Recommending the Best Creditor and Debtor Policy - Report Example

Executive summary The report has been prepared for the company’s CEO with an aim of recommending the best creditor and debtor policy so that the company can be able to undertake its maintenance project successfully without running into financial difficulties. Four alternatives have been considered in the report and the alternative with the least cost implications recommended. The report contains a number of sections including introduction, analysis of the alternatives as well as the recommendation of the best alternative. The report concludes by recommending that the company does not undertake any changes to its debtors and creditors policy. The report also has an appendix in terms of excel sheet that is the computation of the analysis. Table of Contents Executive summary 1 Table of Contents 2 Introduction 3 The effect on the cash flows for the period 1st January to 30th June 2016 on a month to month basis if the company delays payments to creditors in respect of November - February purchases 3 The effect on the cash flows for the period 1st January to 30th June 2016 on a month to month basis if the company offers discounts to trade debtors in respect of November – February sales 4 Summary cash flow budgets for the period 1st January to 30th June 2016 under different headings 4 Whether delaying payments to creditors or the offering of discounts to debtors is worthwhile 8 Conclusion 8 References 9 Introduction The company stands to reap a lot of benefits from financial planning and hence budgeting since it will be able to successfully undertake the maintenance project without having to run into financial difficulties. When the company does not have cash, it will be able to organize for financing in advance hence incurring no delays in project implementation and related costs. This report compares four alternatives that have been proposed by the company However, arising from the analysis, the report recommends that the company should stick to its original policies as regards debtors and creditors since this is the most beneficial to the company in terms of cost implications. However, the company also ought to consider non-financial factors as outlined below in arriving at the final financing decision. The effect on the cash flows for the period 1st January to 30th June 2016 on a month to month basis if the company delays payments to creditors in respect of November - February purchases If the company delays paying for the purchases it makes from November to February, it will be forced to pay interest on every payment that is delayed for more than 30 days at 15%. Since with the new arrangement only 50% of the purchases will be paid for within the 30 day period, it means that the remaining 50% of purchases will attract a 15% interest. From the attached excel sheet (Cashflow on delaying payments), it can be established that the company will incur $648,000 in January, $756,000 in February, $519,750 in March, $648,000 in April and $297,000 in May. It is worth noting that as a result of the maintenance expenses amounting to $33 million during the two months of December and January, the company will experience some finance shortages such that it will be unable to maintain a cash balance of $7,000,000 in both January and February and as such, it will have to ask for bank loan amounting to $ 5,368,000.00 in January and $3,871,000.00 in February. It is worth noting that this loan will attract a 2% monthly interest that will be repaid at the end of June. The total interest to be paid in June is $292,140.00. However, the loan amounting to $9,239,000.00 will be repaid in March when the company will have excess cash in line with its policy. Consequently, the company’s cash balances during the six months will be $7,000,000 in January, $7,000,000 in February, $7,126,250 in March, $10,458,250 in April, $11,381,250 in May and $22,839,110 in June. The effect on the cash flows for the period 1st January to 30th June 2016 on a month to month basis if the company offers discounts to trade debtors in respect of November – February sales The attached excel sheet (Cashflow with discounts) shows the cash balances that the company would have at the end of each month if it was to offer discounts to its debtors. The company will have cash balances amounting to $7,000,000 in January, $7,877,000 in February, $9,877,000 in March, $14,977,000 in April, $15,177,000 in May and $22,498,300 in June. However, it should be noted that the company will have to incur discount expenses which would reduce the total cash received in the long run amounting to $913,600 in November, $456,800 in December, $428,250 in January and $628,100 in February. It also worth noting that owing to the maintenance expense incurred in December and January, the company will have a cash deficit in January and hence will have to borrow $1,435,000 in January so as to bridge the gap. Consequently, the company will have to incur financing costs amounting to $ 28,700.00. Summary cash flow budgets for the period 1st January to 30th June 2016 under different headings NB// The budgets have been extracted from the attached excel sheet a) Delay of payments to creditors As can be seen below, the company would end up paying supplies worth $70,200,000 if it opts to delay paying creditors. The company would also collect cash amounting to $ 139,200,000 and end up with a cash balance of $22,839,110. The company would require taking up a loan amounting to $9,239,000 in the month of January and February so as to maintain a cash balance of $7,000,000 at the end of the month. Consequently, the company would end up paying bank interest amounting to $292,140 for the loan taken. Another expense would be that of 15% interest for any delay beyond 30 days for the supplies. This interest would amount to $2,868,750 for the entire period. Black Diamond Mining Australia Company Limited Cash flow budget For the six Months Ending June 2016 Beginning cash balance $ 7,000,000.00 add: Budgeted cash receipts $ 139,200,000.00 Total cash available for use $ 146,200,000.00 Less: Cash Disbursement Supplies $ 70,200,000.00 Management expenses $ 12,000,000.00 Interest expenses $ 2,868,750.00 maintenance expenses $ 33,000,000.00 Dividends $ 5,000,000.00 Total disbursements $ (123,068,750.00) Cash surplus/ deficit $ 23,131,250.00 Financing Borrowings $ 9,239,000.00 Repayments $ (9,239,000.00) finance costs $ 292,140.00 Net cash from financing $ (292,140.00) Budgeted ending cash balance $ 22,839,110.00 b) Offering discount to trade debtors By offering discount to trade debtors, the company would incur the discount expense since this is cash that will never be paid. The discount for the January- June period would amount to $2,426,750. The huge discount allowances would lead to less cash that that which would normally be collected being collected. This would amount to $128,527,000. On the other hand, payment to creditors would be $63,000,000 and an ending trade balance of $22,527,000. It is also worth noting that the company will have to take a loan in both January and February amounting to $1,435,000 which would consequently lead to bank interest amounting to $28,700. Black Diamond Mining Australia Company Limited Cash flow budget For the six Months Ending June 2016 Beginning cash balance $ 7,000,000.00 add: Budgeted cash receipts $ 128,527,000.00 Total cash available for use $ 135,527,000.00 Less: Cash disbursements Supplies $ 63,000,000.00 Management expenses $ 12,000,000.00 Interest expenses $ - maintenance expenses $ 33,000,000.00 Dividends $ 5,000,000.00 Total disbursements $ (113,000,000.00) Cash surplus/ deficit $ 22,527,000.00 Financing Borrowings $ 1,435,000.00 Repayments $ (1,435,000.00) finance costs $ 28,700.00 Net cash from financing $ (28,700.00) Budgeted ending cash balance $ 22,498,300.00 c) Both delayed payment to creditors and offering discount to traders In this case, the company would incur both expenses associated with delaying payments amounting to $2,868,750 as well as the discount allowed expenses amounting to $2,426,750. This would mean that less cash is collected amounting to $128,527,000 while more supply payments amounting to $70,200,000 will be paid. The consequence of this is that the company will end up with less cash balance amounting to $12,302,410.00 at the end of the six months. It should also be noted that the company will have obtained loans amounting to $2,803,000 during the period and consequently the loan will attract interest amounting to $155,840. Black Diamond Mining Australia Company Limited Cashflow budget For the six Months Ending June 2016 Beginning cash balance $ 7,000,000.00 add: Budgeted cash receipts $ 128,527,000.00 Total cash available for use $ 135,527,000.00 Less: Cash disbursements Supplies $ 70,200,000.00 Management expenses $ 12,000,000.00 Interest expenses $ 2,868,750.00 maintenance expenses $ 33,000,000.00 Dividends $ 5,000,000.00 Total disbursements $ 123,068,750.00 Cash surplus/ deficit $ 12,458,250.00 Financing Borrowings $ 2,803,000.00 Repayments $ (2,803,000.00) finance costs $ 155,840.00 Net cash from financing $ (155,840.00) Budgeted ending cash balance $ 12,302,410.00 d) No change is made from existing policy When the company decides not to undertake any policy change, the only expense or cost relating to the decision will be $189,000 which will be the interest for the $5,450,000 loan that the company would have to take during the period. This means that the company would collect cash amounting to $139,200,000 during the period and pay supplies amounting to $63,000,000. This would lead the company having to end up with a cash balance of $33,011,000 which is the highest amount under any arrangements. Black Diamond Mining Australia Company Limited Cashflow budget For the six Months Ending June 2016 Beginning cash balance $ 7,000,000.00 add: Budgeted cash receipts $ 139,200,000.00 Total cash available for use $ 146,200,000.00 Less: Cash disbursements Supplies $ 63,000,000.00 Management expenses $ 12,000,000.00 Interest expenses $ - maintenance expenses $ 33,000,000.00 Dividends $ 5,000,000.00 Total disbursements $ 113,000,000.00 Cash surplus/ deficit $ 33,200,000.00 Financing Borrowings $ 5,450,000.00 Repayments $ (5,450,000.00) finance costs $ 189,000.00 Net cash from financing $ (189,000.00) Budgeted ending cash balance $ 33,011,000.00 Whether delaying payments to creditors or the offering of discounts to debtors is worthwhile Arising from the above analysis, it has been revealed that delaying payments results in greater cash balances of $ 22,839,110.00 compared to $ 22,498,300.00 when the company offers discounts. As such, I would advise the company to delay payments to creditors if it has to. However, as seen in the analysis, it is clear that both these alternatives involve a lot of expenses. However, the not changing the company policy will only entail incurring the finance costs only and hence bigger closing cash balances. The alternative would also result in increased profits for the company. As such, I would advise the company not to change its policy based on the factors addressed above. However, the company also ought to consider other factors other than those addressed above. Such factors include; i) The company’s shareholders interests and profit targets. If any of the above alternatives is likely to hinder the company from achieving its profit targets, then it should be discarded. ii) The country’s economic conditions should be considered with an aim of determining whether they are likely to affect the policy change decisions whether positively or negatively. iii) Whether the creditors will agree to the new terms. This is because if they are not willing to accept the new terms, the company can only work with the second alternative of offering discounts iv) The ability of all the customers to pay or adopt the new discounts as envisaged in the new policy since bad debts would affect the policy negatively and this would only leave the company with the alternative of delaying debt payment v) Whether the cash balances can be attained through other less costly means. For instance, delaying paying creditors results in 15% interest while the bank would charge 6% interest over a 3 months period. As such, if the company compares the cost of the alternatives, it can be able to make more informed decisions on financing. Conclusion Based on the above analysis, it appears that the company would be better off if it opts not to change its financing policies. This is because the alternative only involves incurring financing costs while the other two alternatives have cost implications in terms of discount related costs and the interest charged by creditors. As such, I would advise the company not to undertake any policy changes regarding its creditors and debtors since it is able to undertake the maintenance projects successfully without incurring any unnecessary costs apart from the bank interest. References Johannes, M2011, Introduction to financial management, New York, John Wiley & Sons. Read More