Johnson knows that RR sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether

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Johnson knows that RR sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether

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Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is re-thinking her company’s working capital policy in light of a recent scare she faced when RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of credit. Had the line of credit not been renewed, RR would not have been able to make payroll, potentially forcing the company out of business. Although the line of credit was ultimately renewed, the scare has forced Johnson to examine carefully each component of RR’s working capital to make sure it is needed, with the goal of determining whether the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit, Johnson is well aware that reducing working capital will improve free cash flow.
 
Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the production manager resisted Johnson’s efforts to question his holdings of raw materials, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about the cash and securities balances. However, with the recent credit scare, this resistance has become unacceptable and Johnson has undertaken a company-wide examination of cash, marketable securities, inventory, and accounts receivable levels.
 
Johnson also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, and free cash flow would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stockouts and loss of sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Johnson has begun her investigation by collecting the ratios shown here. (The partial cash budget shown after the ratios is used later
in this mini case.)

Johnson knows that RR sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether RR’s customers pay more or less promptly than those of its competitors. If there are differences, does that suggest RR should tighten or loosen its credit policy? What four variables make up a firm’s credit policy, and in what direction should each be changed by RR?

Answer & Explanation (1)

Answer

The current ration and quick ratio of RR are lower than industry. This indicates company's less liquid profile as compared to its peers in the industry. This decrease in liquidity can be attributed to increase demand for working capital and less cash available to pay the creditors.
 
Further, the days' sales outstanding or collection period of RR is 45.63 days and industry trade receivable collection period is 32 days. This means company is having significant gaps in its collections of receivables. The company must reconsider its credit terms to the customers. If the company is extending credit to capture more market share at cost of liquidity then still the credit period is too high. The management must deliberate with sales and customer care department to think strategy of decreasing credit limit and increase product or services quality to increase its margins and market share. If we see the profit margin of company which is 2.07% as compared to industry average of 3.5%.This means the extended credit period is not justifiable as profit margins are too thin.
 
Inventory turnover ratio of company is better than industry average. This indicates that customer are willing to buy more as the company is giving more credit terms as compared to industry. Further the company profit margin also low as compared to industry which favors the customer in less cost and extended payment period.
 
Return on invested equity for company is also low. The industry is getting 21% return on equity but RR is getting just 10% on its equity. This can be attributed to its less margin on sales, increased operating expenses and major expense of depreciation and amortization which dilutes the profitability of company. We can see that total liabilities to assets for RR is 58.76% but industry is keeping this same ratio at 50%. This also indicates that interest paid by the company is higher which also reduced its net margins and later return on equity.
However the payables deferral period is 30 days for RR but industry is managing the same at 33 days. It means company is paying more quickly to its creditors than the rest of industry. This also contributes to less liquidity of company and less margin on sales.
 
Keeping in mind the above analysis the company should tighten its credit policy for trade receivables as the company is giving more credit terms at less profit margins. The company should also negotiate more credit terms with its creditors as the company is getting less time to pay than its peers in the industry. If the suppliers are not ready to relax credit time then company should seek alternative suppliers but keeping in mind that input materials quality is not compromised.
 
The important variables of credit policy are credit period, credit standards, cash discount and collection effort. The RR should offer cash discounts on early payment by its receivables. This would motivate the customers to pay early to avail discounts. The credit period of RR should be aligned with industry to improve its current and acid test ratios. Further, the debt burden should be lowered close to industry to avoid unnecessary involvement of financial institutions and interest expense. The credit period should be revised downward, the cash discount should be increased, and the collection effort should be doubled and speedily recovered with ethical protocols.

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