CIMA F1 Syllabus D. Management Of Working Capital And Cash - Extending Credit Period - Notes ^{3 / 12}

Compare the increase in profit with the increase in working capital needed

Illustration:

Anaya wants to extend the credit period given to customers from 1 month to 2 months.

This would lead to an increase in inventory to $70,000 and an increase to payables of $60,000.

Sales and profits are expected to increase by 40%.

Anaya expects a return on all investments to be at least 10%.

Sales are currently $3m and profits are are $200,000.

Should the credit period be extended?

Solution:

With new credit period offered, profit will increase by $200,000 x 40% = $80,000

Current receivables with 1 month credit period are:
$3m / 12 months = $250,000

Sales after extended credit period = $3m + 40% = $4.2m

New receivables with 2 month credit period will be:
$4.2m x 2/12 = $700,000

Increase in receivables = $450,000

So, we have a change in profit of $80,000

Change in working capital of $460,000
Increase in inventory $70,000
Increase in receivables $450,000
Decrease in payables ($60,000)

Return on change is 80,000 / 460,000 x 100 = 17%

This is above the required return of 10%. So Anaya should extend the credit period from 1 month to 2 months.