Case 2: Credit Policy Management Case Luvly Jubbly Inc., is a wholesaler of merchandise with a British flavour. The merchandise is distributed to Canadian retailers in all provinces. Due to the rise in popularity in Canada of British television shows such as Downton Abbey and Sherlock, the companys sales have grown by an average of 15% per year over the last five years. The companys sales are expected to grow by a more modest 10% next year, with all costs and expenses growing proportionately with sales. The company was started 10 years ago by Camilla and Phillip Samuelson, who emigrated from Sweden to Canada 15 years ago. Camilla and Phillip and their three daughters are huge fans of all things British. Before they started the company, they were avid collectors of British memorabilia, particular those for the long-running British soap, East Enders. After one particularly unsettling disagreement with an online retailer of British memorabilia (concerning a misprint on a mug that said West Enders rule!), Camilla and Phillip decided to combine their business acumen with their love of British memorabilia and started their company. With profits from the business, they were able to put all three daughters through university. One of their daughters, Margaret, now works for them as their office manager. Margaret is responsible for sending out invoices and bills, checking on when these invoices and bills come due, and calling customers if bills are still unpaid 60 days after sale. Even with the recent growth in sales, the Samuelsons have noticed a steady decline in their quarterly net profit in the last two years. They think that this may be due to their current policy of giving trade credits. When they first started 10 years ago, to attract customers to their new business they set their credit policy to net 50, which was more generous than the wholesale industry average of net 30. Since then, the company has built up a steady customer base, but has retained the net 50 credit policy. Unfortunately, the rising popularity of British shows and their associated memorabilia in Canada has enticed more companies into the business, including mega-companies such as Walmart. In the midst of this increased competition, a severe financial crisis hit the world market two years ago, forcing some of Luvly Jubblys customers to reduce their orders and forcing a few into bankruptcy. As a result, bad debt increased to about 2% during the last two years. The upcoming year is the first year that bad debt is forecasted to drop back down to its historical level of 1%. Under the current net 50 policy, 85% of customers pay by Day 50, and the remainder pay 10 days later. With the delays in collecting from customers, the Samuelsons have had to use the companys line of credit to pay its expenses. Their bank, the United Bank of Canada, sets both short-term and long-term debt interest rates for the company at 15%. At this point, considering the companys lowered net profit, Camilla and Phillip are finally ready to take a deeper look at their credit policy, and if necessary, to change it. They asked their second daughter, Diana (who has an MBA degree), to take a look at their books. After completing her analysis, Diana gave them two possible alternatives for their credit policy, with suggested outcomes: Alternative #1: 2/20 net 30 Lose 5% sales 50% of customers will pay at Day 20 40% of customers will pay at Day 30 10% of customers will pay at Day 60 Cash, inventory, fixed assets, accounts payable, long-term debt, and equity will remain unchanged Alternative #2: 2/25 net 45 No lost sales 60% of customers will pay at Day 25 35% of customers will pay at Day 45 5% customers will pay at Day 60 Cash, inventory, fixed assets, accounts payable, long-term debt, and equity will remain unchanged Industry average: 2/20 net 30 Average collection period = 28 days Net profit margin = 5% Return on assets = 5.2% Return on equity = 13% The companys most recent statement of comprehensive income and statement of financial position are presented below. The Samuelsons will have to make a decision on the companys credit policy based on the available information. Statement of Comprehensive Income Sales $500,000 Cost of goods sold 300,000 Gross profit $200,000 Operating expenses 100,000 Earnings before interest and taxes $100,000 Interest expense 35,332 Earnings before taxes $64,668 Income taxes (35%) 22,634 Net income $42,034 Statement of Financial Position Cash 10,000 Accounts payable $15,000 Accounts receivable 70,548 Notes payable 35,548 Inventory 20,000 Current liabilities $50,548 Current assets $100,548 Long-term debt 200,000 Fixed assets 500,000 Equity $350,000 Total assets $600,548 Total liabilities & equity $600,548 Questions: 1. What are the three components of a credit policy? Does the companys current credit policy satisfy these three components? (8 marks) 2. What are the effective annual costs for the two proposed credit policy alternatives? If the average borrowing rate for the companys customers is 15%, will these credit policies be attractive to these customers? (12 marks) 3. Construct aging schedules for the current credit policy and the two proposed new credit policies. (26 marks) 4. Construct the Pro-forma Statement of Comprehensive Income and Statement of Financial Position based on the current credit policy and the two proposed credit policies. (20 marks) 5. Calculate the average collection period, net profit margin, return on assets, and return on equity for both the current and the proposed policies. (18 marks) 6. How does the company compare with the industry average in terms of its average collection period, profitability, and returns on assets and equity under the current and proposed policies? (10 marks) 7. Which credit policy should the Samuelsons choose? Provide reasons for your recommendation. (6 marks)