Question
Credit Managment Luvly Jubbly Inc. - wholesaler of merchandise with a British flavour. The merchandise is distributed to Canadian retailers in all provinces. Due to
Credit Managment
Luvly Jubbly Inc. - 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 the company's sales have grown by about 15% per year over the last five years.
The company's sales are expected to grow by 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. Before they started the company, they were avid collectors of British memorabilia, particular those for the long-running British soap, East Enders.
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.
A severe financial crisis hit the world market two years ago, forcing some of Luvly Jubbly's 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 company's 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%.
Considering the company's 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 company's most recent statement of comprehensive income and statement of financial position are presented below.
The Samuelsons will have to make a decision on the company's 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 company's current credit policy satisfy these three components?
2.What are the effective annual costs for the two proposed credit policy alternatives? Ifthe average borrowing rate for the company's customers is 15%, will these credit policies be attractive to these customers?
3.Construct aging schedules for the current credit policy and the two proposed new credit policies.
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.
5.Calculate the average collection period, net profit margin, return on assets, and return on equity for both the current and the proposed policies.
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?
7.Which credit policy should the Samuelsons choose? Provide reasons for your recommendation.
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