Question 5 OR

Receivables, the liquidity-profitability trade-off, credit policy and the operating cycle

18 marks

Time to write
About 36 minutes
Topic
Receivables management

Question

Question 5 OR · 18 marks

  1. What are the various costs associated with accounts receivables.

  2. Explain the liquidity and profitability trade off concept in the management of working capital

  3. What is meant by credit policy? Also mention the Benefits of receivables

  4. Explain the concept of the operating cycle.

Reworded from the university paper; 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

36 minfor 18 marks

Read from the question

  • Explain…What is meant…?Mention…4 asks, each with its own marks below. Answer all 4.

Write it in this order

The parts stand alone: start with the one you are surest of.

  1. Read; underline the asks; jot your points 2 min
  2. 1 (a) Costs of receivables 5 marks 9 min
  3. 2 (b) Liquidity-profitability trade-off 4 marks 7 min
  4. 3 (c) Credit policy and benefits of receivables 5 marks 9 min
  5. 4 (d) Operating cycle 4 marks 7 min
  6. Check: every ask answered, key terms underlined 2 min

Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.

Try it first. About 36 minutes for 18 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.

(a) Costs associated with accounts receivable

  1. Cost of financing (capital cost): funds tied up in debtors must be financed, at an interest cost (borrowed funds) or an opportunity cost (own funds).
  2. Administrative cost: record keeping, credit investigation of customers and other clerical work.
  3. Collection cost: reminders, visits and other efforts to collect overdue amounts.
  4. Default cost (bad debts): amounts customers fail to pay; efficient collection reduces but cannot remove them.

(b) Liquidity and profitability trade-off in working capital management

  • Liquidity means the ability to pay obligations when they fall due; it is greater when more is held in current assets (cash, stock, debtors).
  • Profitability suffers when too much is held in current assets, because they earn less than fixed assets and must be financed.
  • Holding more current assets raises liquidity and lowers risk but reduces profitability; holding less raises profitability but increases the risk of being unable to pay.
  • The finance manager therefore chooses a level of working capital that balances the two, neither so low that solvency is endangered nor so high that funds lie idle.

(c) Credit policy and the benefits of receivables

Credit policy is the set of decisions on to whom credit is given, on what terms (credit period, cash discount) and how debts are collected; it determines both the quantity and the quality of receivables.

Picture itReceivables, the liquidity-profitability trade-off, credit policy and the operating cycle

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.

Benefits of receivables:

  1. Higher sales: many sales cannot be made for cash only.
  2. Meeting competition: where others in the trade sell on credit, a firm must do the same or lose sales.
  3. Higher profits: extra sales beyond a point do not raise costs proportionately, so profit rises.

(d) The operating cycle

The operating cycle is the time it takes for money to go round the cycle cash → raw materials → work-in-progress → finished goods → debtors → cash. Its length (the gross operating cycle) is the inventory days, that is the raw material, work-in-progress and finished goods holding periods, plus the debtors' collection period. Deducting the credit received from suppliers gives the net operating cycle, which ICAI calls the working capital cycle: the time between paying for raw materials and receiving cash from the sale. For example, raw materials 60 days, production 15, finished goods 30 and debtors 30 give a gross cycle of 135 days; less 15 days' supplier credit, the working capital cycle is 60 − 15 + 15 + 30 + 30 = 120 days. The longer the cycle, the more working capital is needed; collecting debtors faster or holding less stock releases cash.

Where the 18 marks sit

#ComponentMarks
1(a) Costs of receivables5
2(b) Liquidity-profitability trade-off4
3(c) Credit policy and benefits of receivables5
4(d) Operating cycle4
Total18
Keyboard: ← → previous and next question, / search

Report a problemopens an email to admin@getkunji.com with the question ID874-Q5ORalready filled in.