Outline: Chapter 23 Accounts Receivable and Inventory

Outline: Chapter 23Accounts Receivable and Inventory • Receivables, Inventory, and the Firm • Importance of receivables and inventory • Size of accounts receivable • Credit and Collection Management • Terms and conditions of sale • International purchases and sales • Credit analysis • Credit decision • Collection policy

Outline: Chapter 23Accounts Receivable and Inventory (continued) • Inventory Management • Types of inventory • Benefits from inventory investment • Costs of inventory investment • Alternative approaches for managing inventory • Analysis of investment in inventory • Interaction of accounts receivable and inventory decisions

Outline: Chapter 23Accounts Receivable and Inventory (concluded) • Appendix 23A: The Economic Order Quantity Model • The basic inventory decision • EOQ assumptions • Safety stocks

Receivables, Inventory, and the FirmImportance of Receivables and Inventory • In managing accounts receivable and inventory the goal remains to maximize the overall value of the firm • High levels of inventory and accounts receivable may help production and marketing efforts but require additional financing and may reduce profits • Large firms may hold 30% of total assets in accounts receivable and inventory, and increases to more than 60% for wholesale firms • Retail and smaller manufacturing firms hold over 50 % of the total assets in receivables and inventory

Receivables, Inventory, and the FirmImportance of Receivables and Inventory(concluded) • The investment in both receivables and inventory is influenced by many factors • The size and type of firm • Its production process • Action of competitors

Receivables, Inventory, and the Firm Size of Accounts Receivable • Size of the investment in accounts receivable is influenced by • Level of sales • Credit and collection policies • Terms and conditions of credit sales • Credit analysis • Credit decision • Collection policy • The credit management operation directly influences the flow of funds to the firm's cash account

Receivables, Inventory, and the Firm Size of Accounts Receivable(concluded) • Factors affecting the investment in accounts receivable Level of Cash sales Level of credit sales Level of accounts receivables Bad debts Terms of sales Credit and Length of Credit analysis collection time before Credit decision policies collection Collection policy

Credit and Collection ManagementTerms and Conditions of Sale • Cash before delivery • Typical arrangement of payment for custom-made goods • Cash on delivery, COD • Typical for risky or irregular deliveries • Payment periods of 30 to 60 days plus a discount for early payment are typical for ordinary trade credit • Open account agreement • The invoice is the bill and contains the terms of sale

Credit and Collection ManagementTerms and Conditions of Sale(concluded) • Seasonal dating • Payment is timed to coincide with the buyer's anticipated cash inflows • A draft • A written order to pay a specified amount of money at a specific point in time to the bearer • A sight draft • Customer pays the amount on presentation of the draft before receiving title to the goods • A time draft • Customer (trade acceptance) or the customer's bank (banker's acceptance) makes payment a certain number of days after accepting the draft

Credit and Collection ManagementInternational Purchases and Sales • Most international purchases and sales include • An order to pay, or draft • A bill of lading • A bill of lading is a shipping document that has a number of functions including • To serve as a contract to order the shipment of goods from one party (the seller) to another (the customer) • To provide title to the goods once the draft has been accepted • A letter of credit • A letter of credit is a written statement made by the customer's bank that it will pay out money (or honor a draft drawn on it), providing the bill of lading and other details are in order

Credit and Collection ManagementCredit Analysis • To conduct a credit analysis, information is needed on the creditworthiness and paying potential of the customer • Among the numerous sources that exist for securing this information are these • Accounting statements • Credit-granting firm may judge the stability and cash-generating ability of the customer • Credit ratings and reports • Dun & Bradstreet is the best known, most comprehensive credit agency, and its credit report includes • Summary of recent accounting statements

Credit and Collection ManagementCredit Analysis(concluded) • Key ratios and trends over time • Information from the firm's suppliers indicating the firm's payment pattern. • Description of the firm's physical condition and unusual circumstances related to the firm or its owners • A credit rating indicating the agency's assessment of the creditworthiness of the potential customer • Banks • Can provide credit information on behalf of their customers • Trade associations • Provide reliable credit information • Company's own experiences

Credit and Collection ManagementCredit Decision • Once the information is collected, a credit decision has to be made • Should credit be granted (and under what terms of sale) or not? • The credit decision compares the costs of granting credit with the benefits to be derived from granting credit, taking into account risk and the magnitude and timing of the cash flows

Credit and Collection ManagementCredit Decision(continued) • To do this, many firms employ an approach based on classifying potential customers • Classify potential customers into risk classes • Many firms use a credit scoring model to determine the risk class of a customer • Determine a credit policy for each risk class • Review risk status of customers at least once a year

Credit and Collection ManagementCredit Decision(continued) • The basic model compares the present value of the benefits with the cost of granting credit, given the risks involved using net present value, NPV • Calculate the annual after-tax cash flow received by a firm from a credit sale, CFt

Credit and Collection ManagementCredit Decision(continued) • Calculate the NPV for the credit-granting decision • If: NPV > 0, grant credit NPV < 0, do not grant credit NPV = 0, you are indifferent

Credit and Collection ManagementCredit Decision(continued) • Making the Credit Decision • Determine the firm’s investment in accounts receivable • Determine the net cash flow

Credit and Collection ManagementCredit Decision(continued) • Use to determine NPV

Credit and Collection ManagementCredit Decision(continued) • Credit decision example • Dynamic Approach Ltd. is considering the possibility of granting credit to customers in risk class VI where the following apply: k = 12%; DSO is 50 days; sales (S) are $196,000; BD are 7% of sales; and, CD are $19,500. Given Dynamic's VC are 78% of sales and T is 40%, should they grant credit to potential customers in risk class VI? Answer: First find the firm’s initial investment in accounts receivable

Credit and Collection ManagementCredit Decision(continued) Next we find Finally, we have Since NPV is positive, Dynamic should grant credit to potential customers in risk class VI.

Credit and Collection ManagementCredit Decision(continued) • Suppose Dynamic is now considering granting credit to firms in risk class VII where the following apply k = 17%; DSO = 55 days; S = $261,500; BD = 11% of S; and, CD = $22,000. Should Dynamic grant credit to firms in class VII? Answer: In a similar fashion to the previous calculations we first get CF0 = (0.78)($261,500)(55/365) = $30,735

Credit and Collection ManagementCredit Decision(concluded) CFt = [$261,500(1 - 0.78) - $261,500(0.11) - $22,000](1 - 0.40) = $4,059 The net present value is then Because the net present value is negative, Dynamic should not grant credit to firms in risk class VII.

Credit and Collection ManagementCollection Policy • Once the granting decision has been made, we must follow up to ensure the collection of these receivables • Managing collections • Days sales outstanding, DSO • Calculated by dividing the firm's accounts receivable by average daily sales • The DSO is an aggregate measure and tends to hide many individual differences among customers in terms of payments • Changes in both the level of receivables and the level of sales affect the DSO

Credit and Collection ManagementCollection Policy(continued) • Receivables pattern approach • Considers customer's varying receivables patterns by focusing on the percent paid relative to the month of sale • Takes a management-by-exception approach to exercise control on accounts receivable by focusing on deviations from the projected pattern • Two significant advantages of a receivables pattern approach from a management standpoint • It disaggregates the receivables into their collection pattern relative to the month in which they occur • Accounts receivable are sales-dependent only in the month of origin, so no matter what the sales pattern, any changes in payment behavior can be recognized immediately

Credit and Collection ManagementCollection Policy(continued) • Analysis of changes in collection policy • Calculating the incremental initial investment • Determine the incremental after-tax cash flows

Credit and Collection ManagementCollection Policy(concluded) • Calculate NPV • Make a policy change if NPV is positive, since the goal of accounts receivable management is to maximize the value of the firm • A similar approach compares the NPV of the new policy with that of the old: if NPVnew > NPVold, then change policy

Inventory ManagementTypes of Inventory • The more efficiently inventory is managed the lower the investment required which, other things being equal, will increase the value of the firm • Types of inventory • Raw materials • Used to manufacture a product • Work-in-process • Partially completed goods • Finished goods • Completed and ready for sale • The purpose of holding inventory is to uncouple the acquisition of the goods, the stages of production, and selling activities

Inventory ManagementBenefits from Inventory Investment • Firms can take advantage of quantity discounts and add to existing inventory • Firms can avoid stock outages • Firms can offer a full line of products for marketing purposes • Inventory speculation is possible; during times of inflation, add to existing inventory

Inventory ManagementCosts of Inventory Investment • Ordering costs • Include clerical costs plus transportation and shipping costs • Carrying costs • Storage • Insurance • Property tax • Spoilage and deterioration • Opportunity cost associated with having funds tied up in nonproductive or excess inventory • Costs of running short • Lost sales • Disruption of the firm's production process

Inventory ManagementAlternative Approaches for Managing Inventory • The ABC method • Breaks up inventory into groups (A, B, and C) according to the investment required and focuses attention where it will do the most good • The EOQ model • Assumes constant demand, constant carrying costs, and constant ordering costs to determine how often and what quantity to order, and the average inventory to have on hand

Inventory ManagementAlternative Approaches for Managing Inventory(concluded) • Material requirements planning, MRP • Uses computers to schedule the deliveries of material and parts close to the time they are needed • The just-in-time approach • Inventory system where the firm contracts with suppliers for both the goods and the time when they will be received

Inventory ManagementAnalysis of Investment in Inventory • An investment in current assets, although it often accompanies a long-term asset investment, also results from a change in policy • Three items must be stressed about making inventory decisions • The emphasis has to be on cash flows • Because various types of inventory are held by firms, close attention should be devoted to the most important items. A management-by-exception framework can be used to control investment in all other items • The risks and returns must be considered. • For many firms, inventory is the most important single investment

Inventory ManagementInteraction of Accounts Receivable and Inventory Decisions • To the extent possible, inventory and receivables policies should be developed and evaluated on a joint basis, because there are trade-offs between them • The investment is the sum of the incremental investment in receivables plus the incremental investment in inventory • The benefits are the incremental cash inflows from the joint receivables/inventory decision

Appendix 23AThe Economic Order Quantity(EOQ) ModelThe Basic Inventory Decision • Based on ordering costs (O), carrying cost (C), annual sales (S), and order quantity (Q) • The total carrying costs equals the average inventory (Q/2) times the carrying cost per unit, C • Total ordering costs equals the number of orders placed per year (S/Q) times the cost of placing each order (O)

The Economic Order Quantity(EOQ) ModelThe Basic Inventory Decision(continued) • Total costs are equal to the carrying costs plus the ordering costs • The EOQ model • Maximize the firm's value by minimizing the total costs

The Economic Order Quantity(EOQ) ModelThe Basic Inventory Decision(continued) • Savings from quantity discount equals the discount per unit times the number of units (S) • The cost equals the additional carrying cost minus the savings in ordering costs due to cutting the number of orders per year • Quantity discount • The additional carrying costs can be calculated by (where Q' is the new order size)

The Economic Order Quantity(EOQ) ModelThe Basic Inventory Decision(concluded) • The savings in ordering costs is obtained by

The Economic Order Quantity(EOQ) ModelEOQ Assumptions • The three major assumptions of the EOQ model are these: • Constant or uniform demand • Constant carrying costs • Constant ordering costs • To make the EOQ approach useful when there is uncertainty and demand is not constant, safety stocks must be added • Even though the EOQ model is simple and assumes both certainty and constant costs, it can easily be modified to accommodate more realistic conditions

The Economic Order Quantity(EOQ) ModelSafety Stocks • Until now we have not allowed for uncertainty in demand or in delivery time • To deal with uncertainty, most firms employ a safety stock • Determining the amount of the safety stock is not always easy, but some points should be mentioned • The greater the uncertainty in either demand or delivery times, the larger the safety stock should be • How critical is it if a firm runs out of inventory? Will it incur substantial lost sales, lose goodwill, or have to shut down the production line?

The Economic Order Quantity(EOQ) ModelSafety Stocks(concluded) • How much does it incur in additional carrying costs by increasing safety stock? • Ultimately, the amount of safety stock carried involves a balancing of the costs incurred if stock runs out versus those arising from carrying more inventory • To maximize the market value of the firm, we should not add safety stock beyond the point where the additional carrying costs equal the benefits derived from avoiding a stock outage

Outline: Chapter 23 Accounts Receivable and Inventory