Finanncial Management 1 -Chapter 19

Chapter 19 Accounts Receivable and Inventory Management Accounts Receivable – consists of money owed to a firm for goods and services sold on credit. a. Trade or Commercial Credit – credit which the firm extend to other firms. b. Consumer or Retail Credit – credit which the firm extends to its final customers. Objectives of Accounts Receivable Management: -

To ensure that the firm’s investment in accounts receivable is appropriate and contributes to shareholder wealth minimization.

Credit Policy - set of guidelines for extending credit to customers. The success or failure of a business depends primarily on the demand for its products – as an example, the higher the sales, the larger its profits and the higher the value of its stocks. Credit policy generally covers the following variables: 1. Credit Standards - refer to minimum financial strength of acceptable credit customer and the amount of available to different customer. - can significantly influence sales. If credit policy is relaxed, while sales may increase, the quality of accounts receivable may suffer. This may result into longer average collection period. To measure credit quality and customer’s worthiness, the following areas are generally evaluated: a. Character – refers to the probability that the customers will pay their debts or obligations. Credit reports provide the background information on people and firm’s past performances from a firm’s bankers, their other suppliers, their customers, and even their competitors. b. Capacity – judgment of customer’s abilities to pay. It is determined in part by the customer’s past records and business methods. c. Capital – measured by the general financial condition of a firm as indicated by an analysis of its financial statements. d. Collateral – represented by assets that customers may offer as security in order to obtain credit. e. Conditions – refer both to general economic trends and to special developments in certain geographic regions or sectors of the economy that might affect customer’s abilities to meet their obligations. 2. Credit Terms – involve both the length of the credit period and the discounts given. Credit period is the length of time buyers are given to pay for their purchases. Discounts are price reductions for early payment.

3. Collection Policy – refers to the procedures the firm follows to collect past-due accounts. Within a reasonable range, the proportion of bad-debt losses and the shorter the average collection period if all other things remain the same. 4. Deliquency and Default – whatever credit policies a business may adopt, there will be some customers who will delay and others who will default entirely, thereby increasing the total accounts receivable costs. Costs associated in Accounts Receivable 1. Credit analysis, accounting and collection costs – the cost of hiring manager plus assistants and bookkeepers within the finance department, acquiring credit information sources; and maintaining and operating a credit and collection department. 2. Capital Costs – once the firm extends credit, it must raise funds in order to finance it. The interest to be paid if the funds are borrowed or the opportunity cost of equity capital will constitute the cost of funds that will be tied up in the receivables. 3. Deliquency Costs – costs that are incurred when the customer is late in paying. It also creates an opportunity cost for any additional time the funds are tied up after the normal collection period. 4. Default Costs – incurred when the customer fails to pay their outstanding balance. At this point, the firm loses the cost of goods sold not paid for. It has to write off the entire sales once it decides the delinquent account has defaulted and is no longer collectible. SUMMARY OF TRADE-OFFS IN CREDIT AND COLLECTION POLICIES PARTICULARS 1. Relaxation of credit standards

BENEFITS ↑ in sales and total contribution margin

2. Lengthening of credit period

↑ in sales and total contribution margin

3. Granting cash discount

↑ in sales and total contribution margin ↓ default costs, opportunity cost or capital cost

4. Intensified collection reports

COSTS ↑ in credit and processing costs, collection costs, default costs (bad debts), capital costs ( opportunity costs) ↑ capital costs (opportunity cost of higher investment in receivables) ↓ profit or net income ↑ higher collection expenses

Marginal or Incremental Analysis of Credit Policies Marginal Analysis –performed in terms of a systematic comparison of the incremental returns and the incremental costs resulting from a change in the firm’s credit policy. a.) Incremental Profit Contribution> Incremental Cost; accept the change in credit policy

b. Incremental Profit Contribution < Incremental Cost; reject the change in credit policy c. Incremental Profit Contribution = Incremental Cost ; indifferent to the change in credit policy Inventory Management Inventories – are essential part of virtually all business operations and must be acquired ahead of sales. The main classifications of inventories are : a. Manufacturing – raw materials, goods-in process, finished goods, factory supplies b. Trading – merchandise Objective of Inventory Management -

To maintain a sufficient amount of inventory to insure the smooth operation of the firm’s production and marketing functions and at the same time tying up funds in excessive and slowmoving inventory.

Functions of Inventory a. Pipeline or Transit Inventories – inventories which are being moved or transported from one location to another. b. Organizational or decoupling inventories – inventories that are maintained to provide each in the production-distribution chain a certain degree of independence from the others. These will also take care of random fluctuations in the deman/supply. c. Seasonal or anticipation stock – built up in anticipation of heavy selling season or in anticipation of price increase or as part of promotional sales campaign. d. Batch or lot-size inventories – inventories that are maintained whenever the user makes or buys material in larger lots than are needed for his immediate purposes. e. Safety or buffer stock – inventories that are maintained to protect the company from uncertainties such as unexpected customer demand, delays in delivery of goods ordered. Costs Associated with Inventories: a. Carrying Cost – cost of capital tied in inventory, storage and handling cost, insurance, property taxes, depreciation and obsolescence, administrative b. Ordering shipping and receiving costs – cost of placing orders including production and setup costs shipping and handling costs. c. Costs of running short – loss of sales, loss of customer goodwill, and description of production schedules.

Inventory Management Techniques: 1. Economic Order Quantity Formula =

(2 x annual demand in units x costs per order) Carrying Costs per unit

a.) Total Inventory Costs = Total Ordering Costs + Total Carrying Costs b.) Total Ordering Costs = (Annual demand in units/ EOQ or order size) X Ordering Cost per order c.) Total Carrying Cost = Average Inventory x Carrying costs per unit d.) Average Inventory = (EOQ or order size)/2 2. Reorder Point = Lead time usage + Safety Stock Level of Monitoring and Inventory Control Systems: Inventory Control – is the regulation of inventory within predetermined limits. Effective inventory management should provide adequate stocks to meet the requirements of the business, while at the same time keeping the required investment at a minimum. 1. Fixed Order Quantity System – system wherein each time the inventory goes down to a predetermined level known as the reorder point, an order for a fixed quantity is placed. It requires the perpetual inventory records of the continuous monitoring of inventory level. 2. Fixed Reorder Cycle System – also known as “periodic review of replacement system” where orders are made after a review of inventory levels has been done at regular intervals. An order is placed at the time of the review the inventory level had gone down since the preceding review. 3. Optional Replenishment System – system which represents a combination of the important control mechanisms of the other two systems described above. 4. ABC Classification System – segregation of materials for selective control is made. Inventories are classified into “A” or high value items, “B” or medium cost items, and “C” or low cost items.