Case #19 - Real Fresh Foods, Inc.
Real Fresh Foods is a mail-order company operating out of a winery near Santa Rosa, California. The
company specializes in sending California specialties to catalog customers nationwide. Sales are seasonal, with
most occurring in November and December—when people select Real Fresh’s Famous Fruit Fantasy boxes as
Christmas gifts. Although seasonal, the company’s sales are fairly predictable, because the bulk of Real Fresh
customers are regulars who come back year after year. The company has also managed to smooth out its sales
somewhat by offering incentives, such as the Fruit of the Month club, that encourage customers to buy
throughout the year.
The nature of the mail-order business is such that most of Real Fresh’s sales are on credit; therefore,
the company has historically had a high accounts receivable balance relative to sales. It has also
historically been short of cash, forcing it to delay payments to suppliers as long as possible (its average
time to pay accounts in 2010, was 67 days).
In January 2011, Tom Appleby and Alice Plummer, the president and treasurer of Real Fresh,
respectively, were discussing the cash flow problem over lunch.
“You know, Tom,” Alice said as she sliced a piece of avocado, “I was reading the other day about a
company called Kringle’s Candles & Ornaments, and it occurred to me that we’re a lot like them. Most of our
assets are current ones like their accounts receivable and inventory; and over half of ours are financed just like
theirs, by current liabilities—that is, accounts payable.” She paused for a sip of chardonnay, and continued,
“They got around their cash flow problems by issuing long-term debt, which took the pressure off their current
obligations. I’ve been looking at that for our company, too; but then I got to thinking, there’s another way
that’s a good deal easier and would produce results just as quickly.”
“Oh? What’s that?” Tom replied, his interest captured.
“All we have to do,” she said, “is to reduce our accounts receivable balance. That will help reduce our
accounts payable balance—since, as our customers begin paying us earlier, we can pay our suppliers
earlier in turn. If we could get enough customers to pay us right away, we could even pay some of the
suppliers.
In time to take advantage of the 2 percent discount they offer for payments within 10 days.” (Real
Fresh’s suppliers operated on a 2/10, net 60 basis.) “That would increase our net income and free up
even more cash to take advantage of even more discounts!” She looked excited at the prospect.
“Sounds great, but how do we get people to pay us earlier?” Tom inquired, doubtfully.
“Easy,” Alice continued. “Up to now we’ve been giving them incentives to pay later. Remember our
‘Buy Now, No Payments for Two Months’ program? Well, a lot of our customers use it, and it’s caused
our accounts receivable balance to runway up. So, what we have to do now is give them incentives to
pay earlier. What I propose is to cancel the buy now/pay later plan and offer a 10 percent discount to
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everyone who pays with their order, instead.
“But won’t that cause our revenues to drop?” Tom asked, again still doubtful.
“Yes, but the drop will be offset by even more new customers who will come in to take advantage of
the discount. I figure the net effect on sales will be just about zero, but our accounts receivable balance
could be cut in half! Now here’s a kicker that I just thought of: After we’ve reduced our accounts
receivable balance as far as practical, I’d like to look into the possibility of reducing our accounts payable
still further by replacing them with a bank loan. The effective rate of interest that we pay by not taking
our suppliers’ discounts is, after all, pretty high. So what I’d like to do is take out a loan once a year of a
sufficient size that would enable us to take all the discounts our suppliers offer. The interest that we’ll
pay on the loan is bound to be less than what we pay in discounts lost—so we’ll see another gain in
earnings on our income statement. In fact, these two initiatives together might have a really significant
impact!”
“You’ve convinced me,” Tom said, “Let’s go back to the office and run some figures to see what
happens!”
Financial statements for Real Fresh Foods, Inc., are presented in Figure 1 (income statement) and
Figure 2 (balance sheet).
To Do
1. Using the data in Figures 1 and 2, compute the company’s average collection
period (ACP) in days. Use a 360-day year when calculating sales per day.
2. Compute the cost, as a percent, that the company is paying for not taking the
supplier’s discounts. (The supplier’s terms are 2/10, net 60; but note from the
bottom of Figure 2 that Real Fresh has been taking 67 days to pay its
suppliers, making that the effective final due date for accounts payable.)
3. Assume that Alice Plummer’s first initiative to offer a 10 percent discount was
implemented, and the company’s average collection period dropped to 32
days. If net sales per day remained the same, as Alice expects, what would be
the new accounts receivable balance? How much cash was freed up by the
reduction in accounts receivable? What is the new accounts payable balance
if the money is used to pay off suppliers?
4. Alice’s second initiative calls for Real Fresh to obtain a bank loan of a
sufficient size to enable the company to take all suppliers’ discounts. What is
the minimum size of this loan? (Hint: To take all suppliers’ discounts, the
average payment period must be 10 days, and net purchases will be
purchases – (Purchases from Figure 1 x .02). Assume that all this happens, and
solve the following formula for the new accounts payable balance, using:
Accounts payable = Average payment period x Purchase per day (based on net
purchases/360)
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5. Now compare the accounts payable you just solved with the new
accounts payable balance you found in question 3. The difference is the
size of the loan that is required.
6. Assume that Fresh &Fruity does obtain an 8 percent loan for one year in
the amount you solved in question 5, and it reduces its accounts payable
balance accordingly. Now the company is taking 2 percent discounts on all
purchases and paying 8 percent a year on the loan balance. What is the
net gain from taking the discounts and paying the interest on a before-tax
basis? On an aftertax basis?
7. Assume that Fresh &Fruity does obtain an 8 percent loan for one year in
the amount you solved in question 5, and it reduces its accounts payable
balance accordingly. Now the company is taking 2 percent discounts on all
purchases and paying 8 percent a year on the loan balance. What is the
net gain from taking the discounts and paying the interest on a before-tax
basis? On an aftertax basis?
8. Suppose the 8 percent loan that Real Fresh obtained was a discount loan,
and the bank further required a 20 percent compensating balance of the
full loan amount. What is the effective rate of interest to Real Fresh? How
does this compare to your answer in question 2 for the cost of not taking
a cash discount?
Figure 1
Current Situation
REAL FRESH FOODS, INC
Income Statement, 2013
Revenue from sales
Gross sales (credit) ....................................................................
$1,179,000
Cost of goods sold:
Beginning inventory...................................................................
$ 141,000
Purchases...............................................................................
$969,000
Less:
Cash
0
discounts .......................................................................................
Net purchases ........................................................................
969,000
Goods available for sale ............................................................
1,110,000
Less: Ending inventory ...............................................................
79,557
Cost of goods sold .....................................................................1,030,443
Gross profit .................................................................................... 148,557
Selling and administrative expenses ............................................. 73,000
Earnings before interest and tax ................................................... 75,557
Interest expense ............................................................................
0
Earnings before tax........................................................................ 75,557
Income taxes @ 33% ..................................................................... 24,934
Net income ....................................................................................
$ 50,623
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Figure 2
Current Situation
REAL FRESH FOODS, INC
Balance Sheet
As of December 31, 2013
Assets:
Cash ...........................................................................................
$ 3,560
Accounts receivable...................................................................
209,686
Inventory ...................................................................................
79,557
Total current assets ...............................................................$292,803
Property, plant and equipment,
11,430
net..................................................................................................
Total assets
$304,233
Liabilities and equity:
Accounts payable ......................................................................
$180,633
Notes payable (bank loans) .......................................................
0
Total current liabilities...........................................................$180,633
Long-term debt ..........................................................................
0
Total liabilities ....................................................................... 180,633
Common stock ...........................................................................
13,600
Additional paid-in capital ..........................................................
83,000
Retained earnings ......................................................................
27,000
Total equity............................................................................ 123,600
Total liabilities and equity .............................................................$304,233
Selected ratios
Profit Margin .............................................................................
4.29%
Return on equity........................................................................
40.96%
Inventory turnover ....................................................................
14.82
Receivables turnover .................................................................
5.62
Average payment period ...........................................................
67
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