Chapter 14 Managing Short-Term Assets

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 18

Chapter Chapter 1414

Managing Short-Term

Assets


• Credit Policy encompasses of a set of decisions that

include a firm’s credit standards, credit terms, methods

used to collect credit accounts, and credit monitoring

procedures

• In general, firms would rather sell for cash than on

credit, but competitive pressures force most firms to

offer credit. Firms prefer to delay their payments,

especially if there are no additional costs associated

with the delay.

Credit ManagementCredit ManagementCredit Policy


• Credit Standards– Standards that indicate the minimum financial

strength a customer must have to be credit worthy

• Terms of Credit– The payment conditions offered to credit customers– Length of credit period and any cash discounts

offered

• Collection Policy– The procedures followed by a firm to collect its

accounts receivables

Credit PolicyCredit PolicyFactors determining the Credit Policy


• The process of evaluating the credit policy and payment patterns to determine whether a shift in the customers’ payment pattern occurs or whether the credit policy needs modifications

Credit ManagementCredit ManagementReceivables Monitoring


• The days sales outstanding (DSO) represents the average length of time required to collect accounts receivable.– The DSO is calculated by dividing accounts receivable by daily

credit sales.

– The DSO can be compared with the industry average and the firm’s own credit terms to get indication of how well customers are adhering to terms prescribed and how customers’ payments, on average, compare with the industry average.

• An aging schedule is a breakdown of a firm’s receivables by age of account. – The report divides receivables into specified periods, which

provides information about the proportion of receivables that are current and the proportion that are past due for given lengths of time.

Methods for monitoring receivablesMethods for monitoring receivables


• Both the DSO and aging schedule can be distorted if sales are seasonal or if a firm is growing rapidly. A deterioration in either the DSO or the aging schedule should be taken as a signal to investigate further, but not necessarily as a sign that the firm’s credit policy has weakened.

• If a firm generally experiences widely fluctuating sales patterns, some type of modified aging schedule should be used to correctly account for these fluctuations.

• If the average collection period or DSO is increasing the firm should consider toughening its credit policy to prevent credit to more customers

Monitoring receivablesMonitoring receivablesBEWARE! Things to note!


• Marginal Costs and Benefits (will revenues rise more than costs?)

• Analyze change in sales, change in variable operating costs, change in average collection period and change in carrying cost of receivables

• Proposed changes should be evaluated the same way as capital budgeting projects would be; changes should be made only if NPV Proposal > 0.

• BEWARE: There is quite a bit of uncertainty in credit policy change analysis because the variables are very difficult to estimate. Further, the end result depends on competitors’ reactions. Thus, the final decision is based on the quantitative analysis plus a great deal of informed judgment.

Analysis of changes in credit policyAnalysis of changes in credit policy


• Raw Materials– Inventories purchased from suppliers that will

ultimately be transformed into finished goods

• Work In-Process– Inventory in various stages of completion

• Finished Goods– Inventories that have completed the production

process and are ready for sale

Inventory ManagementInventory ManagementTypes of inventory


• The goal of inventory management is to provide the inventories required to sustain operations at the lowest possible cost. Steps: (a) Identification of costs involved in purchasing and maintaining inventory, (b) Determination at what point those costs are minimized.

• There are 3 categories of inventory costs.– Carrying costs are associated with having inventory, such as

rent paid where the inventory is stored, and they generally increase in proportion to average amount of inventory carried.

– Ordering costs are associated with placing and receiving an order for new inventory, including costs of generating memos etc. The costs of each order are fixed regardless of order size.

– Costs associated with running short of inventory (stockouts).

Inventory ManagementInventory ManagementOptimal inventory level


Optimal inventory level

= +Total

inventorycosts (TIC)

Total carrying

costs

Total ordering

costs

Q

T O

2

Q PPC

ordersofNumber

orderper Cost

inventoryin units Average

unit/tcosCarrying

C – carrying cost as a percent O – cost per orderPP – purchase price of inventory T – total demand in unitsQ – quantity


Optimal inventory level

• Economic Order Quantity Model (EOQ)– The optimal quantity that should be ordered– It is the quantity that will minimize the total

inventory costs.– The Formula for determining the order quantity

that will minimize total inventory costs is the following:

PPC

TO2 EOQ


Optimal inventory level• Assumptions of the EOQ model

• sales are evenly distributed throughout the period examined and sales can be forecasted perfectly, • orders are received when expected• the purchase price, PP, of each item in inventory is the same regardless of the quantity ordered.

– The following results occur:• As amount ordered increases, total carrying costs increase but total ordering costs decrease, and

vice versa.• If less than the EOQ amount is ordered, then the higher ordering costs more than offset the lower

carrying costs.• If greater than the EOQ amount is ordered, the higher carrying costs more than offset the lower

ordering cost.


Optimal inventory level• But EOQ model should be extended because assumptions for the basic

EOQ are unrealistic– If there is a delay between the time inventory is ordered and when it is received, the firm must reorder

before it runs out of inventory. So, the reorder point is the level of inventory at which an order should be replaced.

– Even if additional inventory is ordered at the appropriate reorder point, unexpected demand might cause it to run out of inventory before the new inventory is delivered. To avoid this, the firm could carry safety stocks.

– Suppliers often offer discounts for ordering large quantities; such discounts are called quantity discounts. To evaluate taking or not taking a quantity discount, the savings of the quantity discount are compared against the increased costs of ordering (and holding) a nonoptimal amount.

– For most firms, it is unrealistic to assume that demand for an inventory item is uniform throughout the year. Thus, the EOQ model cannot be used on an annual basis.


So, how to determine a successful inventory management?

• A successful inventory management is a multi-management process that requires interaction with departments, such as sales and production, but also knowledge of the economy and the business cycles are important to be able to evaluate, for instance, unexpected demand.


• The EOQ model can be used to help establish the proper inventory level, but inventory management also involves the establishment of an inventory control system. These systems vary from the extremely simple to the very complex.

Inventory Control SystemsInventory Control SystemsIntroduction


• Red-Line Method– An inventory control procedure in which a red line is

drawn around the inside of an inventory-stocked bin to indicate the reorder point level

• Computerized Inventory Control System– A system of inventory control in which a computer is

used to determine reorder points and to adjust inventory balances

Inventory Control SystemsInventory Control SystemsControl procedures


• Just-In-Time System– A system of inventory control in which a

manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process

• OutSourcing– The practice of purchasing components rather than

making them in-house

Inventory Control SystemsInventory Control SystemsControl procedures


Proposed problemProposed problemST-3 change in credit policy (page 610)

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Chapter 14 Managing Short-Term Assets