Key Concepts Understand the key issues related to credit management
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0 Credit and Inventory Management 21Credit and Inventory Management
1 Key Concepts Understand the key issues related to credit management Understand the impact of cash discountsBe able to evaluate a proposed credit policyUnderstand the components of credit analysisUnderstand the major components of inventory managementBe able to use the EOQ model to determine optimal inventory levels
2 Chapter Outline Credit and Receivables Terms of the Sale Analyzing Credit PolicyOptimal Credit PolicyCredit AnalysisCollection PolicyInventory ManagementInventory Management TechniquesAppendixTwo Alternative ApproachesDiscounts and Default Risk
3 Credit Management: Key Issues Granting credit increases salesCosts of granting creditChance that customers won’t payFinancing receivablesCredit management examines the trade-off between increased sales and the costs of granting credit
4 Components of Credit Policy Terms of saleCredit periodCash discount and discount periodType of credit instrumentCredit analysis – distinguishing between “good” customers that will pay and “bad” customers that will defaultCollection policy – effort expended on collecting receivables
5 The Cash Flows from Granting Credit Credit Sale Check Mailed Check Deposited Cash AvailableCash CollectionAccounts Receivable
6 Terms of Sale Basic Form: 2/10 net 45 2% discount if paid in 10 daysTotal amount due in 45 days if discount not takenBuy $500 worth of merchandise with the credit terms given abovePay $500( ) = $490 if you pay in 10 daysPay $500 if you pay in 45 days
7 Example: Cash Discounts Finding the implied interest rate when customers do not take the discountCredit terms of 2/10 net 45Period rate = 2 / 98 = %Period = (45 – 10) = 35 days365 / 35 = periods per yearEAR = ( ) – 1 = 23.45%The company benefits when customers choose to forgo discountsCash discounts are designed to shorten the receivables period, however, you reduce your sales level when discounts are taken.
8 Credit Policy Effects Revenue Effects Cost Effects Delay in receiving cash from salesMay be able to increase priceMay increase total salesCost EffectsCost of the sale is still incurred even though the cash from the sale has not been receivedCost of debt – must finance receivablesProbability of nonpayment – some percentage of customers will not pay for products purchasedCash discount – some customers will pay early and pay less than the full sales price
9 Example: Evaluating a Proposed Policy – Part I Your company is evaluating a switch from a cash only policy to a net 30 policy. The price per unit is $100 and the variable cost per unit is $40. The company currently sells 1000 units per month. Under the proposed policy, the company will sell 1050 units per month. The required monthly return is 1.5%.What is the NPV of the switch?Should the company offer credit terms of net 30?
10 Example: Evaluating a Proposed Policy – Part II Incremental cash inflow(100 – 40)(1050 – 1000) = 3000Present value of incremental cash inflow3000/.015 = 200,000Cost of switching100(1000) + 40(1050 – 1000) = 102,000NPV of switching200,000 – 102,000 = 98,000Yes the company should switch
11 Total Cost of Granting Credit Carrying costsRequired return on receivablesLosses from bad debtsCosts of managing credit and collectionsShortage costsLost sales due to a restrictive credit policyTotal cost curveSum of carrying costs and shortage costsOptimal credit policy is where the total cost curve is minimized
13 Credit Analysis Process of deciding which customers receive credit Gathering informationFinancial statementsCredit reportsBanksPayment history with the firmDetermining Creditworthiness5 C’s of CreditCredit ScoringCredit scoring is less subjective than the five Cs, but firms have to be careful with the information they choose to include in the score, e.g. race, gender and geographic location cannot be included in the score
14 Example: One-Time Sale NPV = -v + (1 - )P / (1 + R)Your company is considering granting credit to a new customer. The variable cost per unit is $50, the current price is $110, the probability of default is 15% and the monthly required return is 1%.NPV = (1-.15)(110)/(1.01) = 42.57What is the break-even probability?0 = (1 - )(110)/(1.01) = or 54.09%V = variable cost per unit = probability of default
15 Example: Repeat Customers NPV = -v + (1-)(P – v)/RLook at the previous example, what is the NPV if we are looking at repeat business?NPV = (1-.15)(110 – 50)/.01 = 5,050Repeat customers can be very valuable (hence the importance of good customer service)It may make sense to grant credit to almost everyone once, as long as the variable cost is low relative to the priceIf a customer defaults once, you don’t grant credit again
16 Credit Information Financial statements Credit reports with customer’s payment history to other firmsBanksPayment history with the company
17 Five Cs of CreditCharacter – willingness to meet financial obligationsCapacity – ability to meet financial obligations out of operating cash flowsCapital – financial reservesCollateral – assets pledged as securityConditions – general economic conditions related to customer’s business
18 Collection Policy Monitoring receivables Collection policy Keep an eye on average collection period relative to your credit termsUse an aging schedule to determine percentage of payments that are being made lateCollection policyDelinquency letterTelephone callCollection agencyLegal actionIf the average collection period is well outside your credit terms, then there is definitely a problem. If you offer a discount and the ACP is not less than your “net” terms, then there is probably a problem. An aging schedule can help you pinpoint if you have customers paying late more or less across the board or if there are a few customers that are paying really late.
19 Inventory ManagementInventory can be a large percentage of a firm’s assetsThere can be significant costs associated with carrying too much inventoryThere can also be significant costs associated with not carrying enough inventoryInventory management tries to find the optimal trade-off between carrying too much inventory versus not enough
20 Types of Inventory Manufacturing firm Raw material – starting point in production processWork-in-progressFinished goods – products ready to ship or sellRemember that one firm’s “raw material” may be another firm’s “finished good”Different types of inventory can vary dramatically in terms of liquidity
21 Inventory CostsCarrying costs – range from 20 – 40% of inventory value per yearStorage and trackingInsurance and taxesLosses due to obsolescence, deterioration or theftOpportunity cost of capitalShortage costsRestocking costsLost sales or lost customersConsider both types of costs and minimize the total cost
22 Inventory Management - ABC Classify inventory by cost, demand and needThose items that have substantial shortage costs should be maintained in larger quantities than those with lower shortage costsGenerally maintain smaller quantities of expensive itemsMaintain a substantial supply of less expensive basic materials
23 EOQ Model The EOQ model minimizes the total inventory cost Total carrying cost = (average inventory) x (carrying cost per unit) = (Q/2)(CC)Total restocking cost = (fixed cost per order) x (number of orders) = F(T/Q)Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) + F(T/Q)The optimal order quantity is where the cost function is minimized. This will occur where total carrying cost = total restocking cost. If your students have had calculus, you can have them verify that taking the derivative, setting it equal to zero and solving for Q provides the same result.CC/2 – FT/Q2 = 0CC/2 = FT/Q2Q2 = 2TF/CC
25 Example: EOQConsider an inventory item that has carrying cost = $1.50 per unit. The fixed order cost is $50 per order and the firm sells 100,000 units per year.What is the economic order quantity?Total carrying costs = (2582/2)(1.50) =Total restocking costs = 50(100,000)/2582 =
26 Extensions Safety stocks Reorder points Derived-Demand Inventories Minimum level of inventory kept on handIncreases carrying costsReorder pointsAt what inventory level should you place an order?Need to account for delivery timeDerived-Demand InventoriesMaterials Requirements Planning (MRP)Just-in-Time Inventory
27 Quick Quiz What are the key issues associated with credit management? What are the cash flows from granting credit?How would you analyze a change in credit policy?How would you analyze whether to grant credit to a new customer?What is ABC inventory management?How do you use the EOQ model to determine optimal inventory levels?