International Electric Ltd. at present offers its customers 30 days' credit. Half the customers, by value, pay on time. The other half take an average of 70 days to pay. The business is considering offering a cash discount of 2% to its customers for payment within 30 days.
The credit manager anticipates that half of the customers who now take an average of 70 days to pay (i.e., one-quarter of all customers) will pay in 30 days. The other half (the final quarter) will still take an average of 70 days to pay. The plan will also reduce bad debts by $300,000 a year.
Annual sales revenue of $365 million is made evenly throughout the year. At present, the business has a large overdraft ($60 million) with its bank at 12% a year.
Required:
(a) Calculate the approximate equivalent annual percentage cost of a discount of 2%, which reduces the time taken by customers to pay from 70 days to 30 days. (Hint: This part can be answered without reference to the narrative above.)
(b) Calculate accounts receivable outstanding under both the old and new plans.
(c) How much will the plan cost the business in discounts?
(d) Should the business go ahead with the plan? State what other factors, if any, should be taken into account.
(e) Outline the controls and procedures that a business should adopt to manage the level of its receivables.