Question

Case 2: Credit Policy Management Case Luvly Jubbly Inc., is a wholesaler of merchandise with a British flavour. The merchandise is distributed to Canadian retailers in all provinces. Due to the rise in popularity in Canada of British television shows such as Downton Abbey and Sherlock, the company’s sales have grown by an average of 15% per year over the last five years. The company’s sales are expected to grow by a more modest 10% next year, with all costs and expenses growing proportionately with sales. The company was started 10 years ago by Camilla and Phillip Samuelson, who emigrated from Sweden to Canada 15 years ago. Camilla and Phillip and their three daughters are huge fans of all things British. Before they started the company, they were avid collectors of British memorabilia, particular those for the long-running British soap, East Enders. After one particularly unsettling disagreement with an online retailer of British memorabilia (concerning a misprint on a mug that said “West Enders rule!”), Camilla and Phillip decided to combine their business acumen with their love of British memorabilia and started their company. With profits from the business, they were able to put all three daughters through university. One of their daughters, Margaret, now works for them as their office manager. Margaret is responsible for sending out invoices and bills, checking on when these invoices and bills come due, and calling customers if bills are still unpaid 60 days after sale. Even with the recent growth in sales, the Samuelsons have noticed a steady decline in their quarterly net profit in the last two years. They think that this may be due to their current policy of giving trade credits. When they first started 10 years ago, to attract customers to their new business they set their credit policy to net 50, which was more generous than the wholesale industry average of net 30. Since then, the company has built up a steady customer base, but has retained the net 50 credit policy. Unfortunately, the rising popularity of British shows and their associated memorabilia in Canada has enticed more companies into the business, including mega-companies such as Walmart. In the midst of this increased competition, a severe financial crisis hit the world market two years ago, forcing some of Luvly Jubbly’s customers to reduce their orders and forcing a few into bankruptcy. As a result, bad debt increased to about 2% during the last two years. The upcoming year is the first year that bad debt is forecasted to drop back down to its historical level of 1%. Under the current net 50 policy, 85% of customers pay by Day 50, and the remainder pay 10 days later. With the delays in collecting from customers, the Samuelsons have had to use the company’s line of credit to pay its expenses. Their bank, the United Bank of Canada, sets both short-term and long-term debt interest rates for the company at 15%. At this point, considering the company’s lowered net profit, Camilla and Phillip are finally ready to take a deeper look at their credit policy, and if necessary, to change it. They asked their second daughter, Diana (who has an MBA degree), to take a look at their books. After completing her analysis, Diana gave them two possible alternatives for their credit policy, with suggested outcomes: Alternative #1: 2/20 net 30 • Lose 5% sales • 50% of customers will pay at Day 20 • 40% of customers will pay at Day 30 • 10% of customers will pay at Day 60 • Cash, inventory, fixed assets, accounts payable, long-term debt, and equity will remain unchanged Alternative #2: 2/25 net 45 • No lost sales • 60% of customers will pay at Day 25 • 35% of customers will pay at Day 45 • 5% customers will pay at Day 60 • Cash, inventory, fixed assets, accounts payable, long-term debt, and equity will remain unchanged Industry average: 2/20 net 30 • Average collection period = 28 days • Net profit margin = 5% • Return on assets = 5.2% • Return on equity = 13% The company’s most recent statement of comprehensive income and statement of financial position are presented below. The Samuelsons will have to make a decision on the company’s credit policy based on the available information. Statement of Comprehensive Income Sales $500,000 Cost of goods sold 300,000 Gross profit $200,000 Operating expenses 100,000 Earnings before interest and taxes $100,000 Interest expense 35,332 Earnings before taxes $64,668 Income taxes (35%) 22,634 Net income $42,034 Statement of Financial Position Cash 10,000 Accounts payable $15,000 Accounts receivable 70,548 Notes payable 35,548 Inventory 20,000 Current liabilities $50,548 Current assets $100,548 Long-term debt 200,000 Fixed assets 500,000 Equity $350,000 Total assets $600,548 Total liabilities & equity $600,548 Questions: 1. What are the three components of a credit policy? Does the company’s current credit policy satisfy these three components? (8 marks) 2. What are the effective annual costs for the two proposed credit policy alternatives? If the average borrowing rate for the company’s customers is 15%, will these credit policies be attractive to these customers? (12 marks) 3. Construct aging schedules for the current credit policy and the two proposed new credit policies. (26 marks) 4. Construct the Pro-forma Statement of Comprehensive Income and Statement of Financial Position based on the current credit policy and the two proposed credit policies. (20 marks) 5. Calculate the average collection period, net profit margin, return on assets, and return on equity for both the current and the proposed policies. (18 marks) 6. How does the company compare with the industry average in terms of its average collection period, profitability, and returns on assets and equity under the current and proposed policies? (10 marks) 7. Which credit policy should the Samuelsons choose? Provide reasons for your recommendation. (6 marks)

Answer 1

The three components of Credit Policy are -----

1. Terms of Sale ---- This covers the Credit period, Discount for prompt payments, Payment conditions if any, payment schemes, applicable interest rate for delayed payments etc.
2. Credit Analysis ---- This covers vetting the customers’ credit-worthiness, documentation and procedure requirements, credit amount determination based on customer history etc.
3. Collection Policy ---- This would include follow-up mechanism. Actions in case of default, legal measures et

In its current shape and form, as stated in the question the credit policy lacks whole or part of thes components ---

1. Terms of Sale --- Only the Credit period is stipulated. No provisions are there for discounting early payments or penalising late ones.
2. Credit Analysis --- From what Margaret does (a standard billing), there seems not to be a valid credit analysis in place. No assessment of worthiness; no value-ceilings being applied; no credit/payment history is being checked.
3. Collection Policy ----- Margaret does call if Invoices are not paid for 60 days. But then, no policy exists with regard to the course of action if the call fails to elicit the payment.