Case 3: 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)