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10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter.

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Presentation on theme: "10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter."— Presentation transcript:

1 10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Chapter 10 Accounts Receivable and Inventory Management

2 10.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 1. List the key factors that can be varied in a firm's credit policy and understand the trade-off between profitability and costs involved. 2. Understand how the level of investment in accounts receivable is affected by the firm's credit policies. 3. Critically evaluate proposed changes in credit policy, including changes in credit standards, credit period, and cash discount. 4. Describe possible sources of information on credit applicants and how you might use the information to analyze a credit applicant. 5. Identify the various types of inventories and discuss the advantages and disadvantages of increasing/decreasing inventories 6. 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). After Studying Chapter 10, you should be able to:

3 10.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Credit and Collection Policies Analyzing the Credit Applicant Inventory Management and Control Accounts Receivable and Inventory Management

4 10.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. (1) Average Collection Period (2) Bad-debt Losses Quality of Trade Account Length of Credit Period Possible Cash Discount Firm Collection Program Credit and Collection Policies of the Firm

5 10.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 Credit Standards – The minimum quality of credit worthiness of a credit applicant that is acceptable to the firm. Why lower the firms credit standards? Credit Standards

6 10.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. A larger credit department Additional clerical work Servicing additional accounts Bad-debt losses Opportunity costs Costs arising from relaxing credit standards Credit Standards

7 10.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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. Example of Relaxing Credit Standards

8 10.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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? Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit standards? Example of Relaxing Credit Standards

9 10.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Profitability of ($5 contribution) x (4,800 units) = $24,000 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 = $4,800 on add. investment$4,800 Yes! Yes! Profits > Required pre-tax return Example of Relaxing Credit Standards

10 10.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. (1) Average Collection Period (2) Bad-debt Losses Quality of Trade Account Length of Credit Period Possible Cash Discount Firm Collection Program Credit and Collection Policies of the Firm

11 10.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Credit Period net 30 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 2/10, net 30. 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. Credit Terms

12 10.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Basket Wonders net 30 net 60 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. Example of Relaxing the Credit Period

13 10.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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? Example of Relaxing the Credit Period

14 10.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Profitability of ($5 contribution)x(10,000 units) = $50,000 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 Example of Relaxing the Credit Period

15 10.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 = $40,000 on add. investment$40,000 Yes! Yes! Profits > Required pre-tax return Example of Relaxing the Credit Period

16 10.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. (1) Average Collection Period (2) Bad-debt Losses Quality of Trade Account Length of Credit Period Possible Cash Discount Firm Collection Program Credit and Collection Policies of the Firm

17 10.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Cash Discount 2/10 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 2/10 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. Credit Terms

18 10.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. net 60 2/10, net 60. 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. (30% x 10 days + 70% x 60 days = days = 45 days 360 days per year / 45 days = 8 turns per year Example of Introducing a Cash Discount

19 10.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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

20 10.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Receivable level ($5,000,000 sales) / (6 Turns) = (Original)$833,333 Receivable level ($5,000,000 sales) / (8 Turns) = (New)$625,000 Reduction of $833,333 - $625,000 = investment in A/R$208,333 Example of Using the Cash Discount

21 10.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Pre-tax cost of 0.02 x 0.3 x $5,000,000 = $30,000. the cash discount $30,000. Pre-tax opp. savings(20% opp. cost) x $208,333 = $41,667. on reduction in A/R$41,667. Yes! 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

22 10.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 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. Seasonal Dating

23 10.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. (1) Average Collection Period (2) Bad-debt Losses Quality of Trade Account Length of Credit Period Possible Cash Discount FirmCollectionProgram Credit and Collection Policies of the Firm

24 10.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Present PolicyPolicy APolicy 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 sales1 month Incremental Sales2 months 3 months Default Risk and Bad-Debt Losses

25 10.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Policy APolicy B 1. Additional sales$600,000 $300, Profitability: (20% contribution) x (1) 120,000 60, Add. bad-debt losses: (1) x (bad-debt %) 60,000 54, Add. receivables: (1) / (New Rec. Turns) 100,000 75, Inv. in add. receivables: (.80) x (4) 80,000 60, Required before-tax return on additional investment: (5) x (20%) 16,000 12, Additional bad-debt losses + additional required return: (3) + (6) 76,000 66,000 additional required return: (3) + (6) 76,000 66, Incremental profitability: (2) - (7) 44,000 (6,000) Adopt Policy A but not Policy B. Default Risk and Bad-Debt Losses

26 10.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. collection expenditures bad-debt losses 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 SaturationPoint Collection Expenditures Bad-Debt Losses Collection Policy and Procedures

27 10.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Obtaining information on the credit applicant Analyzing this information to determine the applicants creditworthiness Making the credit decision Analyzing the Credit Applicant

28 10.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Financial statements Credit ratings and reports Bank checking Trade checking Companys own experience amount of information time and expense required The company must weigh the amount of information needed versus the time and expense required. Sources of Information

29 10.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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: Credit Analysis

30 10.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 through Sequential Investigation Process

31 10.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. * For previous customers only a Dun & Bradstreet reference book check. Pending Order Bad past credit experience Dun & Bradstreet report analysis* Reject YesNo Stage 1 $5 Cost Stage 2 $5 - $15 Cost No prior experience whatsoever Sample Investigation Process Flow Chart (Part A)

32 10.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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? Sample Investigation Process Flow Chart (Part B)

33 10.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. ** 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)** FairPoorGood Stage 3 $30 Cost Sample Investigation Process Flow Chart (Part C)

34 10.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Line of Credit 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 Credit-scoring System – A system used to decide whether to grant credit by assigning numerical scores to various characteristics related to creditworthiness. Other Credit Decision Issues

35 10.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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. Other Credit Decision Issues

36 10.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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: Inventory Management and Control

37 10.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Purchasing Production scheduling Efficient servicing of customer demands Inventories provide flexibility for the firm in: Inventory Management and Control

38 10.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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? Appropriate Level of Inventories

39 10.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 Cumulative Percentage of Items in Inventory Cumulative Percentage of Inventory Value A B C ABC Method of Inventory Control

40 10.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Forecast usage Ordering cost Carrying cost Ordering can mean either the purchase or production of the item. The optimal quantity to order depends on: How Much to Order?

41 10.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. C C: Carrying costs per unit per period O O: Ordering costs per order S S: Total usage during the period Total inventory costs (T) = C (Q / 2) + O (S / Q) TIME Q / 2 Q AverageInventory INVENTORY (in units) Total Inventory Costs

42 10.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 () (S) 2 (O) (S) C Economic Order Quantity

43 10.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Basket Wonders 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? Example of the Economic Order Quantity

44 10.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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 () (10,000) 2 ($200) (10,000) $1 Q* = 2,000 Units Economic Order Quantity

45 10.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. EOQ (Q*) represents the minimum point in total inventory costs. Total Inventory Costs Total Carrying Costs Total Ordering Costs Q* Order Size (Q) Costs Total Inventory Costs

46 10.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Order Point 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 OPLead time Order Point (OP) = Lead time X Daily usage Issues to consider: Lead Time Lead Time – The length of time between the placement of an order for an inventory item and when the item is received in inventory. When to Order?

47 10.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Basket Wonders 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 Example of When to Order

48 10.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer LeadTime OrderPoint UNITS DAYS Economic Order Quantity (Q*) Example of When to Order

49 10.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. Our previous example assumed certain demand and lead time. When demand and/or lead time are uncertain, then the order point is: Order Point Order Point = Safety stock (Avg. lead time x Avg. daily usage) + Safety stock Safety Stock Safety Stock – Inventory stock held in reserve as a cushion against uncertain demand (or usage) and replenishment lead time. Safety Stock

50 10.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer OrderPoint UNITS DAYS 2200 Safety Stock 200 Order Point with Safety Stock

51 10.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. UNITS DAYS Safety Stock Actual lead time is 3 days! (at day 21) OrderPoint The firm dips into the safety stock Order Point with Safety Stock

52 10.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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: How Much Safety Stock?

53 10.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. A very accurate production and inventory information system Highly efficient purchasing Reliable suppliers Efficient inventory-handling system Just-in-Time 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: Just-in-Time

54 10.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited Created by Gregory Kuhlemeyer. 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. Supply Chain Management


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