The finance director of Stenigot is concerned about the lax management of the company's trade receivables. Stenigot's trade terms require settlement within 30 days, but its customers take an average of 60 days to pay their bills. In addition, out of total credit sales of £20m per year, the company suffers bad debts of £200,000 per year. Stenigot finances working capital needs with an overdraft at a rate of 8 per cent per year. The finance director is reviewing two options:
Option 1: offering a discount of 1 per cent for payment within 30 days. It is expected that 35 per cent of customers will take the discount, while the average time taken to pay by the remaining customers will remain unchanged. As a result of the policy change, bad debts would fall by £60,000 per year and administration costs would fall by £20,000 per year.
Option 2: Stenigot's debt administration and credit control could be taken over by a factoring company. The annual fee charged by the factor would be 1.75 per cent of sales. Stenigot would gain administration cost savings of £160,000 per year and an 80 per cent reduction in bad debts. The factor would reduce Stenigot's average trade receivables days to 30 days and would advance 80 per cent of invoices at an interest rate of 12 per cent.
(a) Calculate the benefit, if any, to Stenigot of the two suggested options and, in light of your findings, recommend an appropriate course of action to the finance director.
(b) Critically discuss whether it is possible for a company to optimise its working capital position. Your answer should include a discussion of the following matters:
(i) The risk of insolvency;
(ii) The return on assets;
(iii) The level, mix and financing of current assets.