Working Capital Management:Extending Credit Terms To Increase Sales

It is very normal for students of financial management being asked question on the effect of extending credit terms to increase sales.

Append below is a simple illustration for a better understanding of investment in receivables or extension of credit terms:

Illustration:

Company ABC Ltd has a current sales of \$2.6 million. It wants to increase its sales by relaxing its credit policy. The current credit term is 45 days and the proposed terms of credit is 60 days. However the company believes that bad debts will increase from 1.5% to 2% of sales and sales should increase by 10%. The variable operating costs are 72% of the sales. The corporate tax rate is 35% and that the company requires an after-tax return of 15% on its investment.

Question:

Should Company ABC Ltd extend its credit policy from 45 days to 60 days?

Suggested Solution

 \$ \$ Sales Increase (10 % of \$2.6m) 260,000 Contribution margin (100-72%=28%) 72,800 Less: Bad debts 1.5% x\$2.6m 39,000 2.0% x(\$2.6×1.1=\$2.86m) 58,000 Incremental bad debts (19,000) Operating profit before tax 53,800 Operating profit after tax 34,970 Increase in receivables investment =(New sales/360 days x 60 days) deduct (Old sales/360 days x 45 days) \$476,660-\$325,000 151,660 Expected rate of return =Operating profits after tax/Increase in receivables investment 34,970/151,660 =23.06% Less: Original rate of return 15% Incremental rate of return 8.06%

Yes, it is to the advantage of Company ABC Ltd to extend its credit policy as it achieve a higher rate of return of 8.06%

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