®2002 Prentice Hall Publishing 1 Chapter 15 Management of Accounts Receivable and Inventories

1®2002 Prentice Hall Publishing

Chapter 15Management of Accounts

Receivable and Inventories


Credit Policies

• Policy variablesPolicy variables

– Quality of trade accounts acceptedQuality of trade accounts accepted

– Length of the credit periodLength of the credit period

– Cash discountCash discount

– Special terms such as seasonal datingSpecial terms such as seasonal dating

– Collection program of the firmCollection program of the firm

• Largely determine the average collection period Largely determine the average collection period and the proportion of bad-debt lossesand the proportion of bad-debt losses


Credit Standards

• Cost of relaxing credit standardsCost of relaxing credit standards

– Enlarged credit departmentEnlarged credit department

– Clerical workClerical work

– Servicing the added volumeServicing the added volume

• Focus is on the carrying cost of the additional Focus is on the carrying cost of the additional receivables which results fromreceivables which results from

– Increased salesIncreased sales

– A slower average collection periodA slower average collection period


Profitability of a More Liberal Extension of Credit

Added profitability on additional salesAdded profitability on additional sales

Trade-off Trade-off

Opportunity cost of the increased Opportunity cost of the increased

investment in receivablesinvestment in receivables


Some Qualifications

• Estimating the outcomesEstimating the outcomes

– Attach probability distributionsAttach probability distributions

– Changing demand and receivablesChanging demand and receivables

• Production capacityProduction capacity

• Additional inventories associated with a Additional inventories associated with a new credit policynew credit policy


Credit Period

• Credit terms involve both the length of the Credit terms involve both the length of the credit period and the discount givencredit period and the discount given

• Increasing the period to increase salesIncreasing the period to increase sales

– Total additional receivablesTotal additional receivables

• Associated with increased salesAssociated with increased sales

• Represents the slowing in collections Represents the slowing in collections associated with original salesassociated with original sales


Discounts Given

• Varying the discount to speed up the Varying the discount to speed up the payment of receivablespayment of receivables

• Analyze the opportunity savings arising Analyze the opportunity savings arising from a speedup in collections with the cost from a speedup in collections with the cost of the discountof the discount


Seasonal Datings

• Can be tailored to the cash flow of the Can be tailored to the cash flow of the customer and may stimulate demandcustomer and may stimulate demand

– Compare the profitability of additional Compare the profitability of additional sales with the required return on the sales with the required return on the additional investment in receivablesadditional investment in receivables

• Avoid inventory carrying costsAvoid inventory carrying costs

• Compare inventory carrying costs with the Compare inventory carrying costs with the additional investment in receivablesadditional investment in receivables


Default Risk

• Concerned with the slowness of collection Concerned with the slowness of collection and with the portion of the receivables and with the portion of the receivables defaultingdefaulting

• Optimal credit policy provides the greatest Optimal credit policy provides the greatest marginal benefitmarginal benefit


Collection Policy

• Combination of collection proceduresCombination of collection procedures

– Telephoning the customersTelephoning the customers

– Sending a letterSending a letter

– Resending the invoiceResending the invoice

– Paying a person to visitPaying a person to visit

– Legal actionLegal action

– Hiring a collection agencyHiring a collection agency


The Trade-Off

Level of collection expenditureLevel of collection expenditure

• Trade-off Trade-off

Cost of bad-debt losses Cost of bad-debt losses

and receivablesand receivables

• There is a range for greater reductionsThere is a range for greater reductions

• Not a linear relationshipNot a linear relationship


Other Considerations

• Relationship between the collection effort Relationship between the collection effort and demandand demand

• With increased collection efforts, more With increased collection efforts, more customers might take the cash discountcustomers might take the cash discount


Summary of Credit Policies• Involve several decisionsInvolve several decisions

– Quality of accounts acceptedQuality of accounts accepted– Credit periodCredit period– Cash discount givenCash discount given– Special terms such as seasonal datingsSpecial terms such as seasonal datings– Level of collection expendituresLevel of collection expenditures

• Decision should involve a comparison of possible gains Decision should involve a comparison of possible gains from a change in policy and the cost of the changefrom a change in policy and the cost of the change

• Optimal credit policies involves the best combination of Optimal credit policies involves the best combination of credit decisions credit decisions


Effects of Changing Credit Standards

• No credit standardsNo credit standards

– All applicants acceptedAll applicants accepted

– Sales are maximizedSales are maximized

– Large bad-debt lossesLarge bad-debt losses

– Large opportunity cost Large opportunity cost

of carrying receivablesof carrying receivables

• Credit standards initiatedCredit standards initiated

– Applicants rejectedApplicants rejected

– Revenue declinesRevenue declines

– Average collection Average collection

period declinesperiod declines

– Bad-debt losses declinesBad-debt losses declines


Credit Standards are Tightened Increasingly

• Sales revenue declines at an increasing rateSales revenue declines at an increasing rate

• Average collection period and bad-debt Average collection period and bad-debt losses decrease at a decreasing ratelosses decrease at a decreasing rate

• Fewer and fewer bad credit risks are Fewer and fewer bad credit risks are eliminatedeliminated

• Total profits increase at a diminishing rate Total profits increase at a diminishing rate up to a point, after which they declineup to a point, after which they decline


Sensitivity Analysis Proves Valuable in Formulating New Credit and Collection Policies

• If the marginal profit per unit of sales If the marginal profit per unit of sales changes, new credit and collection policies changes, new credit and collection policies might be in ordermight be in order


Evaluating the Credit Applicant

• Obtaining information on the applicantObtaining information on the applicant• Analyzing information to determine the Analyzing information to determine the

applicants creditworthinessapplicants creditworthiness• Making the credit decisionMaking the credit decision

– Establishes whether credit should be Establishes whether credit should be extendedextended

– Establishes the maximum amount of credit Establishes the maximum amount of credit extendedextended


Source of Information

• Financial statementFinancial statement

• Credit ratings and reportsCredit ratings and reports

• Bank checkingBank checking

• Trade checkingTrade checking

• The company’s own experienceThe company’s own experience

– Promptness of past paymentsPromptness of past payments

– Quality of managementQuality of management


Credit Analysis

• ““Four C’s” of creditFour C’s” of credit

– CharacterCharacter

– CollateralCollateral

– CapitalCapital

– CapacityCapacity


Credit Scoring• Characteristics of an individual are quantitatively Characteristics of an individual are quantitatively

ratedrated– Such things as age, occupation, duration of Such things as age, occupation, duration of

employment, home ownership, years of residence, employment, home ownership, years of residence, telephone, and annual incometelephone, and annual income

• Used by companies extending trade credit to screen Used by companies extending trade credit to screen out “clear” accept and reject applicationsout “clear” accept and reject applications

• Marginal applicants can then be analyzed in more Marginal applicants can then be analyzed in more detaildetail


Sequential Investigation Process

• Incremental stages of investigationIncremental stages of investigation• Each stage has a costEach stage has a cost• Each stage can be justified only if the Each stage can be justified only if the

information obtained has value in changing a information obtained has value in changing a prior decisionprior decision

• Each stage costs moreEach stage costs more• Added sophistication is introduced only when Added sophistication is introduced only when

it is beneficial it is beneficial


The Credit Decision• Credit analysisCredit analysis• Decision reached on the disposition of the Decision reached on the disposition of the

accountaccount• Initial saleInitial sale

– Ship goods and extend creditShip goods and extend credit

• Establish a line of credit for an existing accountEstablish a line of credit for an existing account– Represents the maximum risk exposureRepresents the maximum risk exposure– Multiple orders are assumedMultiple orders are assumed

– Streamlines the procedure for shippingStreamlines the procedure for shipping


Outsourcing Credit and Collections

• Third parties offer complete or partial Third parties offer complete or partial services to corporationsservices to corporations

• May be too costly for small- and medium-May be too costly for small- and medium-sized companies to do on one’s ownsized companies to do on one’s own

• Competency may not exist in larger Competency may not exist in larger companiescompanies


Inventory Management and Control

• Inventories form a link between production and Inventories form a link between production and sale of a productsale of a product

• Raw materials inventoryRaw materials inventory– Flexibility in purchasingFlexibility in purchasing

• Work in process inventoryWork in process inventory• Finished goods inventoryFinished goods inventory

– Flexibility in production scheduling and Flexibility in production scheduling and marketingmarketing

• Large inventories allow efficient servicing of Large inventories allow efficient servicing of customer demandscustomer demands


Benefits Versus Costs• BenefitsBenefits

– Economies of production and purchasingEconomies of production and purchasing– Fill orders more quicklyFill orders more quickly– Firm flexibilityFirm flexibility

• CostsCosts– Holding inventoryHolding inventory

• Storage and handling costsStorage and handling costs• Required return on capital tied up in inventoryRequired return on capital tied up in inventory

– Danger of obsolescenceDanger of obsolescence• Balance requires coordination of production, marketing, Balance requires coordination of production, marketing,

and financeand finance


Economic Order Quantity (EOQ)• Assume ordering costs are constant regardless Assume ordering costs are constant regardless

of order sizeof order size• Assume carrying costs are constant per unit Assume carrying costs are constant per unit

of inventory and timeof inventory and time• Total costs = carrying cost + ordering costsTotal costs = carrying cost + ordering costs

• EOQ minimizes the total cost of inventoryEOQ minimizes the total cost of inventory– Balances fixed ordering costs against Balances fixed ordering costs against

variable carrying costsvariable carrying costs

Q

SOCQ

2

C

SOQ

2*


Uncertainty and Safety Stock

• Order point and safety stock become Order point and safety stock become advisable with uncertainty in demand for advisable with uncertainty in demand for inventory and lead timeinventory and lead time

• Order point determines the amount of safety Order point determines the amount of safety stock heldstock held

• Safety stock absorbs random fluctuations in Safety stock absorbs random fluctuations in usage and lead timeusage and lead time


The Amount of Safety Stock• Depends on Depends on

– The uncertainty associated with forecasting demand for The uncertainty associated with forecasting demand for inventoryinventory

• Depends on Depends on – The uncertainty of lead time to replenish stockThe uncertainty of lead time to replenish stock

• Depends on Depends on – The cost of running out of inventoryThe cost of running out of inventory

• Depends on Depends on – The cost when production closes down temporarilyThe cost when production closes down temporarily

• Depends on Depends on – The probability of inventory stockout that management is The probability of inventory stockout that management is

willing to toleratewilling to tolerate


Just-In-Time Inventory Control and the Internet

• Just-in-time inventory controlJust-in-time inventory control– Inventories are acquired and inserted in Inventories are acquired and inserted in

production at the exact times they are neededproduction at the exact times they are needed• Supply chain managementSupply chain management

– Coordination of various suppliers in an Coordination of various suppliers in an efficient manner efficient manner

– Internet use has greatly facilitated supply Internet use has greatly facilitated supply chain managementchain management

• Business-to-business (B2B) types of Business-to-business (B2B) types of transactionstransactions


Inventory and the Financial Manager• Monitoring amounts tied up in inventoriesMonitoring amounts tied up in inventories

– Allocate capital efficientlyAllocate capital efficiently• Watch the inventory turnover ratioWatch the inventory turnover ratio

– Deteriorating trend over time may indicate obsolescence Deteriorating trend over time may indicate obsolescence problems and/or increasing inventory carrying costsproblems and/or increasing inventory carrying costs

• Watching inventory risksWatching inventory risks– Decreased market value of specific inventoriesDecreased market value of specific inventories– ObsolescenceObsolescence– Change in styleChange in style– Physical deteriorationPhysical deterioration– Fluctuations in market priceFluctuations in market price

Documents

®2002 Prentice Hall Publishing 1 Chapter 15 Management of Accounts Receivable and Inventories