit should be given. The credit department believes that 60% of customers will take advantage of the discount by paying at the end of the discount period and the remainder will pay at the end of 50 days. The credit department believes that all bad debts can be effectively eliminated by adopting the above policies and by employing stricter credit investigation procedures costing an additional £50,000 per annum. As less time will be spent chasing debtors, savings of £60,000 in the credit control administration can be made if the new policies are adopted. The credit department are confident that these new policies will not result in any reduction in sales.
Proposal B The company is also considering whether it should factor its trade debts. The accounts department has recently approached a factoring company which has agreed to provide an advance equivalent to 80% of trade debtors (based on an average settlement period of 40 days) at an interest rate of 12%. The factoring company will undertake collection of the trade debts and will charge a fee of 2% of sales turnover for this service. The factoring service is also expected to eliminate bad debts and will lead to credit administration savings of £130,000. The settlement period for trade debtors will be reduced to an average of 40 days, which is equivalent to that of its major competitors.
The company currently has an overdraft of £5.2 million at an interest rate of 14% per annum. The bank has written recently to the company stating that it would like to see a reduction in the overdraft of the company.
Required:
(a) Calculate for each proposal the net annual cost (savings) to the company of changing its existing credit policies and
either(i) adopting the proposals of the credit control department
or(ii) factoring the debts of the company
(b) Explain which of the two proposals (if either) you would support and why
Proposal AThe credit control department has proposed that customers should be given a 2.5% discount if they pay within 30 days. For those who do not pay within this period, a maximum of 50 days credit should be given. The credit department believes that 60% of customers will take advantage of the discount by paying at the end of the discount period and the remainder will pay at the end of 50 days. The credit department believes that all bad debts can be effectively eliminated by adopting the above policies and by employing stricter credit investigation procedures costing an additional £50,000 per annum. As less time will be spent chasing debtors, savings of £60,000 in the credit control administration can be made if the new policies are adopted. The credit department are confident that these new policies will not result in any reduction in sales.
Proposal B The company is also considering whether it should factor its trade debts. The accounts department has recently approached a factoring company which has agreed to provide an advance equivalent to 80% of trade debtors (based on an average settlement period of 40 days) at an interest rate of 12%. The factoring company will undertake collection of the trade debts and will charge a fee of 2% of sales turnover for this service. The factoring service is also expected to eliminate bad debts and will lead to credit administration savings of £130,000. The settlement period for trade debtors will be reduced to an average of 40 days, which is equivalent to that of its major competitors.
The company currently has an overdraft of £5.2 million at an interest rate of 14% per annum. The bank has written recently to the company stating that it would like to see a reduction in the overdraft of the company.
Required:
(a) Calculate for each proposal the net annual cost (savings) to the company of changing its existing credit policies and
either(i) adopting the proposals of the credit control department
or(ii) factoring the debts of the company
(b) Explain which of the two proposals (if either) you would support and why