Question

Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company can change its credit and collection policy sufficiently to cause its DSO to fall to the industry average (without decreasing sales) and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant

Answer 1

Answer:

The effect of this is to add $328.22 to the net income.

Explanation:

The Days Sales Outstanding (DSO) can be calculated using the following formula:

DSO = (Accounts Receivable / Credit Sales) * 365 ................ (1)

This can now be determined using the following 4 steps:

Step 1: Calculation of Aziz Industries' current DSO (DSOa)

Using equation (1), we substitute the relevant values and solve as follows:

DSOa = (11,500 / 100,000) * 365

DSOa = 41.98 Days

Step 2: Calculation of the amount Accounts Receivable needs to be lowered to so that DSO will be 27 days

By this, we have:

y  = the amount that the Accounts Receivable needs to be lowered to = Accounts receivable = ?

Sales = $100,000

DSO =  industry average DSO = 27 days

Substitute the relevant values into equation (1) and solve y, we have:

27 = (y / 100,000) * 365

27 / 365 = y / 100,000

0.073972602739726 = y / 100,000

y = 0.073972602739726 * 100,000

y = $7,397.26

Step 3: Calculation of decrease in Accounts Receivable

Decrease in Accounts Receivable = Aziz Industries' current accounts receivable - y = $11,500 - $7,397.26 = $4,102.74

Step 4: Calculation of addition to net income which is the same as the interest earned

Addition to net income = Decrease in Accounts Receivable * Percentage earned on any cash freed-up by this change = $4,102.74 * 8% = $328.22

Therefore, the effect of this is to add $328.22 to the net income.