Zigg Ltd
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Zigg Ltd. is a wholesale distributor of a variety of imported goods to a range of retail outlets. The company specialises in supplying ornaments, small works of art, high value furnishings (rugs, etc) and other items that the chief buyer for the company feels would have a domestic market. In seeking to improve working capital management, the financial controller has gathered the following information.
Months
Average period for which items are held in inventory
3.5
Average receivables collection period
2.5
Average payables payment period
2.0
You are required to:
(a) Calculate Zigg Ltd.'s funding requirements for working capital measured in terms of months.
(b) In looking to reduce the working capital funding requirement, the financial controller of Zigg Ltd is considering factoring credit sales. The company's annual revenue is €2.5m of which 90% are credit sales. Irrecoverable debts are typically 3% of credit sales. The offer from the factor is conditional on the following:
(1) The factor will take over the sales ledger of Zigg Ltd completely.
(2) 80% of the value of credit sales will be advanced immediately (as soon as sales are made to the customer) to Zigg Ltd, the remaining 20% will be paid to the company one month later. The factor charges 15% per annum on credit sales for advancing funds in the manner suggested. The factor is normally able to reduce the receivables' collection period to one month.
(3) The factor offers a 'no recourse' facility whereby they take on the responsibility for dealing with irrecoverable debts. The factor is normally able to reduce irrecoverable debts to 2% of credit sales.
(4) A charge for factoring services of 4% of credit sales will be made.
(5) A one-off payment of €25,000 is payable to the factor.
The salary of the part-time sales ledger administrator (€12,500) would be saved under the proposals and overhead costs of the credit control department, amounting to €2,000 per annum, would have to be reallocated. Zigg Ltd.'s cost of overdraft finance is 12% per annum. Zigg Ltd. pays its sales force on a commission only basis. The cost of this is 5% of credit sales and is payable immediately the sales are made. There is no intention to alter this arrangement under the factoring proposals.
You are required to:
Critically evaluate the proposal to factor the sales ledger of Zigg Ltd.
(c) Identify:
- how cash flow problems can arise in companies.
- the methods available for easing cash shortages.
- the techniques, other than cash budgeting, that could be
used to monitor and manage cash resources.
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(a) Zigg Ltd.'s funding requirements for working capital measured in terms of months is 4 months.
(b) The factoring proposal is costlier to Zigg's Ltd. by €22,500.00 hence, it should not accepted.
Step-by-step explanation
(a) Calculate Zigg Ltd.'s funding requirements for working capital measured in terms of months as follows: -
Working Capital Requirement (in Months) = Average period for which items are held in inventory + Average receivables collection period - Average payables payment period
= 3.50 months + 2.50 months - 2.00 months
Working Capital Requirement (in Months) = 4 months
(b) Evaluate the proposal to factor the sales ledger of Zigg Ltd as follows: -
Note 1: Increased interest expense as follows: -
Interest Expense = {Total Sales x Percentage of Credit sales x One Month x Percentage of Advance by Factor x (Factor's Interest Rate - Bank's Overdraft Interest Rate)}
= {2,500,000 x 90% x (1/12) x 80% x (15% - 12%)}
Interest Expense = €22,500.00
It has been assumed that is sale is uniform throughout the year hence, one month advance would be outstanding to Zigg's Ltd for whole of the year.
Suggestion: The factoring proposal is costlier to Zigg's Ltd. by €22,500.00 hence, it should not accepted.
(c) The cash flow problems can arise in companies due to following reasons: -
(1) Due to the high account receivables collection period: - The high account receivables collection period delays the collection which may result in cash shortage.
(2) Due to the low account payable period: - The low account payable period result in rapid cash payments which may result in cash shortage.
Following methods available for easing cash shortages: -
(1) Decrease account receivables cash collection period.
(2) Increase account payable days.
By investing fund in short-term securities the company would able to earn extra income as exchange it in cash by selling it whenever it is required. The collection period could also be increased by offering cash discount for early payment.
Please see the attached file for the complete solution
