RST Limited Credit Policy Analysis Evaluating Proposed Policies
RST Limited is currently evaluating its credit policy and considering relaxing its present terms to potentially boost sales. The company is analyzing two proposed policies against its current policy. Currently, RST Limited has annual credit sales of ₹225 lakhs and an accounts receivable turnover ratio of 5 times a year. This analysis delves into the financial implications of these proposed policy changes, examining factors such as collection period, bad debt losses, cost of funds, and profitability. Understanding these factors is crucial for RST Limited to make an informed decision about its credit policy.
Currently, RST Limited has annual credit sales of ₹225 lakhs and an accounts receivable turnover ratio of 5 times. To understand the impact of the proposed policy changes, we must first analyze the current credit policy. The accounts receivable turnover ratio indicates how efficiently the company collects its receivables. A higher ratio suggests a more efficient collection process. In this case, a turnover ratio of 5 implies that the company collects its receivables five times a year. The average collection period, which is the number of days it takes to collect receivables, can be calculated as follows:
Average Collection Period = 365 days / Accounts Receivable Turnover Ratio Average Collection Period = 365 days / 5 = 73 days
This means that, on average, RST Limited takes 73 days to collect its receivables. To further evaluate the current policy, we need to know the bad debt losses and the cost of funds. This information will help us compare the current policy with the proposed policies. The current policy's profitability can be assessed by considering the contribution margin, which is the difference between sales revenue and variable costs. A higher contribution margin indicates that the company is generating more profit from its sales. By comparing the profitability of the current policy with the proposed policies, RST Limited can determine whether the policy changes will result in a net benefit.
RST Limited is considering two proposed credit policies to potentially increase sales. Let's analyze each policy in detail to understand their implications.
Policy 1
Under Policy 1, the company anticipates an increase in credit sales by ₹75 lakhs, resulting in a total of ₹300 lakhs in credit sales. However, this policy is also expected to increase the collection period to 90 days. This longer collection period may tie up more of the company's funds in accounts receivable. The expected increase in bad debt losses is 2% of sales. Additionally, the company's cost of funds is 15% per annum. This policy aims to boost sales by offering more lenient credit terms, but it also carries the risk of higher bad debt losses and increased financing costs.
Policy 2
Under Policy 2, the company projects an increase in credit sales by ₹120 lakhs, bringing the total credit sales to ₹345 lakhs. The collection period is expected to extend to 100 days, even longer than Policy 1. Bad debt losses are projected to be 3% of sales, which is also higher than Policy 1. The cost of funds remains at 15% per annum. This policy is even more aggressive in its approach to increasing sales, but it also carries a higher risk of bad debt losses and financing costs. It is crucial to analyze whether the increased sales revenue will offset the increased costs associated with this policy.
To make an informed decision, RST Limited needs to conduct a thorough financial analysis of the proposed policies. This analysis should consider the impact on sales, collection period, bad debt losses, cost of funds, and overall profitability.
Policy 1 Analysis
- Increase in Sales: ₹75 lakhs
- Total Credit Sales: ₹300 lakhs
- Collection Period: 90 days
- Bad Debt Losses: 2% of ₹300 lakhs = ₹6 lakhs
- Cost of Funds: 15% per annum
First, we need to calculate the average accounts receivable under Policy 1:
Average Accounts Receivable = (Total Credit Sales / 365) * Collection Period Average Accounts Receivable = (₹300 lakhs / 365) * 90 ≈ ₹73.97 lakhs
Next, we calculate the cost of funds tied up in accounts receivable:
Cost of Funds = Average Accounts Receivable * Cost of Funds Rate Cost of Funds = ₹73.97 lakhs * 15% = ₹11.09 lakhs
To evaluate the profitability of Policy 1, we need to consider the contribution margin. Let's assume the contribution margin is a certain percentage of sales. Without specific figures, we will use a hypothetical contribution margin for demonstration purposes. Let's assume a contribution margin of 25%.
Contribution Margin = 25% of ₹300 lakhs = ₹75 lakhs
Now, we can calculate the net benefit of Policy 1 by subtracting the bad debt losses and cost of funds from the contribution margin:
Net Benefit = Contribution Margin - Bad Debt Losses - Cost of Funds Net Benefit = ₹75 lakhs - ₹6 lakhs - ₹11.09 lakhs = ₹57.91 lakhs
Policy 2 Analysis
- Increase in Sales: ₹120 lakhs
- Total Credit Sales: ₹345 lakhs
- Collection Period: 100 days
- Bad Debt Losses: 3% of ₹345 lakhs = ₹10.35 lakhs
- Cost of Funds: 15% per annum
First, calculate the average accounts receivable under Policy 2:
Average Accounts Receivable = (Total Credit Sales / 365) * Collection Period Average Accounts Receivable = (₹345 lakhs / 365) * 100 ≈ ₹94.52 lakhs
Next, calculate the cost of funds tied up in accounts receivable:
Cost of Funds = Average Accounts Receivable * Cost of Funds Rate Cost of Funds = ₹94.52 lakhs * 15% = ₹14.18 lakhs
Assuming the same contribution margin of 25%:
Contribution Margin = 25% of ₹345 lakhs = ₹86.25 lakhs
Now, we can calculate the net benefit of Policy 2:
Net Benefit = Contribution Margin - Bad Debt Losses - Cost of Funds Net Benefit = ₹86.25 lakhs - ₹10.35 lakhs - ₹14.18 lakhs = ₹61.72 lakhs
To compare the policies effectively, we need to analyze the incremental benefits and costs associated with each policy relative to the current policy. We also need to compare the policies against each other.
Incremental Analysis (Policy 1 vs. Current Policy)
To perform an incremental analysis, we need to estimate the contribution margin under the current policy. Let's assume a contribution margin of 25% for the current sales of ₹225 lakhs:
Contribution Margin (Current) = 25% of ₹225 lakhs = ₹56.25 lakhs
We also need to know the bad debt losses under the current policy. Let's assume the current bad debt losses are 1% of sales:
Bad Debt Losses (Current) = 1% of ₹225 lakhs = ₹2.25 lakhs
Now, we calculate the average accounts receivable under the current policy:
Average Accounts Receivable (Current) = (₹225 lakhs / 365) * 73 ≈ ₹45.07 lakhs
Next, we calculate the cost of funds for the current policy:
Cost of Funds (Current) = ₹45.07 lakhs * 15% = ₹6.76 lakhs
Now, we can calculate the net benefit of the current policy:
Net Benefit (Current) = ₹56.25 lakhs - ₹2.25 lakhs - ₹6.76 lakhs = ₹47.24 lakhs
Incremental Benefit (Policy 1) = Net Benefit (Policy 1) - Net Benefit (Current) Incremental Benefit (Policy 1) = ₹57.91 lakhs - ₹47.24 lakhs = ₹10.67 lakhs
Incremental Analysis (Policy 2 vs. Current Policy)
Using the same figures for the current policy, we calculate the incremental benefit of Policy 2:
Incremental Benefit (Policy 2) = Net Benefit (Policy 2) - Net Benefit (Current) Incremental Benefit (Policy 2) = ₹61.72 lakhs - ₹47.24 lakhs = ₹14.48 lakhs
Policy 2 vs. Policy 1
Comparing Policy 2 to Policy 1, we see that Policy 2 results in a higher net benefit. However, it also carries higher risks due to the longer collection period and higher bad debt losses. The decision to choose between Policy 1 and Policy 2 will depend on RST Limited's risk appetite and its ability to manage credit risk.
In addition to the quantitative analysis, RST Limited should also consider qualitative factors before making a decision. These factors include:
- Customer Relationships: Relaxing credit terms may improve customer relationships and loyalty.
- Competitive Landscape: If competitors are offering more lenient credit terms, RST Limited may need to follow suit to remain competitive.
- Operational Efficiency: The company needs to ensure it has the operational capacity to manage the increased sales and collection efforts.
- Economic Conditions: The overall economic climate can impact the ability of customers to repay their debts.
Based on the financial analysis, both proposed policies are expected to increase sales and profitability compared to the current policy. However, they also come with increased risks. Policy 2 appears to be more profitable than Policy 1, but it also has higher bad debt losses and a longer collection period.
RST Limited should carefully weigh the potential benefits against the risks. It is crucial to have robust credit management processes in place to mitigate the risks associated with the relaxed credit terms. The company should also continuously monitor the performance of the chosen policy and make adjustments as needed. It is recommended that RST Limited conduct a sensitivity analysis to understand how changes in key assumptions, such as the contribution margin and bad debt losses, could impact the results. This analysis will help the company make a more informed decision and prepare for potential challenges.