slides for FINANCIAL MANAGEMENT

1. 0-1
Chapter 10Chapter 10
Accounts ReceivableAccounts Receivable
and Inventoryand Inventory
ManagementManagement
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

2. 0-2
After studying Chapter 10,After studying Chapter 10,
you should be able to:you should be able to:
List the key factors that can be varied in a firm's credit policy and
understand the trade-off between profitability and costs involved.
Understand how the level of investment in accounts receivable is
affected by the firm's credit policies.
Critically evaluate proposed changes in credit policy, including
changes in credit standards, credit period, and cash discount.
Describe possible sources of information on credit applicants
and how you might use the information to analyze a credit
applicant.
Identify the various types of inventories and discuss the
advantages and disadvantages of increasing/decreasing
inventories.
Describe, explain, and illustrate the key concepts and
calculations necessary for effective inventory management and
control, including classification, economic order quantity (EOQ),
order point, safety stock, and just-in-time (JIT).

3. 0-3
Accounts Receivable andAccounts Receivable and
Inventory ManagementInventory Management
Credit and Collection
Policies
Analyzing the Credit
Applicant
Inventory Management and
Control

4. 0-4
Credit and CollectionCredit and Collection
Policies of the FirmPolicies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality ofQuality of
Trade AccountTrade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program

5. 0-5
Credit StandardsCredit Standards
The financial manager should continually
lower the firm’s credit standards as long as
profitability from the change exceeds the
extra costs generated by the additional
receivables.
Credit StandardsCredit Standards -- The minimum quality
of credit worthiness of a credit applicant
that is acceptable to the firm.
Why lower the firm’s credit standardsWhy lower the firm’s credit standards??

6. 0-6
Credit StandardsCredit Standards
A larger credit department
Additional clerical work
Servicing additional accounts
Bad-debt losses
Opportunity costs
Costs arising from relaxingCosts arising from relaxing
credit standardscredit standards

7. 0-7
Example of RelaxingExample of Relaxing
Credit StandardsCredit Standards
Basket Wonders is not operating at full capacityBasket Wonders is not operating at full capacity
and wants to determine if a relaxation of theirand wants to determine if a relaxation of their
credit standards will enhance profitability.credit standards will enhance profitability.
The firm is currently producing a single
product with variable costs of $20 and selling
price of $25.
Relaxing credit standards is not expected to
affect current customer payment habits.

8. 0-8
Example of RelaxingExample of Relaxing
Credit StandardsCredit Standards
Additional annual credit sales of $120,000 and an
average collection period for new accounts of 3
months is expected.
The before-tax opportunity cost for each dollar of
funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt lossesIgnoring any additional bad-debt losses
that may arise, should Basket Wondersthat may arise, should Basket Wonders
relax their credit standards?relax their credit standards?

9. 0-9
Example of RelaxingExample of Relaxing
Credit StandardsCredit Standards
Profitability of ($5 contribution) x (4,800 units) =
additional sales $24,000$24,000
Additional ($120,000 sales) / (4 Turns) =
receivables $30,000
Investment in ($20/$25) x ($30,000) =
add. receivables $24,000
Req. pre-tax return (20% opp. cost) x $24,000 =
on add. investment $4,800$4,800
Yes!Yes! Profits > Required pre-tax return

10. 0-10
Credit and CollectionCredit and Collection
Policies of the FirmPolicies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length ofLength of
Credit PeriodCredit Period
Possible Cash
Discount
Firm
Collection
Program

11. 0-11
Credit TermsCredit Terms
Credit PeriodCredit Period -- The total length of time over
which credit is extended to a customer to
pay a bill. For example, “net 30”“net 30” requires
full payment to the firm within 30 days from
the invoice date.
Credit TermsCredit Terms -- Specify the length of time
over which credit is extended to a customer
and the discount, if any, given for early
payment. For example, “2/10, net 30.”“2/10, net 30.”

12. 0-12
Example of RelaxingExample of Relaxing
the Credit Periodthe Credit Period
Basket WondersBasket Wonders is considering changing its
credit period from “net 30”“net 30” (which has resulted
in 12 A/R “Turns” per year) to “net 60”“net 60” (which is
expected to result in 6 A/R “Turns” per year).
The firm is currently producing a single product
with variable costs of $20 and a selling price of
$25.
Additional annual credit sales of $250,000 from
new customers are forecasted, in addition to the
current $2 million in annual credit sales.

13. 0-13
Example of RelaxingExample of Relaxing
the Credit Periodthe Credit Period
The before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.
Ignoring any additional bad-debt lossesIgnoring any additional bad-debt losses
that may arise, should Basket Wondersthat may arise, should Basket Wonders
relax their credit period?relax their credit period?

14. 0-14
Example of RelaxingExample of Relaxing
the Credit Periodthe Credit Period
Profitability of ($5 contribution)x(10,000 units) =
additional sales $50,000$50,000
Additional ($250,000 sales) / (6 Turns) =
receivables $41,667
Investment in add. ($20/$25) x ($41,667) =
receivables (new sales) $33,334
Previous ($2,000,000 sales) / (12 Turns) =
receivable level $166,667

15. 0-15
Example of RelaxingExample of Relaxing
the Credit Periodthe Credit Period
New ($2,000,000 sales) / (6 Turns) =
receivable level $333,333
Investment in $333,333 - $166,667 =
add. receivables $166,666
(original sales)
Total investment in $33,334 + $166,666 =
add. receivables $200,000
Req. pre-tax return (20% opp. cost) x $200,000 =
on add. investment $40,000$40,000
Yes!Yes! Profits > Required pre-tax return

16. 0-16
Credit and CollectionCredit and Collection
Policies of the FirmPolicies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible CashPossible Cash
DiscountDiscount
Firm
Collection
Program

17. 0-17
Credit TermsCredit Terms
Cash DiscountCash Discount -- A percent (%) reduction in
sales or purchase price allowed for early
payment of invoices. For example, “2/10”“2/10”
allows the customer to take a 2% cash discount
during the cash discount period.
Cash Discount PeriodCash Discount Period -- The period of time
during which a cash discount can be taken for
early payment. For example, “2/10”“2/10” allows a
cash discount in the first 10 days from the
invoice date.

18. 0-18
Example of IntroducingExample of Introducing
a Cash Discounta Cash Discount
A competing firm of Basket Wonders is
considering changing the credit period from
“net 60”“net 60” (which has resulted in 6 A/R “Turns”
per year) to “2/10, net 60.”“2/10, net 60.”
Current annual credit sales of $5 million are
expected to be maintained.
The firm expects 30% of its credit customers (in
dollar volume) to take the cash discount and
thus increase A/R “Turns” to 8.

19. 0-19
The before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.
Ignoring any additional bad-debt lossesIgnoring any additional bad-debt losses
that may arise, should the competing firmthat may arise, should the competing firm
introduce a cash discount?introduce a cash discount?
Example of IntroducingExample of Introducing
a Cash Discounta Cash Discount

20. 0-20
Example of UsingExample of Using
the Cash Discountthe Cash Discount
Receivable level ($5,000,000 sales) / (6 Turns) =
(Original) $833,333
Receivable level ($5,000,000 sales) / (9 Turns) =
(New) $555,556
Reduction of $833,333 - $555,556 =
investment in A/R $277,777

21. 0-21
Pre-tax cost of .02 x .3 x $5,000,000 =
the cash discount $30,000$30,000..
Pre-tax opp. savings (20% opp. cost) x $277,777 =
on reduction in A/R $55,555$55,555..
Yes!Yes! Savings > Costs
The benefits derived from released accounts
receivable exceed the costs of providing the
discount to the firm’s customers.
Example of Using theExample of Using the
Cash DiscountCash Discount

22. 0-22
Seasonal DatingSeasonal Dating
Avoids carrying excess inventory and the
associated carrying costs.
Accept dating if warehousing costs plus the
required return on investment in inventory exceeds
the required return on additional receivables.
Seasonal DatingSeasonal Dating -- Credit terms that
encourage the buyer of seasonal products
to take delivery before the peak sales period
and to defer payment until after the peak
sales period.

23. 0-23
Credit and CollectionCredit and Collection
Policies of the FirmPolicies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
FirmFirm
CollectionCollection
ProgramProgram

24. 0-24
Default Risk andDefault Risk and
Bad-Debt LossesBad-Debt Losses
Present
Policy Policy A Policy B
Demand $2,400,000 $3,000,000 $3,300,000
Incremental sales $ 600,000 $ 300,000
Default losses
Original sales 2%
Incremental Sales 10% 18%
Avg. Collection Pd.
Original sales 1 month
Incremental Sales 2 months 3 months

25. 0-25
Default Risk andDefault Risk and
Bad-Debt LossesBad-Debt Losses
Policy A Policy B
1. Additional sales $600,000 $300,000
2. Profitability: (20% contribution) x (1)2. Profitability: (20% contribution) x (1) 120,000120,000 60,00060,000
3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000
4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000
5. Inv. in add. receivables: (.80) x (4) 80,000 60,000
6. Required before-tax return on
additional investment: (5) x (20%) 16,000 12,000
7. Additional bad-debt losses +7. Additional bad-debt losses +
additional required return: (3) + (6)additional required return: (3) + (6) 76,00076,000 66,00066,000
8. Incremental profitability: (2) - (7)8. Incremental profitability: (2) - (7) 44,00044,000 (6,000)(6,000)
Adopt Policy A but not Policy B.Adopt Policy A but not Policy B.

26. 0-26
Collection PolicyCollection Policy
and Proceduresand Procedures
The firm should increase collectioncollection
expendituresexpenditures until the marginal
reduction in bad-debt lossesbad-debt losses equals
the marginal outlay to collect.
CollectionCollection
ProceduresProcedures
Letters
Phone calls
Personal visits
Legal action
SaturationSaturation
PointPoint
Collection ExpendituresCollection Expenditures
Bad-DebtLossesBad-DebtLosses

27. 0-27
Analyzing theAnalyzing the
Credit ApplicantCredit Applicant
Obtaining information on the
credit applicant
Analyzing this information to
determine the applicant’s
creditworthiness
Making the credit decision

28. 0-28
Sources of InformationSources of Information
Financial statements
Credit ratings and reports
Bank checking
Trade checking
Company’s own experience
The company must weigh the amountamount
of informationof information needed versus the timetime
and expense requiredand expense required.

29. 0-29
Credit AnalysisCredit Analysis
the financial statements of the firm
(ratio analysis)
the character of the company
the character of management
the financial strength of the firm
other individual issues specific to
the firm
A credit analyst is likely to utilizeA credit analyst is likely to utilize
information regardinginformation regarding::

30. 0-30
SequentialSequential
Investigation ProcessInvestigation Process
The cost of investigation (determining
the type and amount of information
collected) is balanced against the
expected profit from an order.
An example is provided in the following
three slides 10-31 through 10-33.

31. 0-31
Sample InvestigationSample Investigation
Process Flow Chart (Part A)Process Flow Chart (Part A)
* For previous customers only a Dun & Bradstreet reference book check.
Pending Order
Bad
past credit
experience
Dun & Bradstreet
report analysis*
Reject
YesNoStage 1
$5 Cost
Stage 2
$5 - $15
Cost
No prior experience whatsoever

32. 0-32
Sample InvestigationSample Investigation
Process Flow Chart (Part B)Process Flow Chart (Part B)
Accept
Yes
No
Credit rating
“limited” and/or other
damaging information
unearthed?
No
Yes
Reject
Credit rating
“fair” and/or other
close to maximum
“line of credit”?

33. 0-33
Sample InvestigationSample Investigation
Process Flow Chart (Part C)Process Flow Chart (Part C)
** That is, the credit of a bank is substituted for customer’s credit.
Bank, creditor, and financial
statement analysis
Accept Reject
Accept, only upon
domestic irrevocable
letter of credit (L/C)**
Fair PoorGood
Stage 3
$30 Cost

34. 0-34
Other CreditOther Credit
Decision IssuesDecision Issues
Line of CreditLine of Credit -- A limit to the amount of credit
extended to an account. Purchaser can buy on
credit up to that limit.
Streamlines the procedure for shipping
goods.
Credit-scoring SystemCredit-scoring System -- A system used to
decide whether to grant credit by assigning
numerical scores to various characteristics
related to creditworthiness.

35. 0-35
Other CreditOther Credit
Decision IssuesDecision Issues
Credit decisions are made
Ledger accounts maintained
Payments processed
Collections initiated
Decision based on the core
competencies of the firm.
Outsourcing Credit and CollectionsOutsourcing Credit and Collections
The entire credit and/or collection function(s)
are outsourced to a third-party company.

36. 0-36
InventoryInventory
Management and ControlManagement and Control
Raw-materials inventory
Work-in-process inventory
In-transit inventory
Finished-goods inventory
Inventories form a link between
production and sale of a product.
Inventory typesInventory types::

37. 0-37
InventoryInventory
Management and ControlManagement and Control
Purchasing
Production scheduling
Efficient servicing of customer
demands
Inventories provide flexibilityInventories provide flexibility
for the firm in:for the firm in:

38. 0-38
AppropriateAppropriate
Level of InventoriesLevel of Inventories
Employ a cost-benefit analysisEmploy a cost-benefit analysis
Compare the benefits of economies of
production, purchasing, and product
marketing against the cost of the
additional investment in inventories.
How does a firm determineHow does a firm determine
the appropriate level ofthe appropriate level of
inventories?inventories?

39. 0-39
ABC Method ofABC Method of
Inventory ControlInventory Control
Method which controls
expensive inventory
items more closely than
less expensive items.
Review “A” items
most frequently
Review “B” and “C”
items less rigorously
and/or less frequently.
ABC method ofABC method of
inventory controlinventory control
0 15 45 1000 15 45 100
Cumulative PercentageCumulative Percentage
of Items in Inventoryof Items in Inventory
7070
9090
100100
CumulativePercentageCumulativePercentage
ofInventoryValueofInventoryValue
AA
BB
CC

40. 0-40
How Much to Order?How Much to Order?
Forecast usage
Ordering cost
Carrying cost
Ordering can mean either the purchase orOrdering can mean either the purchase or
production of the item.production of the item.
The optimal quantity to orderThe optimal quantity to order
depends on:depends on:

41. 0-41
Total Inventory CostsTotal Inventory Costs
CC: Carrying costs per unit per period
OO: Ordering costs per order
SS: Total usage during the period
Total inventory costs (T) =Total inventory costs (T) =
CC ((Q / 2Q / 2) +) + OO ((SS // QQ))
TIMETIME
Q / 2Q / 2
QQ
AverageAverage
InventoryInventory
INVENTORYINVENTORY
(inunits)(inunits)

42. 0-42
Economic Order QuantityEconomic Order Quantity
The EOQ or
optimal
quantity
(Q*) is:
The quantity of an inventory item to order
so that total inventory costs are minimized
over the firm’s planning period.
Q*Q* ==
2 (2 (O) () (SS))
CC

43. 0-43
Example of theExample of the
Economic Order QuantityEconomic Order Quantity
Basket WondersBasket Wonders is attempting to determine the
economic order quantity for fabric used in the
production of baskets.
10,000 yards of fabric were used at a constant
rate last period.
Each order represents an ordering cost of $200.
Carrying costs are $1 per yard over the 100-day
planning period.
What is the economic order quantity?What is the economic order quantity?

44. 0-44
Economic Order QuantityEconomic Order Quantity
We will solve for the economic order quantity
given that ordering costs are $200 per order,
total usage over the period was 10,000 units,
and carrying costs are $1 per yard (unit).
Q*Q* ==
2 (2 ($200) () (10,00010,000))
$1$1
Q*Q* == 2,000 Units2,000 Units

45. 0-45
Total Inventory CostsTotal Inventory Costs
EOQ (Q*) represents the minimumEOQ (Q*) represents the minimum
point in total inventory costs.point in total inventory costs.
Total Inventory CostsTotal Inventory Costs
Total Carrying CostsTotal Carrying Costs
Total Ordering CostsTotal Ordering Costs
Q*Q* Order Size (Q)Order Size (Q)
CostsCosts

46. 0-46
When to Order?When to Order?
Order PointOrder Point -- The quantity to which inventory
must fall in order to signal that an order must
be placed to replenish an item.
Order PointOrder Point (OPOP) = Lead timeLead time X Daily usage
Issues to considerIssues to consider::
Lead TimeLead Time -- The length of time between the
placement of an order for an inventory item and
when the item is received in inventory.

47. 0-47
Example of When to OrderExample of When to Order
Julie Miller of Basket WondersBasket Wonders has determined
that it takes only 2 days to receive the order of
fabric after the placement of the order.
When should Julie order more fabric?When should Julie order more fabric?
Lead timeLead time == 2 days2 days
Daily usageDaily usage = 10,000 yards / 100 days= 10,000 yards / 100 days
== 100 yards per day100 yards per day
Order PointOrder Point == 2 days2 days xx 100 yards per day100 yards per day
== 200 yards200 yards

48. 0-48
Example of When to OrderExample of When to Order
00 18 20 38 4018 20 38 40
LeadLead
TimeTime
200200
20002000
OrderOrder
PointPoint
UNITSUNITS
DAYSDAYS
Economic Order Quantity (Q*)Economic Order Quantity (Q*)

49. 0-49
Safety StockSafety Stock
Our previous example assumed certain demand
and lead time. When demand and/or lead time are
uncertain, then the order point is:
Order PointOrder Point =
(Avg. lead time x Avg. daily usage) + Safety stockSafety stock
Safety StockSafety Stock -- Inventory stock held in reserve
as a cushion against uncertain demand (or
usage) and replenishment lead time.

50. 0-50
Order PointOrder Point
with Safety Stockwith Safety Stock
0 18 20 380 18 20 38
400400
20002000
OrderOrder
PointPoint
UNITSUNITS
DAYSDAYS
22002200
Safety StockSafety Stock
200200

51. 0-51
Order PointOrder Point
with Safety Stockwith Safety Stock
UNITSUNITS
DAYSDAYS
Safety StockSafety Stock
Actual leadActual lead
time is 3 days!time is 3 days!
(at day 21)(at day 21)
22002200
20002000
OrderOrder
PointPoint
400400
200200
0 18 210 18 21
The firm “dips”The firm “dips”
into the safety stockinto the safety stock

52. 0-52
How Much Safety Stock?How Much Safety Stock?
Amount of uncertainty in inventory demand
Amount of uncertainty in the lead time
Cost of running out of inventory
Cost of carrying inventory
What is the proper amount ofWhat is the proper amount of
safety stock?safety stock?
Depends on theDepends on the::

53. 0-53
Just-in-TimeJust-in-Time
A very accurate production and
inventory information system
Highly efficient purchasing
Reliable suppliers
Efficient inventory-handling system
Just-in-TimeJust-in-Time -- An approach to inventory
management and control in which inventories
are acquired and inserted in production at the
exact times they are needed.
Requirements of applying this approachRequirements of applying this approach::

54. 0-54
Supply Chain ManagementSupply Chain Management
JIT inventory control is one link in SCM.
The internet has enhanced SCM and
allows for many business-to-business
(B2B) transactions
Competition through B2B auctions helps
reduce firm costs – especially
standardized items
Supply Chain Management (SCM)Supply Chain Management (SCM) – Managing
the process of moving goods, services, and
information from suppliers to end customers.