Corporate Financial Management 3e Emery Finnerty Stowe Accounts Receivable and Inventory Management 23 Corporate Financial Management 3e Emery Finnerty Stowe © Prentice Hall, 2007

Learning Objectives Explain the reasons for granting credit. Evaluate credit granting decisions using the NPV rule. Describe important accounts receivable management tools. Identify and compute inventory management costs. Apply inventory management models to optimize the firm’s inventory.

Chapter Outline 23.1 Accounts Receivable Management 23.2 Credit Standards and Credit Evaluation 23.3 Monitoring Accounts Receivable 23.4 Inventory Management

Receivables, Inventory and the Principles of Finance Incremental Benefits Calculate the incremental cash flows for receivables and inventory decisions. Time Value of Money Compare NPVs of alternative receivables and inventory decisions. Two-Sided Transactions Look for situations that are non-zero-sum games; these may be profitable for you and your supplier or customer. Receivables and inventory decisions can be used to reduce agency and transactions costs.

Receivables, Inventory and the Principles of Finance Self-Interested Behavior Carefully evaluate and monitor the creditworthiness of your credit customers and the quality of goods and services from your suppliers. Comparative Advantage Consider subcontracting business activities to outside vendors if they can provide the services more cheaply and competently. Behavioral Common industry practices provide a starting place for operating efficiently.

23.1 Accounts Receivable Management Credit sales create accounts receivable Trade credit Consumer credit

Why Grant Credit? To facilitate business and promote efficiency Financial intermediation Collateral Information costs Product quality information Employee theft Steps in the distribution process Convenience, safety, and buyer psychology

The Basic Credit Granting Decision Credit should be granted if the NPV of granting credit is positive. The NPV depends on: amount of the sale investment in the sale probability of payment payment period required return collection efforts

The NPV of the Basic Credit Granting Decision Let R = amount of sale p = probability of payment C = the firm’s investment in the sale r = the required return t = time at which payment is expected

The Basic Credit Granting Decision Medi-Supply is considering extending $4,200 of credit to a customer. Medi-Supply has invested $3,750 in the sale and it estimates that the customer has a 90% probability of making the payment. The payment is due in 2 months and the required return is 20% APY. Should Medi-Supply grant credit to this customer? N=2/12 I=20 PMT=0 FV=(.9)4,200 =3,780.00 PV=3,666.87 NPV = 3,666.87 – 3,750 = -$83.13

The Basic Credit Granting Decision What is the minimum probability of payment that Medi-Supply would require from this customer? N=2/12 I=20 PV=3,750 PMT=0 FV=3,865.70 3,865.70 = p(4,200) p = 3,865.70/4,200 = 0.9204 = 92.04%

Credit Policy Decisions Choice of credit terms Setting evaluation methods and credit standards Monitoring receivables Taking actions for slow payments Controlling & administering the firm’s credit functions

23.2 Sources of Credit Information A credit application, including references Applicant’s payment history Information from sales representatives Financial statements for recent years Reports from credit rating agencies Dun & Bradstreet Credit Services Credit bureau reports Industry association credit files

Judgmental Approach to Credit Decisions The five C’s of credit: Character Capacity Capital Collateral Conditions

Credit Scoring Models These combine several financial variables to create a single score or index: S = w1X1 + w2X2 + . . . Credit is granted if the score is above a pre-specified cut-off value. Advantages: Easy to compute Easy to change standards Avoids bias or discrimination Disadvantages: Requires large samples to “calibrate.” Can be “gamed” if parameter values are known

23.3 Monitoring Accounts Receivables Aging schedules Average age of receivables Collection fractions and receivables balance fractions Pursuing delinquent credit customers Changing credit policy

Aging Schedule An aging schedule shows the dollar amount and the percentage of receivables in several age classifications. Age (days) Amount Percent 0 to 30 31 to 60 61 to 90 over 90 $23,200 $9,300 $3,500 $0 64.44% 25.83% 9.72% 0.00% Total $36,000 100.00%

Average Age The average age is computed by using the mid-points of the age ranges: Average Age = 0.6444(15) + 0.2583(45) + 0.0972(75) = 28.58 days

Collection & Receivables Fraction Balances Collection fractions are the percentage of sales collected during various months after the sale. Receivables Balance fractions are the percentage of a month’s sales that remain uncollected at the end of the month of the sale and at the end of successive months.

Collection & Receivables Fraction Balances Greenleaf Inc. had sales of $50,000 in March. The expected collection fractions, the expected receivables balance fractions, and the actual collections of sales are shown in the table. Compute the actual collection fractions and receivables balance fractions for the March sales.

Collection & Receivables Fraction Balances Expected Month Collection Fraction Receivables Sales Collected March April May June 10% 50% 35% 5% 90% 40% 0% $4,000 $22,500 $16,500 $7,000 Totals 100% $50,000

Collection & Receivables Fraction Balances Actual Month Sales Collected Collection Fraction Receivables March April May June $4,000 $22,500 $16,500 $7,000 8% 45% 33% 14% 92% 47% 0% Totals $50,000 100%

Pursuing Delinquent Accounts Letters Telephone calls Personal visits Collection agencies Legal proceedings

Changing Credit Policy Credit policy can be changed by changing: credit terms credit standards collection policies A change in the credit policy affects: sales cost of goods sold bad debt expense carrying costs of receivables administrative costs

Changing Credit Policy Sales of Mabry Fireplace Co. are currently $500,000 under credit terms of “net 30.” Bad debt losses amount to 1.50% and the balance is collected in 1.50 months on average. Under the proposed policy of “2/10, net 30,” sales would increase by 12% and bad debts would decline to 0.75% of sales. About 65% of the customers are expected to take the discount, but on average, their money would actually be collected in 15 days (0.5 months) and the remainder within 45 days (1.5 months). Assume that Mabry’s investment in sales equals 60% and that the required rate of return is 1.50% per month. Should Mabry change its credit policy to the proposed one?

Changing Credit Policy Under the current policy, Mabry’s investment in sales is $300,000. 60%×$500,000 = $300,000. Bad debts are $7,500. $7,500 = 1.50%×$500,000 Sales collections are $492,500. = $500,000 – $7,500 = $492,500 (in 1.50 months).

Changing Credit Policy Under the new policy, sales = $560,000. 1.12×$500,000 = $560,000. Mabry’s investment in sales = $336,000. 60%×$560,000 = $336,000. Bad debt losses = $4,200. 0.75%×$560,000 = $4,200. Discounts taken = 7,280. 65%×2%×($560,000) = $7,280.

Changing Credit Policy Sales collected = $560,000 – $4,200 – $7,280 = $548,520 Amount collected in 0.5 months: 65%×0.98×$560,000 = $356,720 Amount collected in 1.5 months: (100% – 65% – 0.75%)×$560,000 = $191,800

Changing Credit Policy NPV = -336,000 + 354,074 + 187,564 = $205,638 This is larger than the NPV of current policy, $181,623, so switching is favorable.

23.4 Inventory Management Types of inventories: Raw materials Work-in-process Finished goods

Economic Order Quantity (EOQ) Model Let S = constant usage rate of the inventory. F = fixed cost of ordering inventory. C = carrying cost per unit of inventory for the period. Q = units of inventory ordered.

Costs of Carrying Inventory Annual costs Ordering costs Total cost Carrying Costs The investment income foregone when holding inventory. Q* Order Quantity Q

The EOQ Model S = Annual usage F = The fixed cost reordering C = Annual cost of carrying a unit of inventory Q = The order quantity If we start with Q units of inventory, sell at a constant rate each period and replace our inventory with Q when we run out, our average inventory level will be Q 1 2 3 Time

The EOQ Model S = Annual usage F = The fixed cost reordering C = Annual cost of carrying a unit of inventory Q = The order quantity As we transfer Q units each period we incur a trading cost of F each period. If we need S in total over the planning period we will pay $F, times. Q The ordering cost Time 1 2 3

The EOQ Model Carrying cost Q* Size of cash balance Ordering costs Carrying cost Q* Size of cash balance The economic order quantity is where the total costs are minimized.

The EOQ Model The economic order quantity minimizes total inventory costs. The EOQ also exists when the ordering costs costs equal the carrying costs. The EOQ is:

The EOQ Model The Acer Co. sells 10,000 units per year. The cost of placing one order is $45 and it costs $4 per year to carry one unit of inventory. What is Acer’s EOQ?

The EOQ Model Average inventory Q/2 = 475/2 = 237.5 units Number of orders per year S/Q = 10,000/475 = 21 Time between orders Q/S = (365/21) = 17.38 days

F(S/Q) = $45(10,000/475) = $947 per year The EOQ Model Annual ordering cost F(S/Q) = $45(10,000/475) = $947 per year Annual holding cost C(Q/2) = $4(475/2) = $950 per year Total annual cost $947 + $950 = $1,897 per year

Quantity Discounts Quantity discounts can impact the optimal order size. Suppose Acer were offered a discount of $0.02 per unit if it ordered in lots of 500.

Quantity Discounts Total cost with this order size = = Annual Ordering Cost + Annual Carrying Cost – Total Discount This is less than $1,897, so the quantity discount more than makes up the higher costs.

Inventory Management with Uncertainty Types of uncertainty: Future demand Inventory usage rate Delivery time To protect against stockouts, the firm must maintain a safety stock of inventory. Stockouts result in: lost sales customer ill will production down-time

Inventory Management with Uncertainty Reorder point Expected lead-time demand + Safety stock. Annual cost Ordering cost + Carrying cost + Stockout costs.

Inventory Management with Uncertainty Inventory Level Reorder Point Lead Time Safety Stock Level Time

ABC System of Inventory Management Inventory items are classified into three groups on the basis of critical needs. Group A items are most critical. Group C items are least critical. Critical items are managed very carefully.

ABC System of Inventory Management Suppose 15% of our items accounted for 70% of our sales. They would be A items, managed most carefully. 100% Value of inventory 70% Number of items A items B items C items

Materials Requirement Planning Systems MRPs are computer-based inventory planning and management systems. Objectives: smooth production no interruptions handle complex inventory requirements

Just-In-Time (JIT) Inventory Systems Materials should arrive exactly as they are needed in the production process. Reduces inventory holding costs Important factors determining success of JIT systems: Planning requirements Supplier relations Setup costs Other cost factors Impact on credit terms

Summary Accounts receivable are investments that can made using the NPV framework. The five C’s of credit and objective credit-scoring models are both in wide use. Aging schedules, collection fractions, and balance fractions are used to monitor AR. Pursuing delinquent customers and changing credit policy are also based on cash flow analysis.

Summary The EOQ is the order size that minimizes inventory costs. When demand is uncertain, firms maintain safety stocks. The reorder point is the safety stock plus the expected lead time demand. Modern firms uses computer-based systems such as MRP (materials requirement planning) and JIT (just-in-time) systems to compete.