Question

You own an automobile parts company and have been approached by a leading car manufacturer to supply parts to the company. How would you determine that the car manufacturer has a good record of servicing sales and paying its suppliers? What are the signs you would look out for in the financial statements for the possibility of bad debts? What are the advantages and disadvantages of allowing customers to make purchases on credit?

Can i get a detailed response please?

Answer 1

To determine the car manufacturer’s record of servicing sales and paying its suppliers you should determine the company’s accounts payable turnover ratio. This ratio = Total purchases/average accounts payable. This ratio will enable the automobile parts company to determine the car manufacturer’s ability to pay off its accounts payable and will help to determine how many times it pays off its average accounts payable during the course of the year. The higher the ratio the higher is the payment frequency.

For the possibility of bad debts the signs that should be looked out for in financial statements should start with the cash flow statement. In the cash flow statement see the cash flow in terms of payment to all associated partners and vendors. The cash flow statement will give you a good picture of the company’s ability to pay interest and principal payments. You should also look into balance sheet and ensure that the company does not have a very high inventory balance and its payables are also not too high. Ability to service payments can be determined using times interest earned ratio.

The advantages of allowing customers to make purchases on credit are:

• Increased level of sales
• Increased level of business stability
• Better competitive strength in the market

The disadvantages of allowing customers to make purchases on credit are:

• Possibility of missed payments and bad debts
• Need to allocate time and resources later for payment collection efforts
• Slowing the company’s cash flow due to increased level of credit