Chapter 4 Receivable Management

Answer Key

I. TRUE OR FALSE STATEMENTS Black is true and Red is false.

1. Holding all other variables constant, as accounts receivable increases, the cash conversion cycle decreases.
2. Accounts receivable variables under control of the financial manager include level of credit sales, terms of
credit sales, and quality of credit customers.
3. If upon examination of a firm’s existing credit policy it is discovered that bad debt losses have increased
for certain credit groups, it does not follow that extension of credit to those groups should be withheld.
4. An aging of accounts receivable measures the amount of receivables that have been outstanding for given
lengths of time.
5. An increase in sales resulting from an increased cash discount for prompt payment would be expected to
cause an increase in the average collection period.
6. When a company analyzes credit applicants and increases the quality of the accounts rejected, the company
is attempting to maximize sales.
7. Other things held constant, the higher a firm’s days sales outstanding (DSO), the better its credit
department.
8. If a firm sells on terms of 2/10, net/30 and its DSO is 30 days, then the firm probably has some past due
accounts.
9. If a firm that sells on terms of net/30 changes its policy to 2/10, net/30, and if no change in sales volume
occurs, then the firm’s DSO will probably increase.
10. If a firm sells on terms of net/60 and its sales are highly seasonal, with a sharp peak in December, then its
DSO as it is typically calculated (with sales per day = sales for past 12 months/365) would probably be
lower in January than in July.

II. MULTIPLE CHOICE QUESTIONS

Encircle the letter that corresponds to the best answer of the following statements.

1. The primary objective in the management of accounts receivable is to

a. realize no bad debts because of the opportunity cost involved.
b. provide the treasurer of the corporation with sufficient cash to pay the company’s bills on time.
c. coordinate the activities of the manufacturing marketing and financing so that the corporation can
maximize its profits.
d. achieve that combination of sales volume, bad debt experience, and receivables turnover that
maximizes the profits of the corporation.

2. At any point in time, the level of the accounts receivable on a corporate statement of financial position is
least affected by which of the following factors?
a. tight money
b. credit standards of the seller
c. collection practices of the seller
d. length of the company’s production process

3. Ignoring cost and other effects on the firm, which of the following measures would tent to reduce the cash
conversion cycle?
a. Take discounts when offered.
b. Forgo discounts that are currently being taken.
c. Maintain the level of receivables as sales decrease.
d. Buy more raw materials to take advantage of price breaks.

4. An increase in a firm’s collection period means

a. The firm’s current ratio is increasing.
b. The firm’s collection expenses have fallen.
 c. The firm’s receivables turnover ratio is increasing.
d. The firm has become less efficient in the collection of its receivables

5. Changing a firm’s credit terms from 2/10, n/60 to 2/10, n/30 will generally
a. reduce the average collection period and reduce sales.
b. increase the average collection period and reduce sales.
c. reduce the average collection period and increase sales.
d. increase the average collection period and increase sales.

6. The collection of accounts receivable can be accelerated by the use of

a. bank drafts.
b. a lockbox system.
c. remittance advices.
d. turnaround documents.

7. An increase in sales resulting from an increased cash discount for prompt payment would be expected to
cause a(an)
a. increase in the operating cycle.
b. decrease in the cash conversion cycle.
c. increase in the average collection period.
d. decrease in the purchase discounts taken.

8. Which of the following represents methods for converting accounts receivable to cash?
a. Factoring, pledging and electronic funds transfer.
b. Trade discounts, collection agencies and credit approval.
c. Cash discounts, electronic funds transfers and credit approval.
d. Cash discounts, collection agencies and electronic funds transfers.

9. An organization would usually offer credit terms of 2/10, n/30 when

a. the cost of capital approaches the prime rate.
b. the organization can borrow funds at a rate less than the annual interest cost.
c. the organization can borrow funds at a rate exceeding the annual interest cost.
d. most competitors are offering the same terms, and the organization has a shortage of cash.

10. A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the
investment in accounts receivable and a decrease in the number of doubtful accounts. Based upon this
information, the company’s
a. working capital has increased.
b. average collection period has decreased.
c. percentage discount offered has decreased.
d. accounts receivable turnover has decreased.

11. The average collection period for a firm measures the number of days
a. before a typical account becomes delinquent.
b. for a typical check to clear through the banking system.
c. after a typical credit sale is made until the firm receives payment.
d. beyond the end of the credit period before a typical customer payment is received.

12. Which of the following would warrant the least amount of consideration in credit and collection policy
decisions?
a. credit period
b. cash discount given
c. quantity discount given
d. quality of accounts accepted
13. It is the process administering sales credit, enforcing credit and collection policies, and maintaining an
appropriate level of accounts receivable.
a. receivable turnover
b. receivable management
c. working capital management
d. none of the above

14. It indicates the number of times an average amount of receivables is collected during the period and the
efficiency of collection.
a. aging of receivables
b. average collection period
c. average accounts receivable
d. accounts receivable turnover

15. It is the average length of time required to convert a firm’s receivables into cash.
a. cash conversion cycle
b. receivables collection period
c. payables deferral period
d. days sales outstanding

III. MULTIPLE CHOICE PROBLEMS Encircle the letter that corresponds to the best answer.

1. Brew Ca has an average payment period of 30 days, an average age of inventory of 20 days, and a cash
conversion cycle of 30 days. What is Brew Ca’s average collection period?
a. 20 days
b. 40 days (30 + 30 – 20)
c. 80 days
d. None of the above

2. What is the effective annualized cost of foregoing the trade discount on terms 2/10 net 80 (round to the
nearest .1%)?
a. 9.0%
b. 10.5% (2/98 x 360/70)
c. 11.3%
d. 12.0%

3. What is the effective annualized cost of foregoing the trade discount with terms 2/15 net 70 (round to the
nearest .1%)?
a. 13.1%
b. 13.4% (2/98 x 360/55)
c. 14.3%
d. 14.7%

4. A company’s accounts receivable total ₱ 25,000 and the turnover rate is 15 times in one year. A turnover
rate of 10 times in one year is desired to increase sales by 20%. How much must be the increase or decrease
in the accounts receivable?
a. ₱45,000 increase
b. ₱45,000 decrease
c. ₱25,000 increase
d. None of the above

15 = Sales/P25,000
Sales = P375,000

New Sales – P375,000*1.20 = P450,000

 New AR = P450,000/10 = P45,000

Increase in AR = P45,000 – P25,000 = P20,000 D

Use the following information to answer the next 5 questions:

Assume that your firm is considering relaxing its current credit policy. Currently the firm has annual
sales, all credit, of P16 million and an average collection period of 30 days. The firm is considering a change in
credit terms from the current terms of net 30 to 1/30 net 60. The change is expected to generate additional sales
of P2 million. The firm has variable costs of 75% of the selling price. The information provided here, plus
additional information, is summarized in the table below.

New sales (all credit) P18,000,000

Original sales (all credit) P16,000,000
Contribution margin 25%
Percent bad debt losses on new sales 6%
New average collection period 45 days
Original average collection period 30 days
Additional inventory investment P50,000
Pre-tax required rate of return 15%
New percent cash discount 1%
Percent of customers taking the discount 50%

5. If the credit policy change is made, the change in bad debt losses will be:
a. P180,000
b. P160,000
c. P120,000 [(P18,000,000 – P16,000,000) x 6%]
d. P90,000

6. If the credit policy change is made, the change in profit will be:
a. P200,000
b. P380,000 (P2,000,000 x 25% - 120,000)
c. P400,000
d. P550,000

7. If the credit policy change is made, the additional investment in accounts receivable will be:
a. P733,333
b. P850,000
c. P916,667 [(P18,000,000 x 45/360) – P16,000,000 x 30/360)]
d. P1,067,333

8. If the credit policy change is made, the cost of the additional investment in accounts receivable and
inventory will be:
a. P145,000 [(P916,667 + P50,000) x 15%]
b. P137,500
c. P128,000
d. P114,500

9. If the credit policy change is made, the change in the cost of the cash discount will be:
a. P80,000
b. P90,000 (P18,000,000 x 50% x 1%)
c. P100,000
d. P110,000

10. If the credit policy change is made, the net effect (i.e., incremental revenues versus incremental costs) will
be:
 a. P375,000
b. P265,000
c. P145,000 (P500,000 – P120,000 – P145,000 – P90,000)
d. P 85,000

PROBLEMS

4.1
Stop and Chop has an inventory conversion period of 60 days, a receivable conversion period of 35
days, and a payment cycle of 26 days. Sales for the period just ended amounted to P972,000 while cost of sales
amounted to P1,260,000. Credit purchases amounted to P684,000. (Assume 360 days a year.)

Required:

1. How much is the investment in accounts receivable? P94,500 (P972,000 x 35/360)

2. How much is the cash conversion cycle? 69 days (60 + 35 – 26)

4.2
The Sales Director of Sweet Bites suggests that certain credit terms be modified. He estimates that sales
will increase by at least 20% and accounts receivable turnover will be reduced to 8 times from the present
turnover of 10 times. Bad debts, now at 1% of sales will increase to 1.5%. Sales before the proposed changes is
at P900,000. Variable cost ratio is 55% and desired rate of return is 20%. Fixed expenses amount to P150,000.

Required:
1. How much is the increase in profit from the sales? P81,000 (P900,000 x 20% x 45%)
2. How much is the cost of marginal investment in accounts receivable? P4,950
[(P1,080,000/8) – (P900,000/10)] x 55% x 20%
3. How much is the cost marginal bad debt? P7,200 [(P1,080,000 x 1.5%) – (P900,000 x 1%)]

4.3
Kisha Company has annual credit sales of P4 million. Its average collection period is 40 days and bad
debts are 5% of sales. The credit and collection manager is considering instituting a stricter collection policy,
whereby bad debts would be reduced to 2% of total sales, and the average collection period would fall to 30
days. However, sales would also fall by an estimated P500,000 annually. Variable costs are 60% of sales and
the cost of carrying receivables is 12%. (Assume 360 days a year)
Required:

1. How much is the decrease in profit from the sales? P200,000 (P500,000 x 40%)
2. How much is the savings from marginal investment in accounts receivable? P11,000
[(P4,000,000 x 40/360) – (P3,500,000 x 30/360)] x 60% x 12%
3. How much is the savings from marginal bad debt? P130,000 [(P4,000,000 x 5%) – (P3,500,000 x 2%)]

4.4
PhilArm, after computing the annualized cost of the credit terms is considering relaxing its credit
standards to encourage more sales. As a result, sales are expected to increase by 10% from the current 600 units
per year. The average collection period is expected to increase to 45 days from 30 days and bad debts are
expected to double the current 3% level. The selling price per unit is ₱1,500, the variable cost per canoe is ₱800.
The firm's required return on investment is 20%. (Assume a 300-day year)

Required:
1. How much is the firm's additional profit contribution from sales under the proposed relaxation of credit
standards? P42,000 [(P1,500 – P800) x (600 units x 10%)]
2. How much is the cost of marginal investments in accounts receivable under the proposed plan? P6,240
[(660 x 45/300) – (600 x 30/300)] x P800 x 20%
 3. How much is the cost of marginal bad debts under the proposed plan? P32,400
[(P1,500 x 660 x 6%) – (P1,500 x 600 x 3%)]

Current: Proposed:
Credit Sales 600 units 690 units
Ave Collection Period 30 days 45 days
Bad Debts 3% of sales 6% of sales

Required rate of return: 20.00%

Sales ₱1,500
Less: Variable Cost 800
Contribution Margin ₱700
Incremental sales (660 - 600) 60 units
Additional profit contribution from
₱42,000
sales/incremental profit margin

Total Variable Cost: Proposed ₱ 800

Multiplied by: Proposed units x 660 units ₱528,000
Divided by: AR Turnover - Proposed 300 / 45 6.66
Average investment in AR under proposed plan ₱79,200
Less: Average investment in AR under present plan
Total Variable Cost: Present ₱ 800
Multiplied by: Present units x 600 units ₱480,000
Divided by: Present AR Turnover 300 / 30 10 48,000
Marginal investment in accounts receivable ₱31,200
Multiplied by: Required return on investment x 20%
Cost of marginal investment in accounts receivable ₱6,240

Bad Debts under proposed plan 6% x ₱1,500 / unit x 660 units = ₱59,400
Bad Debts under present plan = 3% x ₱1,500 / unit x 600 units = 27,000
Cost of marginal bad debts ₱32,400

Additional profit ₱42,000

Less: Cost of marginal investment in AR 6,240
Less: Cost of marginal investment in Bad Debts 32,400
Net effect on profits ₱3,360

4.5
Chopstop company plans to tighten its credit policy. The projected sales for the coming year are P50M.
The new policy will decrease the average number of days in collection from 75 to 50 days and reduce the ratio
of credit sales to total revenue from 70% to 60%. The company estimates that the projected sales would be 5%
less if the proposed new credit policy were implemented. The firm’s short-term interest cost is 10%. (assume a
360-day year)

Required:

1. How much is the average accounts receivable for the coming year using the present/current credit
policy?
 2. How much is the average accounts receivable for the coming year using the proposed change in credit
policy?
3. How much would be the benefit (cost) of implementing this new policy on income before taxes?
Present/Current (P50M*70%*75/360) 7,291,667
Proposed (P50M*95%*60%*50/360) 3,958,333
Savings (P3,333,333*10%) 333,333
Cost - lost sales (P50M*5%) (2,500,000)
Net annual benefit (cost) (2,166,667)

4.6
GGEM offers branded designer prescription eyeglasses. All sales are currently on credit and with no
cash discount. The firm is considering a 2% cash discount for payment within 10 days. The firm's current
average collection period is 90 days, sales are 700 units per year, selling price is ₱25,000 per unit, variable cost
per unit is ₱18,750, and the average cost per unit is ₱21,000. The firm expects that the change in credit terms will
result in a minor increase in sales of 15 units per year, that 75% of the sales will take the discount, and the
average collection period will drop to 72 days. The firm's bad debt expense is expected to become negligible
under the proposed plan. The bad debt expense is currently 0.025% of sales. The firm's required return on equal-
risk investments is 20%. (Assume a 360-day year)

Required:

1. How much is the cost of the marginal cash discount?

2. How much is the net benefit (cost) of increasing the cash discount?

Unit sales expected from proposed plan 715

Expected percentage of sales that will avail of discount x 75%
Selling Price x ₱25,000
Proposed cash discount x 2%
Cost of cash discount ₱268,125

Incremental unit sales under the proposed plan 15 x 6,250 Units ₱93,750
Add: Cost savings from reduced investment in AR [(P2,681,250-3,281,250)*20%) 120,000
Add: Cost savings from marginal bad debts (700*P25,000*0,025%) 4,375
Less: Cost of cash discount 268,125
Net benefit (cost) of initiating a cash discount ₱(50,000)

4.7
DBA Company is considering changing its credit terms from 2/15, net 30 to 3/10, net 30 in order to
speed collections. At present, 40% of Sonata Company‘s customers take the 2% discount. Under the new term,
discount customers are expected to rise to 50%. Regardless of the credit terms, half of the customers who do
not take the discount are expected to pay on time, whereas the remainder will pay 10 days late. The change
does not involve a relaxation of credit standards; therefore bad debt losses are not expected to rise above their
present 2% level. However, the more generous cash discount terms are expected to increase sales from P2
million to P2.6 million per year. DBA’s variable cost ratio is 75%, the interest rate on funds invested in accounts
receivable is 9 %, and the firm’s income tax rate is 40%.

Required:

1. What is the days sales outstanding (DSO) before the change of credit policy? 27 days
2. What is the days sales outstanding (DSO) after the change of credit policy? 22.5 days
3. How much is the incremental after tax profit from the change in credit terms? P68,493.75
 (150,000-843.75-12,000-23,000)*60%

4.8

Werpa Inc, after computing the annualized cost of the credit terms is considering relaxing its credit
standards to encourage more sales. As a result, sales are expected to increase by 15 percent from the current 600
units per year. The average collection period is expected to increase to 40 days from 30 days and bad debts are
expected to double the current 3 percent level. The selling price per unit is ₱1,550, the variable cost per canoe is
₱750 and the average cost per unit at the 600 unit level is ₱900. The firm's required return on investment is 20
percent. (Assume a 300-day year; for intermediate computations, use 2 d.p.)

Required:

1. What is the firm's additional profit contribution from sales under the proposed relaxation of credit
standards?
2. What is the cost of marginal investments in accounts receivable under the proposed plan?
3. What is the cost of marginal bad debts under the proposed plan?
4. What is the net result of implementing the proposed plan?
4.9
Lodi Optical, Inc, offers branded designer prescription eyeglasses. All sales are currently on credit
and with no cash discount. The firm is considering a 2 percent cash discount for payment within 10 days. The
firm's current average collection period is 90 days, sales are 700 units per year, selling price is ₱25,000 per unit,
variable cost per unit is ₱18,750, and the average cost per unit is ₱21,000. The firm expects that the change in
credit terms will result in a minor increase in sales of 15 units per year, that 75 percent of the sales will take the
discount, and the average collection period will drop to 72 days. The firm's bad debt expense is expected to
become negligible under the proposed plan. The bad debt expense is currently 0.025 percent of sales. The firm's
required return on equal-risk investments is 20 percent. (Assume a 360-day year.)

Required:

1. What is the marginal investment in accounts receivable under the proposed plan?
2. What is the cost of marginal investment in accounts receivable under the proposed plan?
3. What are the savings of marginal bad debts under the proposed plan?
4. What is the cost of the marginal cash discount?
5. What is the net result of increasing the cash discount?