M/s Bhola Guru Pvt. Ltd. is a small-size unlisted company, presently experiencing liquidity problems. The directors, keen on overcoming the difficulty by improving collections, etc., are exploring two alternatives. (i) A

CS Professional · Capital Commodity and Money Market · PYQS · December 2020
M/s Bhola Guru Pvt. Ltd. is a small-size unlisted company, presently experiencing liquidity problems. The directors, keen on overcoming the difficulty by improving collections, etc., are exploring two alternatives. (i) Approximately 70% of annual sales are on credit basis. Normal credit period is 60 days, but many customers exceed this limit, and year end debtors are a true indicator. A scheme of 1.5% discount for payment in 10 days is proposed to be offered. The Company expects that at least half of credit customers would avail of this discount, and bad debts will also fall by 50%. Assume 365 days a year. (ii) Engage a debt factoring company. The factor will extend finance up to 90% of debts arising from credit sales; charge a fee of 2% on total annual credit sales. The factor will also levy finance charges of 11%. With this arrangement administration costs are expected to come down by ₹70,000. Bank overdraft rate for company is 10%. Additional financial information is as follows: Forecast for next year in '000 Sales 4850 Cost of Sales 2862 Bad Debts 48 PAT 325 Stock 455 Trade Debtors 846 Trade Creditors 550 Bank Overdraft 565 Equity Holders Fund 1575 Directors Loans 450 Evaluate each of the two alternatives, and select the best alternative for the company.

Answer & Explanation:

Answer 2(a) Alternate I - Early Payment Discount Particulars (in 000s) Annual Sales 4850.00 Credit Sales (70% of Annual Sales) 3395.00 Year end Debtors 846.00 Year end debtors represent (846 x 365 / 3395) 91 days 50% of debtors value (846 * 0.50) 423.00 Credit Period of each debtors 91 days Discount to be allowed at 1.5% of 423 6.345 Annual Collection from such debtors (423 - 6.345) 416.655 Reduction in Credit Period (91 days - 10 days) 81 days Reduction in Overdraft (416.655 / 365) * 81 92.40 Reduction in Overdraft interest at 10% (A) 9.24 Add reduction in bad debts (50% of 48) (B) 24.00 Total Benefit (A+B) 33.24 Cost by way of 1.5% discount on debtors value at 50% of ₹ 3395 (y) 6.345 Net benefit (x-y) (i.e. 33.24 - 6.345) 26.895 Note: The provided solution has some calculation discrepancies. I have re-calculated based on the problem statement. The original solution's calculation for '50% of debtors value' and subsequent steps seem to be based on a different interpretation or calculation. I've used 50% of the year-end debtors (846) for the discount calculation, and the reduction in overdraft is based on the annual collection from those debtors. Alternate II - Factoring Particulars (in 000s) (in 000s) Annual Sales 4850.00 Credit Sales (70%) 3395.00 Year-end debtors 846.00 90% of year end debtors, taken as indicator (846 * 0.90) 761.40 Saving at Overdraft Interest of 10% (761.40 * 0.10) 76.14 Saving in Administration costs 70.00 146.14 Service Charges 2% of 3395 (3395 * 0.02) (67.90) Interest Costs (11% on 761.40) (761.40 * 0.11) (83.75) (151.65) Net Cost (146.14 - 151.65) (5.51) Conclusion: Of the two alternatives, the first alternative, i.e. to offer a cash discount seems to be the ideal choice, as it maximizes the value of the entity to equity holder (Net benefit of ₹26.895 thousand vs Net Cost of ₹5.51 thousand for factoring).

Topics: Working Capital Management

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