Chapter 15
Management of Accounts
Receivable and Inventories
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Credit Policies
• Policy variables
– Quality of trade accounts accepted
– Length of the credit period
– Cash discount
– Special terms such as seasonal dating
– Collection program of the firm
• Largely determine the average collection
period and the proportion of bad-debt losses
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Credit Standards
• Cost of relaxing credit standards
– Enlarged credit department
– Clerical work
– Servicing the added volume
• Focus is on the carrying cost of the additional
receivables which results from
– Increased sales
– A slower average collection period
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Profitability of a More Liberal
Extension of Credit
Added profitability on additional sales
Trade-off
Opportunity cost of the increased
investment in receivables
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Some Qualifications
• Estimating the outcomes
– Attach probability distributions
– Changing demand and receivables
• Production capacity
• Additional inventories associated with a
new credit policy
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Credit Period
• Credit terms involve both the length of the
credit period and the discount given
• Increasing the period to increase sales
– Total additional receivables
• Associated with increased sales
• Represents the slowing in collections
associated with original sales
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Discounts Given
• Varying the discount to speed up the
payment of receivables
• Analyze the opportunity savings arising
from a speedup in collections with the cost
of the discount
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Seasonal Datings
• Can be tailored to the cash flow of the
customer and may stimulate demand
– Compare the profitability of additional
sales with the required return on the
additional investment in receivables
• Avoid inventory carrying costs
• Compare inventory carrying costs with the
additional investment in receivables
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Default Risk
• Concerned with the slowness of collection
and with the portion of the receivables
defaulting
• Optimal credit policy provides the greatest
marginal benefit
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Collection Policy
• Combination of collection procedures
– Telephoning the customers
– Sending a letter
– Resending the invoice
– Paying a person to visit
– Legal action
– Hiring a collection agency
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The Trade-Off
Level of collection expenditure
• Trade-off
Cost of bad-debt losses
and receivables
• There is a range for greater reductions
• Not a linear relationship
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Other Considerations
• Relationship between the collection effort
and demand
• With increased collection efforts, more
customers might take the cash discount
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Summary of Credit Policies
• Involve several decisions
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Quality of accounts accepted
Credit period
Cash discount given
Special terms such as seasonal datings
Level of collection expenditures
• Decision should involve a comparison of
possible gains from a change in policy and
the cost of the change
• Optimal credit policies involves the best
combination of credit decisions
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Effects of Changing Credit Standards
• No credit standards
• Credit standards initiated
– All applicants accepted
– Applicants rejected
– Sales are maximized
– Revenue declines
– Large bad-debt losses
– Average collection
– Large opportunity cost
of carrying receivables
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period declines
– Bad-debt losses declines
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Credit Standards are Tightened
Increasingly
• Sales revenue declines at an increasing rate
• Average collection period and bad-debt
losses decrease at a decreasing rate
• Fewer and fewer bad credit risks are
eliminated
• Total profits increase at a diminishing rate
up to a point, after which they decline
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Sensitivity Analysis Proves
Valuable in Formulating New
Credit and Collection Policies
• If the marginal profit per unit of sales
changes, new credit and collection policies
might be in order
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Evaluating the Credit
Applicant
• Obtaining information on the applicant
• Analyzing information to determine the
applicants creditworthiness
• Making the credit decision
– Establishes whether credit should be
extended
– Establishes the maximum amount of
credit extended
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Source of Information
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Financial statement
Credit ratings and reports
Bank checking
Trade checking
The company’s own experience
– Promptness of past payments
– Quality of management
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Credit Analysis
• “Four C’s” of credit
– Character
– Collateral
– Capital
– Capacity
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Credit Scoring
• Characteristics of an individual are
quantitatively rated
– Such things as age, occupation, duration of
employment, home ownership, years of
residence, telephone, and annual income
• Used by companies extending trade credit to
screen out “clear” accept and reject
applications
• Marginal applicants can then be analyzed in
more detail
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Sequential Investigation
Process
• Incremental stages of investigation
• Each stage has a cost
• Each stage can be justified only if the
information obtained has value in changing
a prior decision
• Each stage costs more
• Added sophistication is introduced only
when it is beneficial
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The Credit Decision
• Credit analysis
• Decision reached on the disposition of the
account
• Initial sale
– Ship goods and extend credit
• Establish a line of credit for an existing
account
– Represents the maximum risk exposure
– Multiple orders are assumed
– Streamlines the procedure for shipping
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Outsourcing Credit and
Collections
• Third parties offer complete or partial
services to corporations
• May be too costly for small- and mediumsized companies to do on one’s own
• Competency may not exist in larger
companies
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Inventory Management and
Control
• Inventories form a link between production
and sale of a product
• Raw materials inventory
– Flexibility in purchasing
• Work in process inventory
• Finished goods inventory
– Flexibility in production scheduling and
marketing
• Large inventories allow efficient servicing
of customer demands
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Benefits Versus Costs
• Benefits
– Economies of production and purchasing
– Fill orders more quickly
– Firm flexibility
• Costs
– Holding inventory
• Storage and handling costs
• Required return on capital tied up in inventory
– Danger of obsolescence
• Balance requires coordination of production,
marketing, and finance
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Economic Order Quantity (EOQ)
• Assume ordering costs are constant regardless
of order size
• Assume carrying costs are constant per unit of
inventory and time
• Total costs = carrying cost + ordering costs
CQ SO


2
Q
• EOQ minimizes the total cost of inventory
– Balances fixed ordering costs against
variable carrying costs
2SO
*
Q 
C
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Uncertainty and Safety Stock
• Order point and safety stock become
advisable with uncertainty in demand for
inventory and lead time
• Order point determines the amount of safety
stock held
• Safety stock absorbs random fluctuations in
usage and lead time
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The Amount of Safety Stock
• Depends on
– The uncertainty associated with forecasting
demand for inventory
• Depends on
– The uncertainty of lead time to replenish stock
• Depends on
– The cost of running out of inventory
• Depends on
– The cost when production closes down
temporarily
• Depends on
– The probability of inventory stockout that
management is willing to tolerate
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Just-In-Time Inventory
Control and the Internet
• Just-in-time inventory control
– Inventories are acquired and inserted in
production at the exact times they are
needed
• Supply chain management
– Coordination of various suppliers in an
efficient manner
– Internet use has greatly facilitated supply
chain management
• Business-to-business (B2B) types of
transactions
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Inventory and the Financial Manager
• Monitoring amounts tied up in inventories
– Allocate capital efficiently
• Watch the inventory turnover ratio
– Deteriorating trend over time may indicate
obsolescence problems and/or increasing
inventory carrying costs
• Watching inventory risks
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Decreased market value of specific inventories
Obsolescence
Change in style
Physical deterioration
Fluctuations in market price
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