If the optimal order size is placed, the company would have to place about 55 orders to meet its annual requirement:

[Marks allocation: Computation of cost for the current plan = 2; Computation of cost for the optimal order size = 2]

Financing method
The company should continue to take the bank loan to pay for inventory purchases within the discount period to enjoy the discount. This is because the annualised cost of the bank borrowing is 30%, which is lower than the annualised implied interest cost of trade credit (i.e., 37.2%). The company will save about 7.2% in financing costs if it borrows to pay for purchases early to take the discount rather than give up the discount to enjoy the full credit period.

The annualised cost of the bank loan
As a short-term borrowing, the annualised cost of the bank loan can be computed as under:

Assuming the company continues with its current purchase plan of buying 100,000 units at the purchase cost of GH¢120, the company would have to borrow GH¢12,000,000, and the annualised cost of the loan will be 30%:

[Marks allocation: Computation of the annualised cost of borrowing = 2.5; Computation of the annualised implied interest cost of credit =2.5; Advise = 1]

To conclude whether the company is overtrading or not, candidates are expected to identify the symptoms of overtrading and diagnose the company’s situation from the information given to establish whether those symptoms exist or not. Analysis of financial ratios such as growth in sales revenue, growth in current assets, receivables turnover days, inventory turnover days, debt ratios, and liquidity ratios is relevant to the diagnosis.

Overtrading occurs when a company tries to do too much too quickly with too little long-term capital. Typically, a company that is overtrading would exhibit the following symptoms:

• Rapid growth in sales revenue.
• Rapid growth in current assets, particularly inventory and receivables. Inventory turnover days and receivables turnover days might grow longer.
• There is only small growth in equity capital, which may be through reinvestment of profit and not new equity issue. Much of the growth in assets is financed by credit, particularly, trade payables and bank overdraft.
• Significant increases in debt ratios such as total debt ratio and debt-to-equity ratio.
• Significant decreases in liquidity ratios such as current ratio and quick ratio. There might be net current liabilities.

There has been significant growth in sales revenue (50% in 2013 and 103% in 2014). This is accompanied by significant growth in current assets, particularly receivables and inventory. However, receivables turnover days and inventory turnover days have both shortened from 55 to 53 days and from 138 to 83 days respectively. What is more, the payables turnover days has shortened significantly from 34 days to 25 days due to the increased use of bank overdraft in financing working capital needs. Bank overdraft increased by a whopping 237% in 2014.

The company’s liquidity ratios kept dropping over the three years under review. The current ratio dropped from 2.05:1 in 2012 to just 1.54:1 in 2014 while the quick ratio dropped from 1.03:1 in 2012 to 0.75:1 in 2014. Besides, the ratio of long-term capital to total assets kept reducing over the same periods. Long-term capital that stood at 73% of total assets in 2012 had dropped to 54% of total assets. The decreases in liquidity ratio is due to the significant increase in current liabilities, mainly due to the high increment in bank overdraft financing. The growth in long-term capital is due to reinvestment of profits as stated capital stood the same and medium-term loan was being amortised over the period. These suggest that the company is financing most of the rapid growth in sales with short-term funds rather than long-term capital.

Sales revenue is increasing rapidly, liquidity ratios are falling, long-term capital ratio is falling, and there is significant increase in bank overdraft. On the face of it, one would concluded that the company is overtrading. However, the ratio of long-term capital is not yet too low to permit the conclusion that the company is trying to do too much too quickly with too little long-term capital. If the current trends in long-term capital ratio, sales growth, and liquidity ratios continue in the future, the company might experience overtrading in the near future.

Candidates are expected to match the cost of the early discount policy against the benefit of it. The policy change is worthwhile when the benefit, measured in terms of annual interest savings, exceeds the cost, measured in terms of the cash discount that would be given.

Under current policy:
Current credit sales                    = GHS122 million
Current credit period                 = 40 days
Receivables turnover days        = 53 days
Trade receivables, 2014            = GHS24.210 million
Trade receivables, 2013            = GHS11.210 million

Under discount policy:
Credit sales                             = GHS122 million (assumed to be kept at recent sales level)
Credit period                          = 40 days
Discount period                      = 10 days
Discount rate                          = 1.5%
Early payment probability      =60%

Other relevant data:
Financing cost                       = 15%
Cash discount cost                = Credit sales x Discount rate x Early payment probability
Cash discount cost                = GHS122m x 1.5% x 60% = GHS1.098m
If credit policy remains unchanged, average trade receivables would be GHS17.715m:

If early settlement discount is introduced, average trade receivables would be GHS7.353m:

Funds that would be released every year if the early settlement discount is introduced is GHS11.365m:

𝐹𝑢𝑛𝑑𝑠 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑙𝑒𝑎𝑠𝑒𝑑 = 𝐺𝐻𝑆17.715𝑚 − 𝐺𝐻𝑆7.353𝑚=𝐺𝐻𝑆10.362𝑚
Interest charges that would be saved every year due to the early settlement discount is GHS1.554:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑠𝑎𝑣𝑒𝑑=𝐺𝐻𝑆10.362×0.15=𝐺𝐻𝑆1.554𝑚

Summary:
.                                                                                                                                        GHS’m
Benefit of new discount policy: Interest saved every year =                                   1.554
Cost of new discount policy: Cash discount allowed every year =                         1.098
Net benefit of new discount policy =                                                                           0.456

Conclusion:
If the early settlement discount is introduced and 60% of accounts are settled early to take the discount, the company’s profit will increase by GHS0.456m every year. Therefore, management should accept the early settlement discount proposal for implementation.

Switch from financing working capital needs with bank overdraft to financing with trade credit.
If the company continues to finance working capital needs with bank overdraft, the annual financing cost would be 15%.
If the company finances working capital needs with suppliers trade credit the annual financing cost would be 12.3% (assuming simple interest):

Conclusion:
Since the cost of financing with suppliers’ trade credit is lower than the cost of financing with the overdraft facilities, the company should discard its current working capital financing method and finance with trade credit.
Note:
Full credit should be given to candidates who estimate the cost of trade credit based on compound interest:

1) Postpone capital investments.
2) Postpone dividend payments.
3) Accelerate collection from customers by offering incentives for early payment (e.g. early settlement discount, increase in credit limit). This will reduce funds tied up in working capital.
4) Reduce investment in inventory to minimise funds tied up in working capital.
5) Reverse past investment decisions by selling assets previously acquired but are surplus to the company’s needs, or producing negative or lower returns. Even assets that are needed can be sold and leased back.
6) Negotiate with creditors for more favourable payment terms.