CMA Study Group

Gartshore Inc. is a mail-order book company. The company recently changed its credit policy in an attempt to increase sales. Gartshore's variable cost ratio is 70% and its required rate of return is 12%. The company projects that annual sales will increase from the current level of $360,000 to $432,000, but the average collection period on receivables will go from 30 to 40 days. Ignoring any tax implications, what is the cost of carrying the additional investment in accounts receivable, using a 365-day year?

Solution:

The cost of carrying the additional investment in accounts receivable is 12% of 70% of the increase in the average accounts receivable balance. The increase in accounts receivable is $17,761.

The new average accounts receivable balance is $47,342, which is calculated as:

$432,000 in sales divided by the accounts receivable turnover of 9.125 (365 days divided by the collection period of 40 days).

The old average accounts receivable balance is $29,581, which is calculated as:

$360,000 in sales divided by the accounts receivable turnover of 12.17 (365 days divided by the collection period of 30 days).

The difference between the old and new accounts receivable balances is an increase of $17,761 (old = $29,581, new = $47,342), and this incremental amount is used to calculate the increased carrying cost.

Increased carrying cost = (0.12)(0.7)($17,761) = $1,492.

If someone can help me to understand the above question concept, please?

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Zubair
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Hello Zubair

First u have to calculate the average account receivable of each policy :

old policy we use the following formula 
average collection period = average AR / (sales/365)
30 = ? / (360000/365)
30= ? / 986
average AR = 30*986 ( 29580)

second policy 
40 = ? / (432000/365)
40 = ? / 1184
average AR = 40*1184 (47342)

the difference between two averages 47342 - 29580 = 17762

we multiplied 17762 * 70% variable cost (as if we purchased) we get 12432 
so if you invest this amount in current market yield you will get 12432*12% = 1492

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Abdulkareem Yaqti
Supervisor
ABDULKAREEM ABDULELAH YAQTI
ALMADINAH
Saudi Arabia
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Original Message:
Sent: 02-02-2020 09:44 AM
From: Muhammad Zubair Sarwar
Subject: Working Capital

Gartshore Inc. is a mail-order book company. The company recently changed its credit policy in an attempt to increase sales. Gartshore's variable cost ratio is 70% and its required rate of return is 12%. The company projects that annual sales will increase from the current level of $360,000 to $432,000, but the average collection period on receivables will go from 30 to 40 days. Ignoring any tax implications, what is the cost of carrying the additional investment in accounts receivable, using a 365-day year?

Solution:

The cost of carrying the additional investment in accounts receivable is 12% of 70% of the increase in the average accounts receivable balance. The increase in accounts receivable is $17,761.

The new average accounts receivable balance is $47,342, which is calculated as:

$432,000 in sales divided by the accounts receivable turnover of 9.125 (365 days divided by the collection period of 40 days).

The old average accounts receivable balance is $29,581, which is calculated as:

$360,000 in sales divided by the accounts receivable turnover of 12.17 (365 days divided by the collection period of 30 days).

The difference between the old and new accounts receivable balances is an increase of $17,761 (old = $29,581, new = $47,342), and this incremental amount is used to calculate the increased carrying cost.

Increased carrying cost = (0.12)(0.7)($17,761) = $1,492.

If someone can help me to understand the above question concept, please?

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Zubair
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