Should Collins liberalize credit if a 15 percent after-tax return on investment is required? Assume Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.
To determine whether Collins should liberalize credit, we need to consider the factors mentioned in the question: the required return on investment and the need to increase inventory turnover.
1. Calculate the cost of liberalizing credit:
- Calculate the after-tax return on investment: In this case, a 15% after-tax return on investment is required. Depending on the tax rate in your jurisdiction, you'll need to factor in the tax rate to calculate the pre-tax return on investment.
- Determine the cost of liberalizing credit: If liberalizing credit involves offering extended payment terms or lower credit standards, it may increase the risk of bad debts and non-payment. This risk needs to be weighed against the potential increase in sales and the profit associated with those sales.
2. Consider the impact on inventory turnover:
- Determine the desired increase in inventory: If Collins needs to increase its level of inventory to support new sales, calculate the desired increase in inventory based on sales projections and desired inventory turnover.
- Calculate the impact on inventory turnover: If Collins currently has a four times inventory turnover, evaluate how liberalizing credit may affect inventory turnover. For example, if liberalizing credit leads to increased sales but slower customer payment, it could result in a higher inventory level and potentially slower inventory turnover.
3. Evaluate overall financial impact:
- Compare the potential benefits and costs: Consider the potential increase in sales and the associated profit against the increased risk of bad debts and the impact on inventory turnover. Assess whether the potential increase in profit justifies the potential costs and risks of liberalizing credit.
It is important to note that financial decisions like liberalizing credit should be evaluated in the context of the specific business and industry circumstances. Consulting with a financial professional or conducting a comprehensive financial analysis can help ensure an informed decision.