Question 6
Cash management and working capital; relaxing the credit policy
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 6 · 18.75 marksQ6. Comment: "The efficiency of cash management depends on how efficiently a firm manages its inventory and its Receivables".
Meridian Ltd is currently operating at the 65% capacity utilization level; its sales are pegged at Rs. 1,140 lakhs. As per its current credit policy the firm offers a credit period of 20 days, and Meridian Ltd's average collection period is 30 days. With increased competition beginning to erode its bottom-line, the firm's management has been thinking of relaxing its credit terms. Going by the management's projections, such a liberalization of the credit policy is likely to boost sales by 30%.However, since the change is likely to increase the firm's average credit period by 30 days, one section of the company's management opposes it and advocates a status quo. The firm's variable costs are 75% of the sales, and its fixed cost is Rs.120 lakhs. Are you in favor of the proposed change in the firm's credit policy? Assume that Meridian Ltd's opportunity cost of capital is 12%.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Comment…Are…?Two asks in one question: answer both.
- CommentA statement to judge: take a stand on it in your first line, and come back to it at the end.
- Assume that Meridian Ltd's opportunity cost…The paper fixes this: use it as given, and say so in your answer.
What the paper leaves open
- The proposed change raises the average collection period by 30 days, from 30 to 60 days.
- No mark is printed for the question; the paper asks for any four of six, equal marks.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Comment on cash, inventory and receivables management 6 marks 11 min
- 2 Sales, costs and profit under each policy 4 marks 7 min
- 3 Investment in debtors and its opportunity cost 5 marks 9 min
- 4 Net benefit and decision 3.8 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 4's one-line decision, whatever happens: never leave the figures without it.
Try it first. About 38 minutes for 18.75 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Part 1: comment. The statement is broadly true. Cash is tied up throughout the operating cycle: in raw materials, work in progress and finished goods, and then in receivables, until customers pay. The longer the inventory and collection periods, the longer the cycle and the more cash the firm needs. Shortening them (tighter inventory control, quicker collection) releases cash, while a slower cycle forces the firm to hold or borrow more. Cash management also involves synchronising receipts with payments and choosing the cash balance: cash is the least productive asset, so a shortage hampers operations and an excess earns nothing. Efficient inventory and receivables management is therefore a precondition of efficient cash management, though not the whole of it.
1'Pay next month'—the boxes fly off the van and every arm in the lane is full.
Consequences of lengthening the credit periodHigher sales and profit; larger investment in receivables; more bad debts and collection costs.
2Cash on delivery only: fewer takers at the door, but the money is in hand today.
Consequences of shortening the credit periodLower investment in receivables and better liquidity; possible loss of sales and profit.
Part 2: should Meridian relax its credit policy? Figures in ₹ lakh. A more liberal policy raises sales, but also the funds tied up in debtors; the investment in debtors is measured at cost, total cost × collection period ÷ 360. Sales rise 30% to ₹1,482 lakh, which needs 84.5% of capacity, so no new fixed costs arise; the collection period rises from 30 to 60 days (paper note). No bad debts are given.
| Particulars (₹ lakh) | Present | Proposed |
|---|---|---|
| Sales | 1,140.00 | 1,482.00 |
| Variable cost (75%) | 855.00 | 1,111.50 |
| Fixed cost | 120.00 | 120.00 |
| Total cost | 975.00 | 1,231.50 |
| Profit (sales − total cost) | 165.00 | 250.50 |
| Average collection period (days) | 30 | 60 |
| Investment in debtors at cost (total cost × days ÷ 360) | 81.25 | 205.25 |
| Opportunity cost @ 12% | 9.75 | 24.63 |
| Net benefit | 155.25 | 225.87 |
Decision. The change adds ₹85.50 lakh of contribution against ₹14.88 lakh more opportunity cost on the extra funds in debtors: a net gain of ₹70.62 lakh. I am in favour of the proposed change, provided bad debts do not rise sharply, which the projections do not suggest.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Comment on cash, inventory and receivables management | 6 |
| 2 | Sales, costs and profit under each policy | 4 |
| 3 | Investment in debtors and its opportunity cost | 5 |
| 4 | Net benefit and decision | 3.75 |
| Total | 18.75 |
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