CASE STUDY

In March 2018, Darren Sammy the CFO of Quality Foods Ltd., was reviewing the company's credit policy. He was concerned about the increased cost of carrying the company's accounts receivable. The prime interest rate had recently increased to an all-time high of 16 percent. He noticed that the company's receivables' collections had become slower, resulting in a need to increase its short term borrowings.

Quality Foods Ltd. manufactured a diverse line of foods like biscuits, pasta and cakes. Its product lines were marketed through an established distribution system of 2,400 supermarkets and general stores located throughout Punjab and KPK. Its headquarters and manufacturing facilities were located in Hatter with sales offices in Islamabad, Lahore and Peshawar. The company's sales in 2017 were approximately Rs.150 million. Its annual sales growth of 8 percent was consistent with industry's average and considered as good by its shareholders and creditors.

The company offered credit terms of "net 30" to its customers, a common practice in the industry. Even though many of its customers were small, thinly capitalized general stores, Quality Foods Ltd.'s credit standards and collection policies were somewhat liberal. Nonetheless, its average collection period had historically been about 40 days and its bad debt losses were low, averaging 2 percent of annual sales.

During the past year, there had been a significant slowdown in the company's receivables' collections. The average collection period had increased to 60 days. A recent aging of the company's receivables is shown in Table 1. Because of this trend, as well as the high cost of carrying receivables, Sammy was reviewing the company's credit policy and wondering about ways to reduce the firm's investment in receivables. Two principal options were to bring down the receivables through rigidly enforcing the 30 days credit terms and to offer cash discount for early payments. He recognized that the management of accounts receivable involved a trade-off between costs and benefits. Changes in credit policy should be made only when the marginal returns of doing so would exceed the related marginal costs.

He decided to first evaluate the effects of offering a cash discount for payment within a 10-day discount period. He was unsure of the most appropriate discount percentage; however, 2 percent discount for settlement within 10 days of the invoice was an industry practice. He was also unsure of the number of customers that would take advantage of the discount. Given the nature of the company's customers, he did not believe that more than 40 percent would be able to take advantage of the discount. He decided to assume that the remaining customers would continue to stretch their trade credit. Thus, the average collection period from these customers would continue at the current level of 60 days' sales. He did not believe that this change in credit terms would have a noticeable effect on the company's sales, or bad debts. He then considered the consequences of strict enforcement of credit terms. While he believed that this could be done by incurring an administrative cost of Rs. 20,000 per month, the company's marketing manager, Jabbar Khan, felt that this will reduce the company's sales by as much as 20% as customers will shift to other suppliers. A success of credit enforcement policy will bring down the debtors to within 35 days' sales and bad debts to 1.2% of sales.

Jabbar Khan proposed an alternative to the situation. He believed that by relaxing the credit terms to 90 days, he could increase his sales by 20%. He admitted that this would have the impact of increasing bad debts to around 3% of sales. There was a possibility that around 10% of customers will continue to pay within 30 days and the rest will shift to 90 days terms.

Quality Foods Ltd.'s variable expenses, including direct labor, materials, supplies, packaging, freight, and sales commissions, were approximately 75 percent of sales. The company's other expenses, including indirect labor, overhead, salaries, rent, depreciation, property taxes, and insurance, were expected to remain fixed during the foreseeable future. The company's short term borrowing requirements were met through a secured line of credit with its local bank. The interest rate charged on borrowing under the line of credit floated with the KIBOR (Karachi Inter-bank Offered Rate). The company was charged prime plus 2 percent. The KIBOR was forecast to be 12 percent during the next 12 months. Almost all of the company's sales were on credit. Total sales during the next twelve months were forecast to be Rs.160 million.