Chapter 21
CREDIT AND INVENTORY MANAGEMENT
SLIDES
21.1
21.2
21.3
21.4
21.5
21.6
21.7
21.8
21.9
21.10
21.11
21.12
21.13
21.14
21.15
21.16
21.17
21.18
21.19
21.20
21.21
21.22
21.23
21.24
21.25
Key Concepts and Skills
Chapter Outline
Credit Management: Key Issues
Components of Credit Policy
The Cash Flows from Granting Credit
Terms of Sale
Example: Cash Discounts
Credit Policy Effects
Example: Evaluating a Proposed Policy – Part I
Example: Evaluating a Proposed Policy – Part II
Total Cost of Granting Credit
Credit Analysis
Example: One Time Sale
Example: Repeat Customers
Credit Information
Five Cs of Credit
Collection Policy
Inventory Management
Types of Inventory
Inventory Costs
Inventory Management – ABC
EOQ Model
Example: EOQ
Extensions
Quick Quiz
Appendix
21A.1 Alternative Credit Policy Analysis
21A.2 Discounts and Default
CASES
The following case from Cases in Finance by DeMello can be used to illustrate concepts
in this chapter.
Managing Credit Terms
A-284 CHAPTER 21
CHAPTER WEB SITES
Section
21.1
21.2
21.4
21.5
21.7
End-of-chapter material
Web Address
www.treasury.pncbank.com
www.eycashmanagement.com
www.ny.frb.org/pihome/addpub/credit.html
www.nacm.org
www.creditworthy.com
www.dnb.com
www.simba.org
www.economagic.com
CHAPTER ORGANIZATION
21.1
Credit and Receivables
Components of Credit Policy
The Cash Flows from Granting Credit
The Investment in Receivables
21.2
Terms of the Sale
The Basic Form
The Credit Period
Cash Discounts
Credit Instruments
21.3
Analyzing Credit Policy
Credit Policy Effects
Evaluating a Proposed Credit Policy
21.4
Optimal Credit Policy
The Total Credit Cost Curve
Organizing the Credit Function
21.5
Credit Analysis
When Should Credit Be Granted?
Credit Evaluation and Scoring
21.6
Collection Policy
Monitoring Receivables
Collection Effort
CHAPTER 21 A-285
21.7
Inventory Management
The Financial Manager and Inventory Policy
Inventory Types
Inventory Costs
21.8
Inventory Management Techniques
The ABC Approach
The Economic Order Quantity Model
Extensions to the EOQ Model
Managing Derived-Demand Inventories
21.9
Summary and Conclusions
Appendix 21A More on Credit Policy Analysis
A. Two Alternative Approaches
B. Discounts and Default Risk
ANNOTATED CHAPTER OUTLINE
21.1.
Credit and Receivables
Slide 21.1
Slide 21.2
Slide 21.3
Key Concepts and Skills
Chapter Outline
Credit Management: Key Issues
A.
Components of Credit Policy
-Terms of sale – defines credit period and any available discounts
-Credit analysis – estimating probability of default for individual
customers to determine who receives credit and at what terms
-Collection policy – what steps will be taken to collect on
receivables, particularly when customers are late with their
payment
Slide 21.4
Components of Credit Policy
B.
Slide 21.5
The Cash Flows from Granting Credit
The Cash Flows from Granting Credit
A-286 CHAPTER 21
C.
The Investment in Receivables
The investment in receivables depends upon the average collection
period and the level of average daily credit sales.
Accounts receivable = average daily sales * average collection
period
Lecture Tip, page 709: Some students might question why the
amount of investment in accounts receivables is the daily sales
times ACP, since “sales” contains cost plus profit, and the out-ofpocket investment required would be the cost of the receivables,
excluding the profit reflected in the receivables balance. Point out
that the analysis refers to the funds committed to this balance. If
the receivables balance could be reduced by ten days, these ten
days’ receivables would be immediately freed up. Therefore, the
investment in receivables should be viewed in terms of the funds
that are tied up.
21.2.
Terms of the Sale
-Credit period – amount of time allowed for payment
-Cash discount and discount period – percent of discount allowed
if payment is made during the discount period
-Type of credit instrument
A.
Basic form
The terms 2/10 net 60 mean you receive a 2% discount if you pay
in 10 days, total amount due in 60 days if the discount is not taken.
In this example, the 60 days is the credit period, the 10 days is the
discount period and the 2% is the cash discount amount.
The invoice date is the date for which the credit period starts. This
is normally the shipping date, but some companies may post date
the invoice to encourage customers to order early.
Slide 21.6
Terms of Sale
B.
The Credit Period
Credit Period – the length of time before the borrower is supposed
to pay
CHAPTER 21 A-287
Two components: net credit period and discount period
Invoice date – begins the credit period, usually the shipping or
billing date
-ROG – receipt of goods
-EOM – end-of-month (invoice date is the end of the month for all
sales)
-Seasonal dating – invoice date corresponds to the “season” of the
goods
Length of the credit period depends on:
-Buyer’s inventory and credit cycle
-Perishability and collateral value
-Consumer demand
-Cost, profitability and standardization
-Credit risk
-Size of the account
-Competition
-Customer type
C.
Cash discounts
Offered by sellers to induce early payment. Not taking the discount
involves a cost of credit for the purchaser.
Cost of credit – the cost of not taking discounts offered (this is a
benefit to the company granting credit)
Periodic rate = (discount %) / (100 – discount %)
Number of periods per year = m = 365 / (net period – discount
period)
APR = m(periodic rate)
EAR = (1 + periodic rate)m – 1
Example: Consider terms of 1/15, net 45 (assume payment is made
on time in 45 days when the discount is foregone)
Periodic rate = 1/99 = .0101
Number of periods per year = m = 365 / (45 – 15) = 12.166667
APR = 12.166667(.0101) = 12.288%
EAR = (1.0101)12.166667 – 1 = 13.01%
A-288 CHAPTER 21
Lecture Tip, page 711: When a company does not take advantage
of discount terms, such as those given above, it is effectively
borrowing the invoice amount at 1% for 30 days. Some students
will want to use the total time period (45 days); so it is important
to emphasize that the company is only borrowing the money at the
discount rate for the period between the end of the discount period
and the net period.
Slide 21.7
Example: Cash Discounts
Offering discounts generally reduces the average collection period
and thus the cash cycle. This reduces the amount of financing
required, but the company loses sales in the amount of the discount
taken. Consequently, the firm needs to look at the size and timing
of the expected cash flows to determine what, if any, discount
should be offered.
D.
Credit instruments
Evidence of indebtedness
-Open account – invoice only
-Promissory note – basic IOU, may be used when the order is large
or the purchasing firm has a history of late payments
-Commercial draft – request for funds sent directly to the
purchaser’s bank
-Sight draft – payable immediately
-Time draft – payment required by some future date
-Trade acceptance – buyer accepts draft with agreement to pay
in the future
-Bankers’ acceptance – bank accepts draft and guarantees
payment
International Note, page 713: Various investments have been
developed to shift the risk of non-payment of receivables in
international transactions from the seller to a financial institution.
For example, the banker’s acceptance is an irrevocable letter of
credit issued by a bank guaranteeing payment of the face amount.
A letter of credit is simply a promise from the buyer’s bank to
make payment upon receipt of the goods by the buyer. Point out
that, while these guarantee arrangements add to the cost of doing
business, their existence greatly facilitates international trade.
CHAPTER 21 A-289
21.3.
Analyzing Credit Policy
A.
Credit Policy Effects
-Revenue effects – price and quantity sold may be increased
-Cost effects – the cost of running a credit plan and collecting
receivables
-Cost of debt – firm must finance receivables
-Probability of nonpayment – always get paid if you sell for cash
-Cash discount – affects payment patterns and amounts
Slide 21.8
Credit Policy Effects
B.
Evaluating a Proposed Credit Policy
Lecture Tip, page 714: It’s useful to point out that the process for
determining the NPV of a credit policy switch is no different from
the process for determining the NPV of a capital asset replacement
(or “switch”). The analysis involves a comparison of the marginal
costs with the marginal benefits to be realized from the switch. If a
company liberalizes credit terms, the present value of the marginal
profit is compared to the immediate investment in a higher
receivables balance. If a company tightens credit, lower sales
should be expected. The present value of the reduction in profit is
compared to the cash realized from the lower amount invested in
receivables.
Slide 21.9 Example: Evaluating a Proposed Policy – Part I
Slide 21.10 Example: Evaluating a Proposed Policy – Part II
Define:
P = price per unit
v = variable cost per unit
Q = current quantity sold per period
Q = new quantity expected to be sold
R = periodic required return (corresponds to the ACP)
Benefit of switching is the change in cash flow
(P – v)Q - (P – v)Q = (P – v)(Q - Q)
A-290 CHAPTER 21
Periodic benefit is the gross profit * change in quantity. The PV of
switching is:
PV = [(P – v)(Q - Q)] / R
The cost of switching is the amount uncollected for the period +
additional variable costs of production:
Cost = PQ + v(Q - Q)
Finally, the NPV of the switch is:
NPV = -[PQ + v(Q - Q)] + (P – v)(Q - Q)/R
A break-even application – what change in quantity would produce
a $0 NPV?
Q - Q = PQ/[(P-v)/R - v]
21.4.
Optimal Credit Policy
An optimal credit policy is one in which the incremental cash
flows from sales are equal to incremental costs of carrying the
increased investment in accounts receivable.
A.
The Total Credit Cost Curve
Slide 21.11 Total Cost of Granting Credit
Credit policy represents the trade-off between two kinds of costs:
Carrying costs:
-the required return on receivables
-the losses from bad debts
-the costs of managing credit and collections
Opportunity costs:
-potential profit from credit sales lost
B.
Organizing the Credit Function
Credit operations may be outsourced due to the cost of managing
such operations
CHAPTER 21 A-291
Those that manage credit operations internally may either selfinsure against bad debts or may purchase credit insurance
A final alternative is to set up a subsidiary that handles the credit
operations
Lecture Tip, page 718: As noted in the text, separating the finance
and non-finance lines of business by creating a captive finance
subsidiary may lower the firm’s overall cost of debt. Dennis E.
Logue suggests that this is due, in part, to the fact that “different
levels of assets can support varying degrees of leverage.” Put
another way, this suggests that the standard an analyst would
apply to the financial statements of the parent should reflect the
parent’s main line(s) of business, while the standards applied to
the statements of the subsidiary should reflect the fact that it is a
finance company. (See Dennis E. Logue, The Handbook of Modern
Finance, second edition, Warren, Gorham, and Lamont, 1990.)
21.5.
Credit Analysis
Slide 21.12 Credit Analysis
Lecture Tip, page 718: Students receive a large number of credit
card offers during their college career. This can provide a good
example of why credit analysis and assessing borrowing rates is so
important. The default rate is generally higher among college
students; however, companies can charge 18% to 21% on unpaid
balances. Since college students are also more likely to carry a
balance, the marginal benefit of the interest earned outweighs the
marginal cost of defaults. The bank also controls the risk of default
by providing lower credit limits to college students than to
individuals that have been working several years.
A.
When Should Credit Be Granted?
One-Time Sale
Let  be the percentage of new customers who default
NPV = -v + (1 - )P / (1 + R)
The firm risks –v to gain P a period later.
Slide 21.13 Example: One Time Sale
Repeat Business
NPV = -v + (1 - )(P – v)/R
Slide 21.14 Example: Repeat Customers
A-292 CHAPTER 21
B.
Credit information:
-Financial statements
-Credit reports (i.e., Dun and Bradstreet)
-Banks
-Customer’s payment history
Slide 17.18 Five Cs of Credit
C.
Credit Evaluation and Scoring
Credit evaluation – trying to estimate probability of default
Five Cs of Credit
-Character – evidence of willingness to pay
-Capacity – ability to pay out of operating income
-Capital – financial reserves
-Collateral – assets that can be pledged as security
-Conditions – economic conditions that may affect the firm’s
ability to pay
Slide 21.16 The Five C’s of Credit
Lecture Tip, page 721: You may wish to emphasize here that fullblown credit analysis contains both quantitative and qualitative
aspects. As any loan officer will tell you, using the five C’s to
evaluate a potential borrower reflects both types of considerations.
For example, capacity and capital are measured primarily by
examination of the borrower’s financial statements, while
character is measured by both the borrower’s prior credit history,
as well as by the lender’s (often highly unscientific) assessment of
the borrower’s integrity. Complicating the decision is that the most
difficult C to assess, character, is often said to be the most
important determinant of repayment. After all, if a borrower is
unwilling to repay, what difference do the other characteristics
make?
Credit scoring – assigning a numerical rating to customers based
on credit history
Ethics Note, page 721: Credit scoring models were initially
introduced in the 1940s and became widespread in the 1960s.
Companies that use scoring models need to use great care to make
sure that the factors that determine the credit score do not depend
CHAPTER 21 A-293
on race, gender, geographic location or any other criteria that
could be considered discriminatory. Failure to take the proper
precautions is not only unethical; it can lead to substantial legal
problems, customer ill will and lost sales.
21.6.
Collection Policy
A.
Monitoring receivables
Keeping track of payments to try and spot potential problems
(chronic late-payers and possible defaults) to reduce losses.
Slide 21.17 Collection Policy
Aging schedule – a break-down of receivables accounts by age
Lecture Tip, page 723: Wilbur Lewellen and Robert Johnson
demonstrate that two of the traditional receivables monitoring
tools – average collection period and the aging schedule – are
influenced by the pattern of sales and may be misinterpreted by
managers that are unaware of this effect. Fortunately, eliminating
this problem is straightforward; use outstanding balances as a
percentage of the original sales that generated them. Their
solution is discussed in detail in “Better Way to Monitor Accounts
Receivable,” Harvard Business Review, May-June, 1972, pp. 101
– 109.
B.
Collection effort
The sequence of steps taken in collecting overdue accounts.
Typical steps:
-Send delinquency letter
-Call customer
-Employ collection agency
-Initiate legal proceedings
Lecture Tip, page 723: Health-care providers face unusual
challenges in dealing with collection policy. A correspondent on
the financial management listserv made the following comments
regarding collection policy and procedure for a multi-specialty
physician’s group.
“When patients have to pay after all insurance has been
collected, you can either devote a staff person to make the
laborious calls, etc. or turn it over to an A/R firm. To reduce
A-294 CHAPTER 21
staff time, have staff make one letter billing in 15 days and one
call 15 days later.”
“If patient hasn’t paid in 30 days, turn it over to the A/R firm.
This firm contacts the patient for up to 60 days as a ‘billing
agent’ NOT COLLECTION FIRM to ask the patient to comply
in a ‘soft’ manner – YOU DO NOT WANT TO UPSET
PATIENTS!!” (emphasis in original)
“After 60 days, the account turns into aggressive collection
and the A/R firm turns into an aggressive COLLECTION
AGENCY with all the powers to collect.”
In other words, the steps in the collection policy used at this firm
progress from mild to aggressive, as suggested in the text.
Real-World Tip, page 724: Securitization involves selling an
expected series of cash flows to investors. It works something like
this: a company has accounts receivable of $10 million with an
average collection period of 45 days. The accounts receivable
might be packaged as securities and sold to investors at 95% of its
value, or $9.5 million. When customers make payments on their
accounts, the money is forwarded to the investors. The company
receives its cash much sooner and the investor bears the risk of
default on the accounts. The larger the probability of default on the
accounts, the larger the discount the investor will require. Similar
securities have been developed for mortgages, student loans, etc.
21.7.
Inventory Management
A.
The Financial Manager and Inventory Policy
Many people, not just those in the finance function, influence the
level of inventory. Nonetheless, financial managers see the results
of inventory decisions in many places – ROA, inventory turnover
and Days’ Sales in Inventory ratios, to name a few.
Slide 21.18 Inventory Management
Slide 21.19 Types of Inventory
B.
Inventory Types
For a manufacturer, inventory is classified into one of three
categories:
-Raw materials
-Work-in-progress
-Finished goods
CHAPTER 21 A-295
Classification into one of these categories depends on the firm’s
business; what are raw materials for one firm may be finished
goods for another. Inventory types have different levels of
liquidity. Demand for raw materials and work-in-progress depends
on the demand for finished goods.
C.
Inventory Costs
There are two basic types of costs associated with current assets in
general and inventory in particular – carrying costs and shortage
costs.
Slide 21.20 Inventory Costs
Lecture Tip, page 725: Boeing/McDonnell Douglas Corporation,
in St. Louis, Missouri, is one of the largest manufacturers of
military aircraft in the world. For many years, the firm has
employed hundreds of subcontractors not only to produce aircraft
components, but also to maintain stocks of raw materials inventory
for the firm. Inventory managers have found that it is often less
costly to pay someone to maintain these inventories.
21.8.
Inventory Management Techniques
A.
The ABC Approach
Inventory is subdivided into three (or more) groups and the groups
are analyzed to determine the relationship between inventory value
and quantity represented in each group.
Slide 21.21 Inventory Management – ABC
B.
The Economic Order Quantity Model
EOQ – the restocking quantity that minimizes total inventory costs
based on the assumption that inventory is depleted at a steady pace.
Total carrying costs = (average inventory)(carrying cost per unit)
= (Q/2)(CC)
Total restocking costs = (fixed cost per order)(number of orders)
= F(T/Q)
A-296 CHAPTER 21
Total costs = carrying costs + restocking costs
= (Q/2)(CC) + F(T/Q)
EOQ 
2TF
CC
The EOQ is the point where the total carrying costs just equal to
the total restocking costs.
Slide 21.22 EOQ Model
Lecture Tip, page 727: The EOQ model assumes that the firm’s
inventory is depleted at a constant rate until it hits zero. Firms
with seasonal demand may not be able to use the EOQ model
without some adjustments. One way to adjust the equation is to
compute “T” based on the high sales level and use that number to
compute the EOQ during periods of high sales. Conversely, during
periods of low sales, compute “T” based on the low sales figures
and use that number to compute EOQ. What will happen is that the
“optimal” order quantity will change depending on the seasonality
in sales. Another option is to try and develop a cost formula that
accounts for the seasonality and then use calculus to minimize the
new cost function.
Lecture Tip, page 729: If students have had calculus, you can
point out that this is just the quantity that minimizes the cost
function and can be found by taking the first derivative, setting it
equal to zero and solving for Q.
Q
T
TC  CC  F
2
Q
TC CC  FT

 2 0
Q
2
Q
CC FT
 2
2
Q
2 FT
Q2 
CC
2 FT
Q
CC
Slide 21.23 Example: EOQ
CHAPTER 21 A-297
C.
Extensions to the EOQ Model
-Safety stocks – minimum level of inventory that must be kept on
hand, inventory won’t actually reach zero, will increase the
carrying cost component above what is predicted by the EOQ
model
-Reorder points – place orders before inventory reaches a critical
level. Designed to account for delivery time
Slide 21.24 Extensions
D.
Managing Derived-Demand Inventories
-Materials Requirements Planning – computer based systems that
manage the manufacturing process to make sure that inventory will
be available when it is required
-Just-in-Time Inventory – order inventory so that it will arrive
when needed. Reduces the cost of storing inventory.
Lecture Tips, page 733: The primary advantage of JIT systems is
the reduction in inventory carrying costs that, for a large
manufacturer, can be substantial. As with every financial decision,
however, there is no increase in return without an increase in risk.
In this instance, the risk is that an interruption in the supply of
inventory items will require the user to shut down production
virtually immediately. As part of a larger program to reduce costs,
GM adopted a variant of the JIT system, but found it necessary to
temporarily halt production of some models in early 1994 as a
result of labor strikes at a supplier’s plants.
21.9.
Summary and Conclusions
Slide 21.25 Quick Quiz
A-298 CHAPTER 21
APPENDIX 21A
ANALYSIS
A.
MORE ON CREDIT POLICY
Two Alternative Approaches
Slide 21A.1 Alternative Credit Policy Analysis
1. The One Shot Approach
No switch cash flow: (P – v)Q
Switch cash flow: invest vQ now, receive PQ next period
Present value of switch net cash flow: PQ / (1 + R) - vQ
NPV = present value of switch net cash flow – no switch cash flow
NPV = PQ / (1 + R) - vQ - (P – v)Q
If repeated every period, the firm gets the NPV now and in every
period, giving:
PQ / (1 + R) - vQ - (P – v)Q + { PQ / (1 + R) - vQ - (P – v)Q}/R
This reduces to: -[PQ + v(Q - Q)] + (P – v)(Q - Q)/R
2. The Accounts Receivable Approach
Periodic benefit: (P – v)(Q - Q)
Incremental investment in receivables: PQ + v(Q - Q)
Carrying cost per period: [PQ + v(Q - Q)]*R
Net benefit per period: (P – v)( Q - Q) – {[PQ + v(Q - Q)]*R}
NPV = [(P – v)( Q - Q) – {[PQ + v(Q - Q)]*R}]/R
This reduces to: -[PQ + v(Q - Q)] + (P – v)(Q - Q)/R
Example: Suppose we have the following information for Griffie
International, which is considering a change from no credit terms to
terms of net 20.
P = 100;
v = 75; Q = 1,000; Q = 1,050;
R = 1.5% for 20 days
Using the original method:
NPV = -[100*1,000 + 75(1,050 – 1,000)] + (100 – 75)(1,050 –
1,000)/.015 = -$20,416.67
CHAPTER 21 A-299
Using the one-shot approach:
NPV = [(100*1,050)/1.015 – 75*1,050] – (100 – 75)*1,000 +
{[(100*1,050)/1.015 – 75*1,050] – (100 – 750)*1,000}/.015 =
-$20,416.67
To break even, Griffie needs 63 additional units.
B.
Discounts and Default Risk
Slide 21A.2 Discounts and Default
Define:
 = percentage of credit sales that go uncollected
d = percentage discount allowed for cash customers
P = credit price (no discount)
P = cash price = P(1 – d)
Assuming no change in Q, then:
Net incremental cash flow = [(1 - )P - v]Q – (P – v)Q = PQ(d - )
NPV = -PQ + PQ(d - )/R
A break-even application:  = d – R(1 – d) is the break-even default
rate.