10-1

Chapter 10
Accounts Receivable
and Inventory
Management
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
10-2
After studying Chapter 10,
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).
10-3
Accounts Receivable and
Inventory Management
Credit and Collection
Policies
Analyzing the Credit
Applicant
Inventory Management and
Control
10-4
Credit and Collection
Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program
10-5
Credit Standards
The financial manager should continually
lower the firms credit standards as long as
profitability from the change exceeds the
extra costs generated by the additional
receivables.
Credit Standards -- The minimum quality
of credit worthiness of a credit applicant
that is acceptable to the firm.
Why lower the firms credit standards?
10-6
Credit Standards
A larger credit department
Additional clerical work
Servicing additional accounts
Bad-debt losses
Opportunity costs
Costs arising from relaxing
credit standards
10-7
Example of Relaxing
Credit Standards
Basket Wonders is not operating at full capacity
and wants to determine if a relaxation of their
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.
10-8
Example of Relaxing
Credit 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 losses
that may arise, should Basket Wonders
relax their credit standards?
10-9
Example of Relaxing
Credit Standards
Profitability of ($5 contribution) x (4,800 units) =
additional sales $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

Yes! Profits > Required pre-tax return
10-10
Credit and Collection
Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program
10-11
Credit Terms
Credit Period -- The total length of time over
which credit is extended to a customer to
pay a bill. For example, net 30 requires
full payment to the firm within 30 days from
the invoice date.
Credit 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.
10-12
Example of Relaxing
the Credit Period
Basket Wonders is considering changing its
credit period from net 30 (which has resulted
in 12 A/R Turns per year) to 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.
10-13
Example of Relaxing
the Credit Period
The before-tax opportunity cost for each dollar
of funds tied-up in additional receivables is
20%.

Ignoring any additional bad-debt losses
that may arise, should Basket Wonders
relax their credit period?
10-14
Example of Relaxing
the Credit Period
Profitability of ($5 contribution)x(10,000 units) =
additional sales $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


10-15
Example of Relaxing
the 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

Yes! Profits > Required pre-tax return
10-16
Credit and Collection
Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program
10-17
Credit Terms
Cash Discount -- A percent (%) reduction in
sales or purchase price allowed for early
payment of invoices. For example, 2/10
allows the customer to take a 2% cash discount
during the cash discount period.
Cash Discount Period -- The period of time
during which a cash discount can be taken for
early payment. For example, 2/10 allows a
cash discount in the first 10 days from the
invoice date.
10-18
Example of Introducing
a Cash Discount
A competing firm of Basket Wonders is
considering changing the credit period from
net 60 (which has resulted in 6 A/R Turns
per year) to 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.
10-19
The before-tax opportunity cost for each dollar
of funds tied-up in additional receivables is
20%.

Ignoring any additional bad-debt losses
that may arise, should the competing firm
introduce a cash discount?
Example of Introducing
a Cash Discount
10-20
Example of Using
the 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


10-21
Pre-tax cost of .02 x .3 x $5,000,000 =
the cash discount $30,000.

Pre-tax opp. savings (20% opp. cost) x $277,777 =
on reduction in A/R $55,555.

Yes! Savings > Costs

The benefits derived from released accounts
receivable exceed the costs of providing the
discount to the firms customers.
Example of Using the
Cash Discount
10-22
Seasonal 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 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.
10-23
Credit and Collection
Policies of the Firm
(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program
10-24
Default Risk and
Bad-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
10-25
Default Risk and
Bad-Debt Losses
Policy A Policy B

1. Additional sales $600,000 $300,000
2. Profitability: (20% contribution) x (1) 120,000 60,000
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 +
additional required return: (3) + (6) 76,000 66,000

8. Incremental profitability: (2) - (7) 44,000 (6,000)

Adopt Policy A but not Policy B.
10-26
Collection Policy
and Procedures
The firm should increase collection
expenditures until the marginal
reduction in bad-debt losses equals
the marginal outlay to collect.
Collection
Procedures
Letters
Phone calls
Personal visits
Legal action
Saturation
Point
Collection Expenditures
B
a
d
-
D
e
b
t

L
o
s
s
e
s

10-27
Analyzing the
Credit Applicant
Obtaining information on the
credit applicant
Analyzing this information to
determine the applicants
creditworthiness
Making the credit decision
10-28
Sources of Information
Financial statements
Credit ratings and reports
Bank checking
Trade checking
Companys own experience
The company must weigh the amount
of information needed versus the time
and expense required.
10-29
Credit 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 utilize
information regarding:
10-30
Sequential
Investigation 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.
10-31
Sample Investigation
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
Yes No
Stage 1
$5 Cost
Stage 2
$5 - $15
Cost
No prior experience whatsoever
10-32
Sample Investigation
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?
10-33
Sample Investigation
Process Flow Chart (Part C)
** That is, the credit of a bank is substituted for customers credit.
Bank, creditor, and financial
statement analysis
Accept Reject
Accept, only upon
domestic irrevocable
letter of credit (L/C)**
Fair Poor Good
Stage 3
$30 Cost
10-34
Other Credit
Decision Issues
Line 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 System -- A system used to
decide whether to grant credit by assigning
numerical scores to various characteristics
related to creditworthiness.
10-35
Other Credit
Decision Issues
Credit decisions are made
Ledger accounts maintained
Payments processed
Collections initiated

Decision based on the core
competencies of the firm.
Outsourcing Credit and Collections
The entire credit and/or collection function(s)
are outsourced to a third-party company.
10-36
Inventory
Management 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 types:
10-37
Inventory
Management and Control
Purchasing
Production scheduling
Efficient servicing of customer
demands
Inventories provide flexibility
for the firm in:
10-38
Appropriate
Level of Inventories
Employ 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 determine
the appropriate level of
inventories?
10-39
ABC Method of
Inventory 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 of
inventory control
0 15 45 100
Cumulative Percentage
of Items in Inventory
70
90
100
C
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a
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P
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c
e
n
t
a
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e


o
f

I
n
v
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n
t
o
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y

V
a
l
u
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A
B
C
10-40
How Much to Order?
Forecast usage
Ordering cost
Carrying cost
Ordering can mean either the purchase or
production of the item.
The optimal quantity to order
depends on:
10-41
Total Inventory Costs
C: Carrying costs per unit per period
O: Ordering costs per order
S: Total usage during the period
Total inventory costs (T) =
C (Q / 2) + O (S / Q)
TIME
Q / 2
Q
Average
Inventory
I
N
V
E
N
T
O
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Y


(
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10-42
Economic 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 firms planning period.
Q* =
2 (O) (S)
C
10-43
Example of the
Economic Order Quantity
Basket 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?
10-44
Economic 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* =
2 ($200) (10,000)
$1
Q* = 2,000 Units
10-45
Total Inventory Costs
EOQ (Q*) represents the minimum
point in total inventory costs.
Total Inventory Costs
Total Carrying Costs
Total Ordering Costs
Q* Order Size (Q)
C
o
s
t
s

10-46
When to Order?
Order Point -- The quantity to which inventory
must fall in order to signal that an order must
be placed to replenish an item.
Order Point (OP) = Lead time X Daily usage
Issues to consider:
Lead Time -- The length of time between the
placement of an order for an inventory item and
when the item is received in inventory.
10-47
Example of When to Order
Julie Miller of Basket 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?
Lead time = 2 days
Daily usage = 10,000 yards / 100 days
= 100 yards per day
Order Point = 2 days x 100 yards per day
= 200 yards
10-48
Example of When to Order
0 18 20 38 40
Lead
Time
200
2000
Order
Point
U
N
I
T
S

DAYS
Economic Order Quantity (Q*)
10-49
Safety Stock
Our previous example assumed certain demand
and lead time. When demand and/or lead time are
uncertain, then the order point is:
Order Point =
(Avg. lead time x Avg. daily usage) + Safety stock
Safety Stock -- Inventory stock held in reserve
as a cushion against uncertain demand (or
usage) and replenishment lead time.
10-50
Order Point
with Safety Stock
0 18 20 38
400
2000
Order
Point
U
N
I
T
S

DAYS
2200
Safety Stock
200
10-51
Order Point
with Safety Stock
U
N
I
T
S

DAYS
Safety Stock
Actual lead
time is 3 days!
(at day 21)
2200
2000
Order
Point
400
200
0 18 21
The firm dips
into the safety stock
10-52
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 of
safety stock?
Depends on the:

10-53
J ust-in-Time
A very accurate production and
inventory information system
Highly efficient purchasing
Reliable suppliers
Efficient inventory-handling system
Just-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 approach:
10-54
Supply 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) Managing
the process of moving goods, services, and
information from suppliers to end customers.
10-55
Trade Credit and
Shareholder Value
Trade credit arises when goods
sold under delayed payment
terms
Traced to Romans due to
obstacles faced in transferring
money through various trading
areas
Credit terms are taken for
granted today
Value can be added by managing
three areas:
aggregate investment in
receivables
credit terms
credit standards
Over-investing in receivables
can be costly
...but, if credit terms are not
competitive, then lost sales can
be costly
10-56
Conclusion
Minimize bad debts and
outstanding receivables
Maintain financial flexibility
Optimize mix of company assets
Convert receivables to cash in a
timely manner
Analyze customer risk
Respond to customer needs
10-57
A/R Management and
Shareholder Value
Marketing Strategy
Market Share Obj.
Aggregate Inv. in A/R Credit Terms Credit Standards
Total Dollar Investment Length of Time to Pay Acceptance of Marg Cust.
Max Shareholder Value
10-58
Trade vs. Bank Credit
Length of terms
Security
Amounts involved
Resource transferred (goods vs.
money)
Extent of analysis
10-59
Why Extend Credit?
Financial Motive
Operating Motive
Contracting Motive
Pricing Motive
All reasons are related to market
imperfections
10-60
Financial Motive
Potential of getting a higher
price
Sellers raise capital at lower
rates than customers and have
cost advantages vis-a-vis banks
due to:
similarity of customers
the information gathered in the
selling process
lower probability of default
(the goods purchased are an
essential element of the
buyers business)
seller can more easily resell
product if payment is not
made.
10-61
Operating Motive
Respond to variable and
uncertain demand
Change credit terms rather than:
install extra capacity,
building or depleting
inventories,
or forcing customers to wait.
10-62
Contracting Cost Motive
Buyer gets to inspect goods
prior to payment
Seller has less theft with
separation of collection and
product delivery
10-63
Pricing Motive
Change price by changing credit
terms
10-64
Trends Affecting Trade
Credit
Zero net working capital
objective
Improved internal and external
credit-related information
Electronic commerce
10-65
The Credit Decision
Process
Marketing contact


Credit investigation


Customer contact for information


Finalize written documents, e.g.. security agreements


Establish customer credit file


Financial analysis
T
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10-66
Basic Credit Granting
Model
S - EXP(S)
NPV = ----------------- - VCR(S)
1 + iCP

Where:

NPV = net present value of the credit sale
VCR = variable cost ratio
S = dollar amount of credit sale
EXP = credit administration and collection expense ratio
i = daily interest rate
CP = collection period for sale
10-67
Managing the Credit
Policy
Should we extend credit?
Credit policy components
Credit-granting decision
10-68
Should We Extend Credit?
Follow industry practice
Extent and form of credit offer
in-house credit card
sell receivables to a factor
captive finance company?
10-69
Components of Credit
Policy
Development of credit standards
profile of minimally acceptable
credit worthy customer
Credit terms
credit period
cash discount
Credit limit
maximum dollar level of credit
balances
Collection procedures
how long to wait past due date
to initiate collection efforts
methods of contact
whether and at what point to
refer account to collection
agency
10-70
Credit-Granting Decision
Development of credit standards
Gathering necessary information
Credit analysis: applying credit
standards
Risk analysis
10-71
Grant-Granting Sequence
No
Order and credit
request received
New/increased
credit limit
Material
change in
customer
status
Redo credit
investigation
Size of proposed
credit limit
Medium Small Large
Indepth
credit invest.
Moderate
credit invest.
Minimal
credit invest.
Check new A/R
total vs credit lmt
No Yes
Yes
Extend Credit
No
Yes
Record
disposition
Set up,post
A/R, ship
10-72
Credit Standards
Based on five C's of Credit
Character
Capital
Capacity
Collateral
Conditions
Determine risk classification
system
Link customer evaluations to
credit standards
10-73
Gathering Information
credit reporting agencies, e.g..
Dun & Bradstreet
credit interchange bureaus,
NACM
bank letters
references from other suppliers
financial statements
field data gathered by sales reps
10-74
Credit Analysis: Applying
the Standards
Nonfinancial
concerned with willingness to
pay, character
Financial
ability to pay, financial ratios
etc.. (other Cs of credit)
Credit scoring models
Example:

Y = .000025(INCOME) +
0.50(PAYHIST) +
0.25(EMPLOYMT)
10-75
Emergence of Expert
Systems
Example of decision rule:

If gross income is equal to or
grater than $20,000 and the
applicant has not been
delinquent and gross income per
household member is equal to or
greater than $12,000 and
debt/equity ratio is equal to or
greater than 30% but less than
50% and personal property is
equal to or greater than $50,000,
then grant credit.
10-76
Factors Affecting Credit
Terms
Competition
Operating cycle
Type of good (raw materials vs
finished goods, perishables, etc.)
Seasonality of demand
Consumer acceptance
Cost and pricing
Customer type
Product profit margin
10-77
Cash Discounts
The lower the VC, the higher the
feasible discount
Based on companys cost of
funds
Consider timing effect when
changing discounts
Should be based on products
price elasticity
Higher the bad debt experience,
higher the optimal discount
10-78
Practice of Taking Cash
Discounts
51% of firms always took cash
discount
40% sometimes
9% take discount and pay late
Study found that 4 or 5
companies would be more
profitable if cash discount was
eliminated
10-79
A/R Management in
Practice
Discounts appear to be changed
to match competitors, not
inflation or interest rates
The higher a firms contribution
margin, the more likely the firm
should be to offer discounts.
A price cut is thought to have
more impact than instituting a
cash discount
The more receivables a firm has,
does not necessarily relate to
use of penalty fees
The greater amount of
receivables does not relate to a
more active credit evaluation.
10-80
Receivables, Collections,
and EDI
If credit approval is delayed...
buyers using EDI purchase
orders and JIT manufacturing
can encounter serious
problems.
sellers can now ship within
hours of receiving
orders...thus seller must be
able to handle electronically
transmitted orders.
Seller may also issues electronic
invoices and be paid
electronically using an EDI-
capable bank so that remittance
data can be automatically read
by sellers A/R system
Trend is for use of data
transmission to automate the
cash application process
10-81
Summary
Investment in A/R represents
a significant investment.
Key aspects outlined
credit policy
credit standards
credit granting sequence
credit limits
credit terms
Management of A/R is
influenced by what
competitors are doing not by
shareholder wealth
considerations.
Proper use of NPV techniques
can ensure that credit
decisions enhance
shareholder value.