Finance 3121

Chapter 17Management of

Accounts Receivable and Inventory

Finance 3122

Receivables Management

• For a firm to grant credit to its customers:

– Establish Credit and Collection Policies

– Evaluate Individual Credit Applications

• Credit Management as a Career

Finance 3123

Accounts Receivable A/R• Large investment for most companies• Essentially an investment decision• Extend credit whenever the marginal returns from extending

credit exceed the marginal costs• Liberal credit policy provides returns in the form of increased

sales and gross profit, but...• Costs

Cost of funds Costs of credit checking Collection costs Increase in bad debts • Trade credit/ Consumer credit

Finance 3124

Credit Policy• Credit standards– Criteria used to screen credit applications– Controls the quality of accounts

• Credit terms– Conditions under which credit extended must be repaid (including

discounts)– Use of Electronic Data Interchange (EDI)

• Collection efforts– Methods employed in an attempt to collect payment on past due

accounts– Think of the picture “Rocky I”

• Credit line

Finance 3125

Credit Standards• Quality

– Time a customer takes to repay– Probability a customer will fail to repay

• Default risk - Dun & Bradstreet Rating

• Measures of quality– Average collection period– Bad-debt ratio

• Balance between too lenient and too strict– Too restrictive a policy - lost sales and profits– Too lenient a policy - Higher investigation costs, Bad debt losses, collection

costs, high investment in A/R

Finance 3126

Net Change in Pretax profits Associated With Granting Credit

• Marginal profitability of additional sales = Profit contribution ratio X Additional sales

• Additional investment = Additional ave daily sales X Ave collection period• Cost of additional investment in A/R = Additional

investment in A/R X Pretax required return• Additional bad-debt loss = Bad-

debt loss ratio X Additional sales

• Additional collection expenses• Cost of additional investment in inventory =

Additional inventory X Pretax required return• Net change in pretax profits =

Marginal returns - Marginal costs

Finance 3127

Credit Terms• Credit period

– Time allowed for payment• e.g. 30 days

• Cash discount– Allowed if payment is made within a specific

period of time– Specified as % of the invoiced amount– Granted to speed up collection of A/R– e.g. 2/10, n/30; 2/10 EOM, n/30– Kinked demand curve if oligolopistic competition

exists and everyone changes their terms.

Finance 3128

Credit Terms (Concluded)• Seasonal dating (Not a “Social Event”)

– Offered to retailers on seasonal merchandise– Accept delivery well ahead of peak season– Pay shortly after peak sales

• Advantages– Promotes sales - goods are on hand– Reduces manufacturing inventories– Allows producers to smooth production and

distribution – Assists retailers in financing inventory– e.g. O.M. Scott

Finance 3129

Collection Efforts• Methods employed to attempt to collect

payments on past due accounts– Letters– Telephone Calls– Personal Visits– Collection Agencies– Legal Proceedings

• Balance between leniency and alienating customers

Finance 31210

Collection Efforts (Concluded)

• Monitoring status– Average Collection Period– Aging of Accounts Analysis

• Classifying accounts into categories according to the number of days they are past due

• Changes in the age composition of accounts may reveal changes in the quality of A/R

– Both methods are affected by fluctuations in sales

Finance 31211

Analysis of a Change in Credit Policy

• Increase in the credit period– Increase the quantity of goods sold– Increase in profits– Cost increases from additional investment in

A/R, collection costs, bad debt costs • Liberalization of cash discount

– Increase in sales & pretax profit contribution– Reduction in A/R balance

• Additional income from alternative investments• Decrease in cost of funds• Reduction in cash revenue

Finance 31212

Analysis of a Change in Credit Policy (Concluded)

• Increase in collection effort– Reduced sales and pretax profit contribution– Increased collection expenses– Possible reduced bad-debt losses

• Size of Credit Line– Limits are not as enforced as

rejection– How large a line?

Finance 31213

Evaluation of Credit Applications

• Gathering information– Experience with customer– Credit reporting agencies - e. g. Equifax– Banks– Financial statements submitted by applicant– Personal visits

• How much does the analysis cost ?– Begin with the least costly and time consuming source– Is it worth it to proceed further?

Finance 31214

Evaluation of Credit Applications (Concluded)

• Numerical scoring system– Multiple Discriminant Analysis (MDA)– Expert systems

• Six C’s of credit– Character– Capacity– Capital– Collateral– Conditions– Country

Finance 31215

Inventory ( INV )• Buffer in the procurement-production-sales cycle• Role of Electronic Data Interchange (EDI)• Flexibility

– Timing the purchase of raw materials– Scheduling production facilities & employees– Meeting fluctuating & uncertain demand

• Investment of funds• Benefits & costs of holding inventory• Collaborative Forecasting And Replenishment

– Parties exchange data electronically(such as details of future sales promotions, analysis of sales trends)

Finance 31216

Types of Inventory• Raw materials inventory

– Stores of items used in production– Quantity discounts– Assure supply in times of scarcity

• Work-in-process inventory– Items at some intermediate state of completion– Allows for asynchronous schedules– Size related to length and complexity of production

cycle• Finished goods inventory

– Items ready and available for sale– Permits prompt filling of orders– Economies of scale

Finance 31217

Costs Associated with an Inventory Policy

• Ordering costs– Costs of placing and receiving an order of goods

• Carrying costs– Costs of holding inventory for a given period of time– Expressed as

• Cost per unit per period• A % of the inventory value per period (e.g. 20%)

• Stockout costs– Incurred when a firm is unable to fill an order– Involves:

• Lost sales• Rescheduling production• Placing and expediting special orders

Finance 31218

Inventory Control Models

• ABC Inventory Classification• Basic EOQ Model

– Deterministic Model– Assumes:

• Annual demand or usage is known with certainty• Usage is constant - no seasonality• Orders to replenish are instantaneously filled• No need for safety stocks

19

Finance 312

EOQ ( Q* )• Total costs = Ordering costs + Carrying costs• Total costs = ( # of orders per year X Cost per order ) +

( Ave INV X annual carrying cost per unit )

• Total costs = ( D/ Q X S ) + ( Q/ 2 X C )

• Q* = 2SD / C

• T* = Q*

D /365or

365 X Q*

D

20

Finance 312

Inventory Control Models (Concluded)

• Reorder Point – Defined as the inventory level at which an order

should be placed for replenishment of an item

• Extensions of Basic EOQ Model– Nonzero lead time

– Probabilistic inventory control methods

• Just-in-time inventory systems

rQ = X D

365

n

Finance 31221

Conclusion

• Receivables Management– Credit Policy

• Credit Standards

• Credit Terms

• Collection Efforts

• Credit Line

– Evaluation of Credit Application

• Inventory Management– Inventory costs

– EOQ