Chapter
Twenty
Credit and Inventory
Management
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
20.1
Chapter Outline
•
•
•
•
•
•
•
•
•
Credit and Receivables
Cash Management
Terms of the Sale
Analyzing Credit Policy
Optimal Credit Policy
Credit Analysis
Collection Policy
Inventory Management
Inventory Management Techniques
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.2
Credit Management: Key Issues 20.1
• Granting credit increases sales
• Costs of granting credit
– Chance that customers won’t pay
– Financing receivables
• Credit management examines the trade-off
between increased sales and the costs of
granting credit
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.3
Components of Credit Policy
• Terms of sale
– Credit period: length of time between sale and collection
– Discounts: price reduction for early payment
– Cash discount period: length of time between sale and
payment with discount
– Credit instrument: evidence of indebtedness
Types of credit instruments
- Invoice
- Promissory note – used for large purchases and risky customers,
they are signed after the delivery of the goods
- Commercial draft – to obtain a credit commitment for a customer
before the goods are delivered
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.4
Components of Credit Policy (cont.)
• Credit analysis – distinguishing between “good”
customers that will pay and “bad” customers that will
default
• Collection policy – effort expended on collecting on
receivables
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20.5
Cash Management
• Cash = total bank deposits + currency + marketable
securities
• Rationale for holding cash:
1- Speculative Motive – cash needed to take advantage of special
cash bargains which come along
2- Precautionary Motive – cash needed for unexpected events
3- Transactions Motive – cash needed to conduct business
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.6
Cash Management
• Float: difference between cash on the firm’s books
and cash as the bank has it. Due to check processing
and clearing.
• Disbursement Float: float from checks written
• Collection Float: float from checks received
• Net Float = Disbursement float – Collection float
• Managing float – reduce cash collection time.
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.7
Example – Cash Management
Each business day, on average, a company writes
checks totalling $43,000 to pay its suppliers. The
usual clearing time for the checks is five days.
Meanwhile, the company is receiving payments from
its customers each day, in the form of checks,
totalling $57,000. The cash from the payments is
available to the firm after 2 days. Calculate the
company’s disbursement float, collection float, and
net float.
Disbursement float = 43,000 (5) = $215,000
Collection Float = -57,000 (2) = -$114,000
Net float = $215,000 + (-$114,000) = $101,000
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.8
The Cash Flows from Granting Credit
Figure 1
Customer mails
payment
Company receives Company deposits
payment
payment
Cash becomes
available
Collection time
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.9
Notes
• A/R = Credit sales per day x ACP
• Nominal annual cost of foregoing the discount = (x) (y)
(discount / [1 - discount]) (365 / [days credit is outstanding – discount period]
- EAR = (1+x)^y -1
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20.10
Example
A firm’s credit terms are 2/10 net 30, and 65% of
its customers take the discount while 35% do
not. All sales are credit sales. Find the average
collection period.
Solution:
ACP = 0.65(10) + 0.35(30) = 17 days
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.11
Terms of Sale 20.2
• Basic Form: 2/10 net 45
– 2% discount if paid in 10 days
– Total amount due in 45 days if discount not taken
• Buy $500 worth of merchandise with the
credit terms given above
– Pay $500(1 - .02) = $490 if you pay in 10 days
– Pay $500 if you pay in 45 days
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.12
Example: Cash Discounts
• Finding the implied interest rate (EAR) when
customers do not take the discount
• Credit terms of 2/10 net 45 and $500 loan
• EAR = [1 + (discount / [1 - discount])]^ (365 / [days
credit is outstanding – discount period] - 1
• EAR = (1 + 0.020408)365/(45-10) – 1
• EAR = (1.020408)10.4286 – 1 = 23.45%
• The company benefits when customers choose to
forego discounts
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20.13
Example
- A firm offers the following credit terms, 2/20 net 45.
A customer purchases $100 of raw materials. Bank
financing is available at 18%.
- Find: the nominal cost of foregoing the discount,
EAR of the firm, EAR of the bank, and real $ cost of
not taking the discount
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20.14
Total Cost of Granting Credit 20.4
• Carrying costs
– Required return on receivables
– Losses from bad debts
– Costs of managing credit and collections
• Shortage costs
– Lost sales due to a restrictive credit policy
• Total cost curve
– Sum of carrying costs and shortage costs
– Optimal credit policy is where the total cost curve
is minimized
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
20.15
Figure 20.1 The Costs of Granting Credit
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20.16
Credit Analysis 20.5
• Process of deciding which customers receive credit
• Gathering information
–
–
–
–
Financial statements
Credit reports
Banks
Payment history with the firm
• Determining Creditworthiness
– 5 Cs of Credit
– Credit Scoring
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20.17
Credit Information
• Financial statements (balance sheet, income statement,
statement of cash flows)
•
•
•
•
•
Physical condition of the business
Credit ratings
Reports from customer’s bank
Timeliness of payments to others and your firm
Background of firm owners
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20.18
Five Cs of Credit
• Character – customer’s willingness to meet
financial obligations
• Capacity – customer’s ability to meet financial
obligations out of operating cash flows (ratio
analysis)
• Capital – customer’s financial reserves
• Collateral – assets pledged as security by
customer in the event of default
• Conditions – general economic conditions
related to customer’s business
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20.19
Credit Score
• Credit score: is the mathematical score
representing the probability that the customer
will default
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20.20
Collection Policy 20.6
• Monitoring receivables
– Keep an eye on average collection period relative
to your credit terms
– Use an aging schedule to determine percentage of
payments that are being made late
Aging Schedule: breaks a firm’s A/R down, showing
how long particular accounts have been
outstanding.
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20.21
Example- Aging Schedule
• If the credit terms are net 60
• Age of Account
Value
0-10 days
$40,000
11-30 days
30,000
31-60 days
15,000
61-90 days
10,000
over 90 days
8,000
$103,000
%
38.8
29.1
14.6
9.7
7.8
100%
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20.22
Collection Policy (cont.)
• Collection policy – what to do about collecting
delinquent accounts (how to assure payments in A/R)
- Letter to customer
- Phone call to customer
- Collection Agency
- Legal action
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20.23
Inventory Management 20.7
• Inventory can be a large percentage of a firm’s
assets
• Costs associated with carrying too much
inventory
• Costs associated with not carrying enough
inventory
• Inventory management tries to find the optimal
trade-off between carrying too much inventory
versus not enough
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20.24
Types of Inventory
• Manufacturing firm
– Raw material – starting point in production process
– Work-in-progress – partially finished goods requiring
additional work before they become finished goods
– Finished goods – completed products ready to ship or
sell
• Remember that one firm’s “raw material” may
be another company’s “finished good”
• Different types of inventory can vary
dramatically in terms of liquidity
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20.25
Inventory Costs
• Carrying costs – range from 20 – 40% of
inventory value per year
–
–
–
–
–
Storage and tracking
Insurance and taxes
Losses due to obsolescence, deterioration or theft
Opportunity cost of capital
Interest expense
• Shortage costs
– Restocking costs
– Lost sales or lost customers
• Consider both types of costs and minimize the
total cost
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20.26
Inventory Management – ABC Approach 20.8
ABC Method
• Classify inventory by cost, demand and need
• Those items that have substantial shortage costs
should be maintained in larger quantities than those
with lower shortage costs
• Generally maintain smaller quantities of expensive
items, monitor closer, and order often
• Maintain a substantial supply of less expensive basic
materials, require little monitoring, and order
infrequently
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20.27
Economic Order Quantity (EOQ) Model
• The EOQ model minimizes the total inventory cost by
finding the optimal inventory level to order
• Total carrying cost = (average inventory) x (carrying
cost per unit) = (Q/2)(CC)
• Total restocking cost = (fixed cost per order) x
(number of orders) = F(T/Q)
• # of order per period = (usage rate per year / quantity
ordered)
= (T / Q)
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20.28
EOQ Model (cont.)
• Total Cost = Total carrying cost + total restocking
cost [ TC = (Q/2)(CC) + F(T/Q)]
Q 
*
2TF
CC
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20.29
Example 1 : EOQ
• A firm uses 2,300 switch assemblies per week and then
reorders another 2,300. If the relevant carrying cost per switch
assembly is $10 and the fixed order cost is $800, is the firm’s
inventory policy optimal? Why or why not?
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20.30
Example 2: EOQ
• Consider an inventory item that has carrying
cost = $1.50 per unit. The fixed order cost is
$50 per order and the firm sells 100,000 units
per year.
– What is the economic order quantity?
2(100,000)(50)
Q 
 2582
1.50
*
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20.31
Extensions
• Safety stocks
– Minimum level of inventory kept on hand (to prevent
inventory stock outs)
– Increases carrying costs
• Reorder points
– At what inventory level should you place an order?
– Need to account for delivery time
Example
A firm uses 1000 units per week. It takes 1½ weeks to receive
an order. The firm holds a safety stock of 250 units. Find
the reorder point.
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20.32
Extensions (cont.)
• Derived-Demand Inventories: Sales depend on
consumer demand
– Materials Requirements Planning (MRP): use
computer-based systems for ordering and/or scheduling
production of demand-dependent inventories
– Just-in-Time Inventory: design for inventory in which
parts, raw materials, and other work-in-process is delivered
exactly as needed for production. The goal is to minimize
inventory
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.