0. Chapter 20 Credit and Inventory Management
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

1. Key Concepts and Skills
Understand the key issues related to credit management
Understand the impact of cash discounts
Be able to evaluate a proposed credit policy
Understand the components of credit analysis
Understand the major components of inventory management
Be able to use the EOQ model to determine optimal inventory ordering
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2. Chapter Outline Credit and Receivables Terms of the Sale
Analyzing Credit Policy
Optimal Credit Policy
Credit Analysis
Collection Policy
Inventory Management
Inventory Management Techniques
Appendix
Two Alternative Approaches
Discounts and Default Risk
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3. Credit Management: Key Issues
Granting credit generally increases sales
Costs of granting credit
Chance that customers will not pay
Financing receivables
Credit management examines the trade-off between increased sales and the costs of granting credit
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4. Components of Credit Policy
Terms of sale
Credit period
Cash discount and discount period
Type of credit instrument
Credit analysis – distinguishing between “good” customers that will pay and “bad” customers that will default
Collection policy – effort expended on collecting receivables
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5. The Cash Flows from Granting Credit
Credit Sale Check Mailed Check Deposited Cash Available
Cash Collection
Accounts Receivable
Obviously, the timeline is not drawn to scale, and the distance between each point would differ across companies.
Lecture Tip: Some students might question why the amount of investment in accounts receivables is the daily sales times ACP, since “sales” contains cost plus profit, but the out-of-pocket 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.
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6. Terms of Sale 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( ) = $490 if you pay in 10 days
Pay $500 if you pay in 45 days
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7. Example: Cash Discounts
Finding the implied interest rate when customers do not take the discount
Credit terms of 2/10 net 45
Period rate = 2 / 98 = %
Period = (45 – 10) = 35 days
365 / 35 = periods per year
EAR = ( ) – 1 = 23.45%
The company benefits when customers choose to forgo discounts
Cash discounts are designed to shorten the receivables period; however, you reduce your net sales level when discounts are taken, unless the discount entices new customers to purchase.
Lecture Tip: 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.
The last statement on the slide implicitly assumes that the customer eventually pays and does so on time.
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8. Credit Policy Effects Revenue Effects Cost Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales
Cost Effects
Cost of the sale is still incurred even though the cash from the sale has not been received
Cost of debt – must finance receivables
Probability of nonpayment – some percentage of customers will not pay for products purchased
Cash discount – some customers will pay early and pay less than the full sales price
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9. Example: Evaluating a Proposed Policy – Part I
Your company is evaluating a switch from a cash only policy to a net 30 policy. The price per unit is $100, and the variable cost per unit is $40. The company currently sells 1,000 units per month. Under the proposed policy, the company expects to sell 1,050 units per month. The required monthly return is 1.5%.
What is the NPV of the switch?
Should the company offer credit terms of net 30?
Lecture Tip: It’s useful to point out that the process for determining the NPV of a credit policy switch is the same as 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.
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10. Example: Evaluating a Proposed Policy – Part II
Incremental cash inflow
(100 – 40)(1,050 – 1,000) = 3,000
Present value of incremental cash inflow
3,000/.015 = 200,000
Cost of switching
100(1,000) + 40(1,050 – 1,000) = 102,000
NPV of switching
200,000 – 102,000 = 98,000
Yes, the company should switch
100*1000=amount of immediate CF needed to cover the extension in time to pay.
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11. Total Cost of Granting Credit
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
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12. Figure 20.1
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13. Credit Analysis 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
Credit scoring is less subjective than the five Cs, but firms have to be careful with the information they choose to include in the score. For example, race, gender and geographic location cannot be included in the score.
Lecture Tip: 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 are 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 for several years.
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14. Example: One-Time Sale
NPV = -v + (1 - )P / (1 + R)
Your company is considering granting credit to a new customer. The variable cost per unit is $50; the current price is $110; the probability of default is 15%; and the monthly required return is 1%.
NPV = (1-.15)(110)/(1.01) = 42.57
What is the break-even probability?
0 = (1 - )(110)/(1.01)
 = or 54.09%
V = variable cost per unit
 = probability of default
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15. Example: Repeat Customers
NPV = -v + (1-)(P – v)/R
In the previous example, what is the NPV if we are looking at repeat business?
NPV = (1-.15)(110 – 50)/.01 = 5,050
Repeat customers can be very valuable (hence the importance of good customer service)
It may make sense to grant credit to almost everyone once, as long as the variable cost is low relative to the price
If a customer defaults once, you don’t grant credit again
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16. Credit Information Financial statements
Credit reports with customer’s payment history to other firms
Banks
Payment history with the company
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17. Five Cs of Credit
Character – willingness to meet financial obligations
Capacity – ability to meet financial obligations out of operating cash flows
Capital – financial reserves
Collateral – assets pledged as security
Conditions – general economic conditions related to customer’s business
Lecture Tip: You may wish to emphasize here that full-blown 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?
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18. Collection Policy Monitoring receivables Collection policy
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
Collection policy
Delinquency letter
Telephone call
Collection agency
Legal action
If the average collection period is well outside your credit terms, then there is definitely a problem. If you offer a discount and the ACP is not less than your “net” terms, then there is probably a problem. An aging schedule can help you pinpoint if you have customers paying late across the board or if there are a few customers that are paying really late.
Lecture Tip: 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.
Real-World Tip: 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., although the attractiveness of such securities declined with the credit crisis in 2008.
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19. Inventory Management
Inventory can be a large percentage of a firm’s assets
There can be significant costs associated with carrying too much inventory
There can also be significant costs associated with not carrying enough inventory
Inventory management tries to find the optimal trade-off between carrying too much inventory versus not enough
Lecture Tip: Dell has one of the best inventory management systems in place. There have been numerous articles written in the financial press concerning their policies. The management at Dell believes that by carrying low levels of inventory on hand, they are able to pass the savings along to customers when component prices drop, which happens regularly. They are also able to stay on top of the new technology and offer it to customers as soon as it becomes available instead of trying to get rid of out-dated equipment. In fact, Dell is so effective at managing its inventory and receivables, that it has historically had a negative cash cycle, meaning that the firm is selling and collecting on inventory before it is paying for it!
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20. Types of Inventory Manufacturing firm
Raw material – starting point in production process
Work-in-progress
Finished goods – products ready to ship or sell
Remember that one firm’s “raw material” may be another firm’s “finished goods”
Different types of inventory can vary dramatically in terms of liquidity
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21. 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
Shortage costs
Restocking costs
Lost sales or lost customers
Consider both types of costs, and minimize the total cost
Lecture Tip: Boeing Corporation 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.
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22. Inventory Management - ABC
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
Maintain a substantial supply of less expensive basic materials
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23. EOQ Model The EOQ model minimizes the total inventory cost
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)
Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) + F(T/Q)
The optimal order quantity is where the cost function is minimized. This will occur where total carrying cost = total restocking cost. If your students have had calculus, you can have them verify that taking the derivative, setting it equal to zero and solving for Q provides the same result. (See the IM for a derivation.)
CC/2 – FT/Q2 = 0
CC/2 = FT/Q2
Q2 = 2TF/CC
Lecture Tip: 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 develop a cost formula that accounts for the seasonality and then use calculus to minimize the new cost function.
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24. Figure 20.3
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25. Example: 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?
Total carrying costs = (2,582/2)(1.50) = 1,936.50
Total restocking costs = 50(100,000)/2,582 = 1,936.48
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26. Extensions Safety stocks Reorder points Derived-Demand Inventories
Minimum level of inventory kept on hand
Increases carrying costs
Reorder points
At what inventory level should you place an order?
Need to account for delivery time
Derived-Demand Inventories
Materials Requirements Planning (MRP)
Just-in-Time Inventory
Lecture Tips: 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.
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27. Quick Quiz What are the key issues associated with credit management?
What are the cash flows from granting credit?
How would you analyze a change in credit policy?
How would you analyze whether to grant credit to a new customer?
What is ABC inventory management?
How do you use the EOQ model to determine optimal inventory levels?
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28. Ethics Issues
It is illegal for companies to use credit scoring models that apply inputs based on such factors as race, gender, or geographic location.
Why do you think such inputs are deemed illegal?
Beyond legal issues, what are the ethical and business reasons for excluding (or including) such factors?
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29. Comprehensive Problem
What is the effective annual rate for credit terms of 2/10 net 30?
What is the EOQ for an inventory item with a carrying cost of $2.00 per unit, a fixed order cost of $100 per order, and annual sales of 80,000 units?
Period rate = 2 / 98 = %
Period = 30 – 10 = 20 days
365 / 20 = periods per year
EAR = ( )^18.25 = 44.59%
EOQ = (2(80,000)(100)/2)^.5 = 2,828
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30. End of Chapter
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