FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER CHAPTER

TWENTY-THREETWENTY-THREE

Receivables and Inventory Receivables and Inventory ManagementManagement

Learning ObjectivesLearning Objectives

1. Discuss accounts receivable and inventories.1. Discuss accounts receivable and inventories.

2. Name four major policy variables in the area 2. Name four major policy variables in the area of credit management.of credit management.

3. Discuss the trade-offs between benefits from 3. Discuss the trade-offs between benefits from anticipated sales and the costs of carrying an anticipated sales and the costs of carrying an account.account.

4. Compare the different types of insurance 4. Compare the different types of insurance available against bad debts.available against bad debts.

5. Explain the different benefits and costs 5. Explain the different benefits and costs involved in inventory control.involved in inventory control.

IntroductionIntroduction

Accounts receivables and inventories are usually Accounts receivables and inventories are usually the largest part of current assets for a firmthe largest part of current assets for a firm

Accounts receivables for the selling firm represents Accounts receivables for the selling firm represents an account payable for the purchaseran account payable for the purchaser

In this chapter we investigate:In this chapter we investigate: credit analysis of individual accountscredit analysis of individual accounts the setting of overall credit and collection policiesthe setting of overall credit and collection policies the use of credit insurancethe use of credit insurance the evaluation of receivables managementthe evaluation of receivables management the role of captive finance companiesthe role of captive finance companies

Credit Analysis of Credit Analysis of Individual AccountsIndividual Accounts

The purpose of credit analysis is to assess the The purpose of credit analysis is to assess the credit worthiness of potential customers and the credit worthiness of potential customers and the corresponding risk of late payments or defaultcorresponding risk of late payments or default

Credit analysis consists of:Credit analysis consists of:1. gathering information about the potential customer1. gathering information about the potential customer

2. analysing the information to derive a credit 2. analysing the information to derive a credit decision about the payment terms and amount of decision about the payment terms and amount of trade credit grantedtrade credit granted

Credit agencies provide credit ratings and reports Credit agencies provide credit ratings and reports on companies (Dun & Bradstreet)on companies (Dun & Bradstreet)

Credit Analysis of Credit Analysis of Individual AccountsIndividual Accounts

The credit decision is based on:The credit decision is based on: the evaluation of the applicant's the evaluation of the applicant's

liquidity and ability to meet short-liquidity and ability to meet short-term obligationsterm obligations

the applicant’s attitudethe applicant’s attitude and character and character

the economic trade-offthe economic trade-off

Credit PoliciesCredit Policies

A firm’s credit and collection policy is A firm’s credit and collection policy is determined by the trade-off between higher determined by the trade-off between higher profits from increased sales and the costs of profits from increased sales and the costs of having to finance investments in accounts having to finance investments in accounts receivable or bad debt lossesreceivable or bad debt losses

Policy variables include:Policy variables include: length of the credit period length of the credit period

2/10 net 302/10 net 30 quality of credit standardsquality of credit standards cash discountscash discounts collection procedurescollection procedures

Credit InsuranceCredit Insurance Credit insuranceCredit insurance

is designed to indemnify a firm’s unexpected losses is designed to indemnify a firm’s unexpected losses caused by non-performing customerscaused by non-performing customers

is subject to limitations and exclusions such as co-is subject to limitations and exclusions such as co-insurance clausesinsurance clauses

co-insurance clausesco-insurance clauses – requires the insured to bear a – requires the insured to bear a percentage of any loss incurredpercentage of any loss incurred

Export Development Corporation (EDC) helps Export Development Corporation (EDC) helps facilitate the management of international customers facilitate the management of international customers for small and medium-sized Canadian companiesfor small and medium-sized Canadian companies

Use of Credit Cards Use of Credit Cards in Retailingin Retailing

By honouring major credit cards retailers:By honouring major credit cards retailers: can shift the risk of losses from bad debt to the can shift the risk of losses from bad debt to the

sponsoring banksponsoring bank do not require invoicing or collection proceduresdo not require invoicing or collection procedures eliminate receivables because it receives cash eliminate receivables because it receives cash

after depositing its sales slip with the bankafter depositing its sales slip with the bank The decision to honour credit cards has to The decision to honour credit cards has to

weigh the costs against benefitsweigh the costs against benefits

Captive Finance Captive Finance CompaniesCompanies

Captive finance companiesCaptive finance companies are wholly owned subsidiaries of the are wholly owned subsidiaries of the

parent companyparent company are common for companies that sell are common for companies that sell

high- cost equipment (cars, planes)high- cost equipment (cars, planes) the assets of the finance the assets of the finance

subsidiary consist of financingsubsidiary consist of financing contracts that provide contracts that provide predictable cash flowpredictable cash flow

Inventory ManagementInventory Management

The main concern with inventory management is The main concern with inventory management is to balance the benefits and costs of carrying to balance the benefits and costs of carrying inventoriesinventories

Four approaches to inventory control include:Four approaches to inventory control include:1. 1. The ABC approachThe ABC approach – involves dividing inventory – involves dividing inventory

into categories in relationship to their contribution into categories in relationship to their contribution to inventory value per unitto inventory value per unit

2. 2. The economic order quantity (EOQ) modelThe economic order quantity (EOQ) model – – determines the optimal inventory level minimizing determines the optimal inventory level minimizing the total shortage and carrying coststhe total shortage and carrying costs

Inventory ManagementInventory Management

3. 3. Materials requirement planning (MRP)Materials requirement planning (MRP) – – a computer-based system for ordering a computer-based system for ordering and/or scheduling production of demand-and/or scheduling production of demand-dependent inventory itemsdependent inventory items

4. 4. Just-in-time (JIT)Just-in-time (JIT) – attempt to schedule – attempt to schedule delivery of raw materials and the delivery of raw materials and the completion of necessary work-in-progress completion of necessary work-in-progress components exactly when they are components exactly when they are required in order to reduce inventory to required in order to reduce inventory to its lowest possible levelits lowest possible level

The Impact of Price-Level The Impact of Price-Level Changes on InventoriesChanges on Inventories

Price level changes can have a serious Price level changes can have a serious impact on inventoriesimpact on inventories

With rising price levels, inventory profits With rising price levels, inventory profits accrue and reported earnings may not accrue and reported earnings may not reflect the firm’s profitability reflect the firm’s profitability

In Canada, the problem of inventory In Canada, the problem of inventory profits is magnified because the last-in, profits is magnified because the last-in, first-out method is not acceptable for first-out method is not acceptable for tax purposestax purposes

SummarySummary

1. For most firms, account receivables and 1. For most firms, account receivables and inventories are the most important inventories are the most important categories of current assets. Management categories of current assets. Management is concerned with reaching optimal levels is concerned with reaching optimal levels where the marginal benefits of added where the marginal benefits of added investment just equal incremental costs.investment just equal incremental costs.

2. Returns from investments in accounts 2. Returns from investments in accounts receivable are realized through increased receivable are realized through increased profitable sales. Costs include the expenses profitable sales. Costs include the expenses of financing and losses from bad debts.of financing and losses from bad debts.

SummarySummary

3. Credit information on individual accounts is 3. Credit information on individual accounts is available from credit rating agencies, banks, available from credit rating agencies, banks, other suppliers, and from customers other suppliers, and from customers themselves.themselves.

4. The cost of short-term bank borrowing is 4. The cost of short-term bank borrowing is usually the cost of financing receivables. The usually the cost of financing receivables. The most difficult aspect of credit analysis is the most difficult aspect of credit analysis is the assessment of the effects of altered credit assessment of the effects of altered credit policies on sales and the estimation of bad policies on sales and the estimation of bad debts.debts.

SummarySummary

5. Credit insurance is for accounts large enough that a 5. Credit insurance is for accounts large enough that a default can cause serious financial difficulties for the default can cause serious financial difficulties for the supplying firm. For international sales, the Export supplying firm. For international sales, the Export Development Corporation provides export insurance Development Corporation provides export insurance and other assistance. In retailing, acceptance of and other assistance. In retailing, acceptance of general credit cards sponsored by banks provides general credit cards sponsored by banks provides insurance against losses from bad debts and a insurance against losses from bad debts and a reduced investment in accounts receivable. Captive reduced investment in accounts receivable. Captive finance companies are wholly owned subsidiaries set finance companies are wholly owned subsidiaries set up by firms producing high-cost equipment in up by firms producing high-cost equipment in industries where extended credit is customary.industries where extended credit is customary.

SummarySummary

6. The main costs of inventories include 6. The main costs of inventories include warehousing, handling, insurance, warehousing, handling, insurance, obsolescence, spoilage, and financing. obsolescence, spoilage, and financing. Price level changes can have a serious Price level changes can have a serious impact on inventories.impact on inventories.