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

2. 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.

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

4. 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.

5. 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.

6. 23.1 Accounts Receivable Management
Credit sales create accounts receivable
Trade credit
Consumer credit

7. 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

8. 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

9. 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

10. 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, PV=3,666.87
NPV = 3, – 3,750 = -$83.13

11. 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, = p(4,200)
p = 3,865.70/4,200 = = 92.04%

12. 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

13. 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

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

15. Credit Scoring Models
These combine several financial variables to create a single score or index: S = w1X1 + w2X
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

16. 23.3 Monitoring Accounts Receivables
Aging schedules
Average age of receivables
Collection fractions and receivables balance fractions
Pursuing delinquent credit customers
Changing credit policy

17. 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%

18. Average Age
The average age is computed by using the mid-points of the age ranges:
Average Age
= (15) (45) (75)
= days

19. 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.

20. 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.

21. 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

22. 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%

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

24. 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

25. 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?

26. 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).

27. 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.

28. 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

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

30. 23.4 Inventory Management Types of inventories: Raw materials
Work-in-process
Finished goods

31. 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.

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

33. 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
Time

34. 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

35. 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.

36. 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:

37. 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?

38. 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) = days

39. 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

40. 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.

41. 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.

42. 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

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

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

45. 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.

46. 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

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

48. 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

49. 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.

50. 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.