A small shoe manufacturer of Delhi operates on a very narrow margin of profit in order to survive a keen competition in the market. He has no problem on the count of operating cost, such as cost of material, labour cost and other overheads insofar as he is able to get raw material of desired quality at reasonable cost. The labour force is highly efficient. He buys raw material at net 90 terms of credit which is a liberal term of credit. But he is facing problems on account of customers whom he provides net 60 term of credit. Around 20% of his customers are stretching the payment beyond 60 days. So the average life of credit sale gets longer which raises the financing cost. Collection cost is as high as 4.0 per cent of the credit sales and bad debt loss is also sizeable at 2.0 per cent of the credit sale. The manufacturer plans to improve his return on investment. He can make the credit term still liberal for a greater sale. But that will raise the financing cost of credit. In face of high cost of funds, it will erode his profitability more than the profit on the enhanced sale. On the contrary, if he tightens the term of credit, he will lose sales that will lower the asset turnover and thereby the return on investment.
Presently, the financial figures are as follows:
1. Sales Rs 2,00,000
2. Total asset Rs 1,20,000
3. Operating profit Rs 20,000
4. Cost of funds 16%
If he liberalises the term of credit to 90 days, sales may go up by 10%. The collection cost may go up by 0.50%. A greater amount of cash will be tagged with the receivables. Under these circumstances, he is to find a solution.
1. Find what should be the optimal term of credit.
2. Should he provide 2% discount if customers pay within 10 days?
3. What measures should he take to cut the average age of receivables?
4. Should he liberalise the credit term to net 90?
5. What measures can be taken to prune collection cost and bad debt losses?