10-1 chapter 10 accounts receivable. 10-2 accounts receivable and inventory management u credit and...

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-1 Chapter 10 Chapter 10 Accounts Accounts Receivable Receivable

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Page 1: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-1

Chapter 10Chapter 10

Accounts ReceivableAccounts ReceivableAccounts ReceivableAccounts Receivable

Page 2: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-2

Accounts Receivable and Accounts Receivable and Inventory ManagementInventory Management

Credit and Collection Policies

Analyzing the Credit Applicant

Inventory Management and Control

Page 3: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-3

Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm

(1) Average Collection Period

(2) Bad-debtLosses

Quality ofQuality ofTrade AccountTrade Account

Length ofCredit Period

Possible CashDiscount

FirmCollectionProgram

Page 4: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-4

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??

Page 5: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-5

Credit StandardsCredit Standards

A larger credit department

Additional clerical work

Servicing additional accounts

Bad-debt losses

Opportunity costs

Costs arising from relaxing Costs arising from relaxing credit standardscredit standards

Page 6: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-6

Example of Relaxing Example of Relaxing Credit StandardsCredit Standards

Basket Wonders is not operating at full capacity Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their and 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.

Page 7: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-7

Example of Relaxing Example 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 losses Ignoring any additional bad-debt losses that may arise, should Basket that may arise, should Basket

Wonders relax their credit standards?Wonders relax their credit standards?

Page 8: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-8

Example of Relaxing Example 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

Page 9: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-9

Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm

(1) Average Collection Period

(2) Bad-debtLosses

Quality ofTrade Account

Length ofLength ofCredit PeriodCredit Period

Possible CashDiscount

FirmCollectionProgram

Page 10: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-10

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”.

Page 11: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-11

Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period

Basket Wonders Basket 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.

Page 12: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-12

Example of Relaxing Example 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 losses Ignoring any additional bad-debt losses that may arise, should Basket Wonders that may arise, should Basket Wonders

relax their credit period?relax their credit period?

Page 13: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-13

Example of Relaxing Example 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

Page 14: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-14

Example of Relaxing Example 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

Page 15: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-15

Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm

(1) Average Collection Period

(2) Bad-debtLosses

Quality ofTrade Account

Length ofCredit Period

Possible CashPossible CashDiscountDiscount

FirmCollectionProgram

Page 16: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-16

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.

Page 17: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-17

Example of Introducing Example 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.

Page 18: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-18

The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.

Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should the competing firm that may arise, should the competing firm

introduce a cash discount?introduce a cash discount?

Example of Introducing Example of Introducing a Cash Discounta Cash Discount

Page 19: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-19

Example of Using Example 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

Page 20: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-20

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 the Example of Using the Cash DiscountCash Discount

Page 21: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-21

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.

Page 22: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-22

Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm

(1) Average Collection Period

(2) Bad-debtLosses

Quality ofTrade Account

Length ofCredit Period

Possible CashDiscount

FirmFirmCollectionCollectionProgramProgram

Page 23: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-23

Default Risk and Default Risk and Bad-Debt LossesBad-Debt Losses

PresentPolicy 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

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10-24

Default Risk and Default 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) 120,000 120,000 60,000 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 +7. Additional bad-debt losses +

additional required return: (3) + (6)additional required return: (3) + (6) 76,000 76,000 66,000 66,000

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

Adopt Policy A but not Policy B.Adopt Policy A but not Policy B.

Page 25: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-25

Collection Policy Collection Policy and Proceduresand Procedures

The firm should increase collection collection expenditures expenditures until the marginal

reduction in bad-debt losses bad-debt losses equals the marginal outlay to collect.

Collection Collection Procedures Procedures

Letters

Phone calls

Personal visits

Legal action

SaturationSaturationPointPoint

Collection ExpendituresCollection Expenditures

Bad

-Deb

t L

oss

esB

ad-D

ebt

Lo

sses

Page 26: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-26

Analyzing the Analyzing the Credit ApplicantCredit Applicant

Obtaining information on the credit applicant

Analyzing this information to determine the applicant’s creditworthiness

Making the credit decision

Page 27: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-27

Sources of InformationSources of Information

Financial statements Credit ratings and reports Bank checking Trade checking Company’s own experience

The company must weigh the amount amount of information of information needed versus the time time

and expense requiredand expense required.

Page 28: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-28

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 utilize A credit analyst is likely to utilize information regardinginformation regarding::

Page 29: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-29

Sequential Sequential 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 10-30 through 10-32.

Page 30: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-30

Sample Investigation Sample Investigation Process Flow Chart (Part A)Process Flow Chart (Part A)

* For previous customers only a Dun & Bradstreet reference book check.

Pending Order

Badpast creditexperience

Dun & Bradstreetreport analysis*

RejectYesNoStage 1$5 Cost

Stage 2$5 - $15

Cost

No prior experience whatsoever

Page 31: 10-1 Chapter 10 Accounts Receivable. 10-2 Accounts Receivable and Inventory Management u Credit and Collection Policies u Analyzing the Credit Applicant

10-31

Sample Investigation Sample Investigation Process Flow Chart (Part B)Process Flow Chart (Part B)

Accept

Yes

No

Credit rating“limited” and/or otherdamaging information

unearthed?

No

Yes

Reject

Credit rating“fair” and/or otherclose to maximum

“line of credit?”

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10-32

Sample Investigation Sample 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 financialstatement analysis

Accept RejectAccept, only upon

domestic irrevocableletter of credit (L/C)**

Fair PoorGood

Stage 3$30 Cost

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10-33

Other Credit Other 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.