HOW TO COMPUTE THE FINANCIAL VIABILITY/IMPACT OF A FIRM WHEN THERE IS AN INCREASE IN ACCOUNTS RECEIVABLE. 

Step: 

(1) Compute the additional profit from the increase in sales from the extension of credit terms to its customers

(2) Compute the cost of additional investment in accounts receivable

(3) Compute the cost of additional bad debts.

(4) Finally, sum up step (1) to step (3) to see whether there is a net gain to the firm

· Additional profit from in increase in sales minus(-)

· additional cost of additional investment in accounts receivable +

· Additional cost of additional bad debts

SIMPLE ILLUSTRATION 

Company XYZ has a yearly sale volume of $12 million. The cost of goods is 80% of annual sales. Top management wants to increase sales by 10% by extending its credit terms from 30 days to 45 days. Bad debts is estimated to increase from 1% to 2% of yearly sales.

Company XYZ’s cost of tying up funds in accounts receivable is 10%.

 Required:

 Should Company XYZ relax or extend its credit terms from 30 to 45 days? 

Suggested Solution:

Step 1: Compute the additional profit from increase in sales

· Additional sales =($12 million x 10%) =$1.2 million

· Assuming there is no increase in fixed costs, profit/contribution from additional sales =$1.2 million x 20% =$240,000

    Step 2: Compute the additional cost of additional investment in accounts receivables

· Original investment in accounts receivable

· 30/360 x $12 million=$1 million

· 45/360 x $12 x 1.1 = $1.65 million

· Additional investment of accounts receivable =$1.65m -$1.0 m = $650,000

· Cost = 10%(cost of fund) x $650,000 =$65,00

Step 3: Compute additional cost of bad debts ( 1% to 2% of sales)

·  (2% x$12m x1.1=$264,000)-(1% x$12m=$120,000) =$144,000

 The result of the relaxation or extension of its credit period from 30 days to 45 days:

· $240,000-($65,000+$144,000) =$31,000 net gain