Analysis of Credit Days

Question:

Explain calculation of ratios.
 

Average debtor days is the number of days taken by a company to recover its dues from its creditors. It will be given by the formulae (365 Days*Average Receivables)/ Credit sales.(Gibson, 2012) Since given from the statement of financial performance and the ledger, average receivables are 362,500 and also given that credit sales during the year were 1,450,000. Hence Average debtor days would be 91.25. What it implies is that Big Red Bicycle collects its receivables once every 3 months or 4 times in a year. Average debtor days gives an indication as to how efficiently a company is realising its payments, they wouldn’t want to have too liberal a policy for extending credit as it affects the working capital capital requirements consequently increasing the need of capital and thereby increasing the costs of financing.

Credit days is the number of days taken by a company to pay its dues owed to suppliers and vendors. Like the average debtor days given by the formulae (365 Days*Average Payables)/Cost of sales. Given from the statement of financial performance, average payables are 80,000 and cost of sales were 380,000. Therefore, average credit days were 77.This implies that Big red bicycle were paying their receivables once every 77 days. Usually a difference in credit days and debtor days indicates that the company would be employing more working capital. However that can be industry specific depending on the nature of product or service that a company is offering.

Creditor days is a good indicator as to how well a company is making use of credit available to it. It wouldn’t want to have a number less than the industry as it would mean that the company is missing out on the use of debt free funds and neither would it want to have a number much above the industry average because it could lead to loss in trade discounts and loss of market credibility.

Average stock turnover is given by average inventory or stocks maintained during the year divided by net sales during the period. (Raoa & Rao, 2009)Average stock would be given by the average of opening and closing stock. The opening stock is 100,000 and closing stock is 300,000 as given from the statement of financial position. Hence the average inventory is 200,000. The sales are 2,900,000. Hence the average stock turnover would be 14.5. This means that the company does sales which is 14.5 times its inventory.

Currently the company is making 50% of its sales in credits which is an extremely high percentage. The company should strive to reduce its dependence in credit sales as it affects its cash flow and liquidity ratios. Also the amount of credit it extends is lower than the extend of credit it enjoys from its suppliers which increases the net working capital requirement and consequently the financing costs impacting rhe overall profitability.The company should seek to achieve parity between the two to ensure better cash flows and better liquidity positions. Current ratio is the ratio between current assets to current liabilities and should the current liabilities exceed current assets it becomes a problematic scenario for the company. In fact current ratio should be comfortably above 1 to ensure that operating expenses are taken care of and financing expenses are also met. At the current policy of extending credit to debtors the company is subjecting itself to severe cash crunch which might hamper its operating efficiency.

Analysis of Stock Turnover

Second recommendation would be to penalize the employees on credit sales and reward the employees for cash sales. To increase the cash flow and ensure smoother operations they can have differential commission systems for credit sales and cash sales without increasing the expenses incurred on the commission. As now the company employs a 5% flat commission rate on sales they can change it to 3.5% for credit sales and 6% for cash sales assuming that this added incentive would result in atleast 25% of more sales happening through cash. The net result would be more cash sales, alebit at the same expenditures on commissions. Since the staff are not trained on credit terms they would initially require some training but they would have to be encouraged to push more cash sales and if they are provided with an incentive of more commissions they would have added reasons to push for cash sales.

The three sources of information used for the analysis and to arrive at the recommendation are: scenario information, statement of financial information and ageing debtors budget. 

i)The manufacturing capacity is 8000 units and as given we will assume that the company sells all its units. Since selling price per bicycle is $500. Total Revenues will be 4,000,000 dollars obtained by multiplying the quantity sold with the selling price of one bicycle. Now variable costs are 2 million as given variable cost per unit is $250 and fixed costs are 1,280,000. Hence profit on 8000 bicycles will be 720,000. Now the marginal profit on sale of 1 bicycle from this point onwards is $250. Hence for 280,000 of additional profit more 1120 bikes will have to be sold. Hence total 9120 bicycles have to be sold for a profit of 1 million dollars

ii)Total maximum revenues at current level of manufacturing would be 4 million dollars and the fixed costs are 1.28 million dollars. To ensure a profit of 1 million on sale of 8000 bikes the remaining cost of 1.72 million would have to be allocated to the variable expenses. Hence variable cost incurred on per bicycle would 215 dollars should the company want to make a pre-tax profit of 1 million at current manufacturing levels.

Since the negotiations with suppliers is going to be difficult it will be really difficult to achieve the second scenario of achieving a pre-tax profit of 1 million dollars at the current manufacturing level. It is also given that the company Big Red Bicycles have an option to shift operations to India where they can manufacture 10,000 units. Since it is also given that they will be able to sell everything they manufacture the should explore the option to shift their operations to India instead of Indonesia as it gives them an opportunity to maximise their profits. Should they be able to manufacture and sell 10000 bicycles it would result in revenues of 5 million dollars and pre-tax profits of 1.22 million dollars after accounting for the variable and fixed costs from overseas operations. Shifting overseas also gives them an option to cut down on their waste disposal expenses which stood at 60,000 for the year 2012. Not only will they save the money on waste removal but the utilization of these parts will also cut their variable costs thereby increasing their profitability. Should they chose to resort to this option they would also save on the warehousing costs since the warehousing costs of the currently leased premises is quite expensive.

However the potential risks from outsourcing cannot be ignored. Though the benefits from outsourcing are obvious there is significant literature which describes the risks associated with outsourcing. (Kremic, et al., 2011) Hence it is critical for Big Red Bicycle to evalauate the risks at various levels before making the outsourcing decision.

The three sources of information used for the analysis are: Scenario Information, Statement of Financial Performance and ledger accounts.

Generally, for tax purposes, you must keep your records in an accessible form (either printed or electronic) for five years. (ATO, 2016)

The table below gives the cash receipts of BRB for the last 3 months.

July	August	September
20,000	10,000	10,000

The table below gives the cash payments made by BRB

July	August	September
4300	5200	5250

The table below gives the credit purchases on which GST were incurred

July	August	September
29300	30500	30250

The table below gives the credit sales on which GST were incurred

July	August	September
180000	204300	150000

Hence to arrive at the total GST liability the total cash payments would be subtracted from total cash sales. Total credit purchases would be subtracted from total credit sales. Hence the table below gives the total GST liability for Big Red Bicycle.

July	August	September
166,400	189,600	124,500

Making an action plan is the process wherein planning what needs to be done, when it needs to be node and by whom it needs to be done along with the resurces or inputs nesecarry for it are put into a document in a specific format.It is also the process of stream lining a companies objectives which it strives to achieve. It is a part of a companies planning process. (Shaviro, 2010)We will implement the action plan for the recommendation to decrease BRB’s credit sales and improve their credit sales. The person responsible would be Sam Geller, the sales general manager and Holly Burke, the HR manager. The activities undertaken by Sam Geller would be to make the sales team aware of the credit policies and ensure that credit is not extended beyond the 30-day limit. Holly Burke would come into the picture as she has to make sure that the staff is trained and made aware of the company’s credit policy and that they don’t become too liberal about it like they have been in the past. Right now the company has a very poor average collection period of 92 days which is making their liquidity positions highly vulnerable and exposing them to a lot of financial risks. Apart from that to make sure that more and more cash sales are made. It would require constant monitoring and the first deadline should be the first month of the first quarter to monitor whether receivables arising from credit sales of last month have been realised. Hence we lay down the action plan.

Action Step	Responsible person	Deadline	Potential Challenges
To decrease the credit sales and improve the average collection period	Sales Manager	1st month ending Q1	Might lead to dissatisfaction among some regular customers who are used to the long credit cycles
To train the sales team about company’s credit policies	HR manager	1st quarter ending	Might be a time taking initiative and may also incur some training costs
To submit a prosposal to the bank to raise money through debt.	John Black,CFO	2nd quarter	The liquidity ratios would have to be improved before the banks extend credit.

References

ATO, 2016. GST.

Gibson, C. H., 2012. Financial Reporting and Analysis. s.l.:Cengage Learning.

Raoa, C. M. & Rao, K. P., 2009. INVENTORY TURNOVER RATIO AS A SUPPLY CHAIN PERFORMANCE MEAUSRE. Serbian Journal of Management, pp. 41-50.