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Financial Management

This document discusses cash discounts and their implications. It begins by defining a cash discount as a reduction in payment offered to customers who pay within a specified time period, which is less than the normal credit period. It then discusses how cash discounts can impact sales volume, average collection period, bad debts, and profits per unit. Specifically, it states that sales volume and average collection period would likely decrease while bad debts and profits would increase with cash discounts. The document then provides an example cash discount scenario for a company and calculates that offering a 2% discount for payment within 10 days would increase the company's profits.

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shruti
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485 views8 pages

Financial Management

This document discusses cash discounts and their implications. It begins by defining a cash discount as a reduction in payment offered to customers who pay within a specified time period, which is less than the normal credit period. It then discusses how cash discounts can impact sales volume, average collection period, bad debts, and profits per unit. Specifically, it states that sales volume and average collection period would likely decrease while bad debts and profits would increase with cash discounts. The document then provides an example cash discount scenario for a company and calculates that offering a 2% discount for payment within 10 days would increase the company's profits.

Uploaded by

shruti
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CASH DISCOUNT

A Cash Discount is a reduction in payment


offered to customers to induce them to repay
credit obligations within a specified period of
time, which will be less than the normal credit
period.
Cash discount indicates the Rate of Discount
and the Period for which it is available. If the
customer does not avail the offer, he must make
payment within the normal credit period.

Implications of Cash
Discount
The cash discount has implications for the sales volume,
average collection period/ average investment in
receivables , bad debts and profit per unit.
In taking a decision regarding the grant of cash discount,
the management has to see what happens to these
factors if it initiates increase or decrease in the discount
rate .
1. The sales volume will increase. The grant of discounting
reduced prices. If the demand for the product is elastic,
reduction in prices will result in higher sales volume.

2. Since the customers, to take advantage of the


discount , would like to pay within the discount
period, the average collection period would be
reduced.
3. The reduction in the collection period would lead to a
reduction in the investment in receivables as also the
cost. This decrease would also cause a fall in bad
debt expenses. As a result, profits would increase.
4. The discount would have a negative effect on the
profits.

Effects of Increase in Cash discounts


ITEM

Direction of
change
I = Increase D=
Decrease

Effects on profits

Sales volume

Average Collection
period

Bad debt expenses

Profit per unit

Question
Sagar company currently makes all sales on
credit and offers no cash discount. It is
considering a 2% cash discount for payment
within 10 days. The firms current average
collection period is 60 days, sales are 2,00,000
units, selling price is Rs.30 per unit , variable cost
per unit is Rs.20 and average cost per unit is
Rs.25 at the current sales volume.

It is expected that the change in credit terms will


result in increase in sales to 2,25,000 units and
the average collection period will fall to 45 days.
However, due to increased sales, increased
working capital required will be Rs. 1,00,000 ( it
does not take into account the effects of
debtors ).
Assuming that 50% of the total sales will be on
cash discount and 20% is the required return on
investment, should the proposed discount be
offered ?

PARTICULARS

AMOUNT

Increased Sales revenue ( 25,000* Rs. 30)

7,50,000

Less: Variable costs ( 25,000* Rs.20)

Incremental Contribution
Add : Savings in cost due to decrease
investments in debtors. ( WN 1)
Less: Cost of additional working capital ( Rs.
1,00,000 * 0.20 )
Less: Cost involved in cash discounts
( 0.02*2,25,000 units*Rs.30*0.5)

PROFIT

(5,00,000)
2,50,000
29,167
( 20,000)
( 67,500)

1,91,667

It is advised that the firm should offer Cash discounts to


its customers.

Working note 1 ( WN1 )


1. Savings due to decrease in average collection period:
Average investment in accounts receivable= Cost of
sales/Receivables turnover
.
Present investment in debtors ( without cash discount )
=
( 2,00,000* Rs.25 ) / 6 (360 days/60) = Rs. 8,33,333
.
Expected investment in debtors ( with cash discount )=
( 2,00,000*Rs.25 + 25,000*Rs.20 ) / 8 (360 days/45) =
Rs.6,87,500
Decrease in investment debtors= Rs.8,33,333Rs.6,87,500= Rs.1,45,833

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