Current Asset Management

Accounts Receivableand Inventory

Overview of Accounts Receivable Management

Seek to identify the impact of decisions on accounts receivable and how to determine the optimal credit and collection policies.

Establishment of a credit policy

Is the company prepared to offer credit?

Why do firms accumulate accounts receivable and inventory?

Assuming credit is to be offered, what standards will be applied in the decision to grant credit to a customer?

How much credit should a customer be granted?

What credit terms will be offered?

Definitions Accounts receivable

– Money owed to a business for goods or services sold in the ordinary course of business.

Trade credit

– Short-term credit provided by suppliers of goods or services to other businesses.

Consumer credit

– Credit extended to individuals by suppliers of goods and services, or by financial institutions through credit cards

Why do firms accumulate accounts receivable and inventory? Given that accounts receivable and inventory are

assets that do not provide an explicit rate of return, it is important to understand why firms might still want to have these investments.

Granting credit, resulting in Accounts Receivable, is often an essential business practice and can enhance sales. (But also will increase costs.)

Holding adequate inventory is necessary to avoid loss of sales due to stock-outs and have an efficient manufacturing process.

Finding the Optimum Level of Accounts Receivable

Accounts Receivable represent your money sitting in someone else’s bank account. It earns you nothing!

So, if the firm does grant credit, how do we minimize the impact on cash flow

Firm’s managers must review the firm’s credit policies and evaluate the impact of any proposed changes in policies based on the NPV of incremental cash flows due to the proposed changes

Benefits and Costs of Granting Credit

Benefits

– Increased sales.

Costs

– Opportunity cost of investment.

– Cost of bad debts and delinquent accounts.

– Cost of administration.

– Cost of additional investment.

Credit Policy

Credit policy’ refers to a supplier’s policy on whether credit will be offered to customers and the terms on which it will be offered.

The decision to offer credit

– Is the company prepared to offer credit?

– Offering credit is equivalent to a price reduction.

– What do competitors offer?

Credit Policy cont.. Selection of credit-worthy customers

– Company’s past experience with customer.

– Use of decision tree:

• Grant credit immediately.

• Investigate/Consider.

• Refuse credit immediately.

– Cost of granting credit = expected bad debt cost + investment opportunity cost + collection cost

– Cost of refusing credit = expected value of marginal net benefit forgone

Credit Policy cont.. Limit of credit extended

– Setting limits — about risk management.

– The more sales on credit, the greater the potential loss from default.

– Offer less credit to newer customers.

Credit terms

– Credit period.

– Discount period.

– Discount rate.

– Effective rate

Collection Policy ‘Collection policy’ refers to the efforts made to collect

delinquent accounts either informally or by a debt collection agency.

Procedures implemented:

– Reminder notice.

– Personal letters and telephone calls.

– Personal visits.

– Legal action or debt collection agency.

Procedures adopted may have an impact on sales

Five Cs of Credit

Character – willingness to meet financial obligations Capacity – ability to meet financial obligations out of operating

cash flows Capital – financial reserves Collateral – assets pledged as security Conditions – general economic conditions related to

customer’s business

Accounts Receivable - Terms The terms of sale are generally stated in the

form X / Y, n Z This means that the customer can deduct X

percentage if the account is paid within Y days; otherwise, the full amount must be paid within Z days.

Example: 2/10 n 30–The company offers a 2% discount if the

invoice is paid in 10 days. Otherwise,–Balance due in 30 days.

Average Collection Period (ACP) Old Policy; 2/10, n30

– 35% of customers pay in 10 days– 62% of customers pay in 30 days– 3% of customers pay in 100 days– ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days

New Policy; 2/10, n40– 35%of customers pay in 10 days– 60% of customers pay in 40 days– 5% of customers pay in 100 days– ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days

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Quiz No 3

If in the current scenario ACP increased from 25.1 days to 32.5 days ,assuming the sales per day is $1 million ,what will be the cost of change in credit policy of a company ??

Analysis of Accts. Receivable Changes to Credit Policy Develop pro forma financial statements for

each policy under consideration. Use the pro formas to estimate incremental

cash flows by comparing forecasts to current policy cash flows.

Use the incremental cash flows to estimate the NPV of each policy change.

Choose the policy change that maximizes the value of the firm (highest NPV).

Example:ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount

Why might they do this?-Increase sales-Increase market share

What costs will the firm incur as a result?-Cost of carrying accounts receivable-Potential increase in bad debts-Credit analysis and collection costs

Analysis of Accts. Receivable Changes

Analysis of Accts. Receivable Changes Assume the Net Incremental Cash Flows associated

with ABC’s new credit policy are as follows: (They lose one month of cash flow which they will have to borrow)

External financing (Init. Investment) = $28,000 t=0– Increase in sales = $30,000 – Increase in COGS = $15,000 – Increase in Bad Debts = $3,000– increase in Other Expenses = $5,000– Increase in Interest Expense = $500– Increase in Taxes = $2,600– Total Incr. Operating Cash Flow = $3,900/yr.

Analysis of Accts. Receivable Changes Calculate the NPV of the change (k = 12%): PV of the expected inflows of $3,900 per year

from t = 0 to infinity (perpetuity)= $3,900/.12 = $32,500

NPV = PV of inflows - initial investment= $32,500 - $28,000 = $4,500

Since NPV > 0, ABC should undertake the credit policy change

Methods of Collection

Send reminder letters. Make telephone calls. Hire collection agencies. Sue the customer. Settle for a reduced amount. Write off the bill as a loss.

Most firms use some of the following:

Inventory Management Typically, inventory accounts for about four to five

percent of a firm's assets. In manufacturing firms, this could be 20 to 25% of the firm’s assets.

Inventory sitting on your shelf earns nothing! In fact, it costs you 20 to 30% of the value of the

inventory just to keep and maintain it. Therefore, the objective is to minimize the

investment in inventory without sacrificing production requirements

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Inventory Mangement

In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order.

The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.

Inventory Management Determining Optimal Inventory (where total

costs are minimized)

TotalInventory

Costs=

TotalCarrying

Costs

TotalOrdering

Costs+

Note: We are not talking about the cost of the Inventory itself, but costs of holding and maintaining the inventory

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Inventory Costs Carrying Costs

Warehouse rent, insurance, security costs,utility costs, maintenance costs, property taxes,move and re-arrange, obsolescence, and opportunity cost, i.e., using cash for profitable projects rather than being tied up in inventory.

Ordering costsClerical expense, telephone, Material Resource Planning (MRP) system, management time, receiving costs, etc.

Time

OrderQuantity

Q

InventoryLevel

(units)

The EOQ Model assumes the firm orders a fixed amount (Q) at equal intervals.

Time

OrderQuantity

Q

InventoryLevel

(units)

The EOQ Model

Average inventory = Order Quantity

2

=Total

InventoryCosts

( ) CC + ( ) OCOQ2

S OQ

Where:OQ = Order Size (order quantity)S = Annual Sales VolumeCC = Carrying Cost per UnitOC = Ordering Cost per Order

TotalInventory

Costs=

TotalCarrying

Costs

TotalOrdering

Costs+

Order Size (units)

Cost($)

Ordering Costs, per unit

= ( )OC S OQ

Ordering Costs

Ordering costs per unit go down as order size increases. Assumes orderingcosts are relatively fixed.

Carrying Costs

Order Size (units)

Cost($)

Carrying Costs = ( ) CC OQ 2

= ( )OC S OQ

Ordering Costs

Carrying costs increaseas the size of the inventory increases.

Total Costs = Carrying Costs + Order CostsTotal Cost = OQ x CC + S x OC

2 OQ

Order Size (units)

Cost($)

Carrying Costs = ( ) CC OQ 2

= ( )OC S OQ

Ordering Costs

X

Y The economic order quantity is the intersection of the X and Y points where total inventory cost is minimized

Inventory Management

– The ordering quantity that minimizes the total costs of inventory.

Determining Optimal Inventory

OQ =2 x S x OC

CC

Inventory Management

– Economic Order Quantity (EOQ)

Example:Awesome Autos expects to sell 1,560 new automobiles in the next year. It currently costs $40 per order placed with the manufacturer. Carrying costs amount to $50 per auto. How many autos should they order each time they place an order?

Determining Optimal Inventory

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Solution:

OQ =2 x S x OC

CC

=

= 49.96 50 cars

2(1560)4050

Inventory Management Determining Optimal Inventory

– Economic Order Quantity (EOQ)

Example:Awesome Autos expects to sell 1,560 new automobiles in the next year. It currently costs $40 per order placed with the manufacturer. Carrying costs amount to $50 per auto. How many autos should they order each time they place an order? How many orders per year?

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Solution:

OQ 50autos in each order Place 1,560/ 50 = 31.2 orders each

year Order cost = 31.2 x $40 = $1,248

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Answer :

(If sales are $1M per day, this will cost $7.4M!)

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InventoryHigh Levels Low Levels

Benefit: • Happy customers• Few production delays (always

have needed parts on hand)Cost: • Expensive• High storage costs• Risk of obsolescence

Cost: • Shortages• Dissatisfied

customersBenefit: • Low storage costs• Less risk of

obsolescence

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Accounts ReceivableHigh Levels (favourable credit

terms)Low Levels

(unfavourable terms)

Benefit: • Happy customers• High salesCost: • Expensive• High collection costs• Increases financing costs

Cost: • Dissatisfied

customers• Lower SalesBenefit: • Less expensive