FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER CHAPTER TWENTY-THREE TWENTY-THREE Receivables and Inventory Management

Learning Objectives 1. Discuss accounts receivable and inventories. 2. Name four major policy variables in the area of credit management. 3. Discuss the trade-offs between benefits from anticipated sales and the costs of carrying an account. 4. Compare the different types of insurance available against bad debts. 5. Explain the different benefits and costs involved in inventory control.

Introduction Accounts receivables and inventories are usually the largest part of current assets for a firm Accounts receivables and inventories are usually the largest part of current assets for a firm Accounts receivables for the selling firm represents an account payable for the purchaser Accounts receivables for the selling firm represents an account payable for the purchaser In this chapter we investigate: In this chapter we investigate: l credit analysis of individual accounts l the setting of overall credit and collection policies l the use of credit insurance l the evaluation of receivables management l the role of captive finance companies

Credit Analysis of Individual Accounts The purpose of credit analysis is to assess the credit worthiness of potential customers and the corresponding risk of late payments or default The purpose of credit analysis is to assess the credit worthiness of potential customers and the corresponding risk of late payments or default Credit analysis consists of: Credit analysis consists of: 1. gathering information about the potential customer 2. analysing the information to derive a credit decision about the payment terms and amount of trade credit granted Credit agencies provide credit ratings and reports on companies (Dun & Bradstreet) Credit agencies provide credit ratings and reports on companies (Dun & Bradstreet)

Credit Analysis of Individual Accounts The credit decision is based on: The credit decision is based on: l the evaluation of the applicant's liquidity and ability to meet short-term obligations l the applicant’s attitude and character l the economic trade-off

Credit Policies A firm’s credit and collection policy is determined by the trade-off between higher profits from increased sales and the costs of having to finance investments in accounts receivable or bad debt losses A firm’s credit and collection policy is determined by the trade-off between higher profits from increased sales and the costs of having to finance investments in accounts receivable or bad debt losses Policy variables include: Policy variables include: l length of the credit period Þ 2/10 net 30 l quality of credit standards l cash discounts l collection procedures

Credit Insurance Credit insurance Credit insurance is designed to indemnify a firm’s unexpected losses caused by non-performing customers is designed to indemnify a firm’s unexpected losses caused by non-performing customers is subject to limitations and exclusions such as co-insurance clauses is subject to limitations and exclusions such as co-insurance clauses co-insurance clauses – requires the insured to bear a percentage of any loss incurred co-insurance clauses – requires the insured to bear a percentage of any loss incurred Export Development Corporation (EDC) helps facilitate the management of international customers for small and medium-sized Canadian companies Export Development Corporation (EDC) helps facilitate the management of international customers for small and medium-sized Canadian companies

Use of Credit Cards in Retailing By honouring major credit cards retailers: By honouring major credit cards retailers: can shift the risk of losses from bad debt to the sponsoring bank can shift the risk of losses from bad debt to the sponsoring bank do not require invoicing or collection procedures do not require invoicing or collection procedures eliminate receivables because it receives cash after depositing its sales slip with the bank eliminate receivables because it receives cash after depositing its sales slip with the bank The decision to honour credit cards has to weigh the costs against benefits The decision to honour credit cards has to weigh the costs against benefits

Captive Finance Companies Captive finance companies Captive finance companies l are wholly owned subsidiaries of the parent company l are common for companies that sell high- cost equipment (cars, planes) l the assets of the finance subsidiary consist of financing contracts that provide predictable cash flow

Inventory Management The main concern with inventory management is to balance the benefits and costs of carrying inventories The main concern with inventory management is to balance the benefits and costs of carrying inventories Four approaches to inventory control include: Four approaches to inventory control include: 1. The ABC approach – involves dividing inventory into categories in relationship to their contribution to inventory value per unit 2. The economic order quantity (EOQ) model – determines the optimal inventory level minimizing the total shortage and carrying costs

Inventory Management 3. Materials requirement planning (MRP) – a computer-based system for ordering and/or scheduling production of demand- dependent inventory items 4. Just-in-time (JIT) – attempt to schedule delivery of raw materials and the completion of necessary work-in-progress components exactly when they are required in order to reduce inventory to its lowest possible level

The Impact of Price-Level Changes on Inventories Price level changes can have a serious impact on inventories Price level changes can have a serious impact on inventories With rising price levels, inventory profits accrue and reported earnings may not reflect the firm’s profitability With rising price levels, inventory profits accrue and reported earnings may not reflect the firm’s profitability In Canada, the problem of inventory profits is magnified because the last-in, first-out method is not acceptable for tax purposes In Canada, the problem of inventory profits is magnified because the last-in, first-out method is not acceptable for tax purposes

Summary 1. For most firms, account receivables and inventories are the most important categories of current assets. Management is concerned with reaching optimal levels where the marginal benefits of added investment just equal incremental costs. 2. Returns from investments in accounts receivable are realized through increased profitable sales. Costs include the expenses of financing and losses from bad debts.

Summary 3. Credit information on individual accounts is available from credit rating agencies, banks, other suppliers, and from customers themselves. 4. The cost of short-term bank borrowing is usually the cost of financing receivables. The most difficult aspect of credit analysis is the assessment of the effects of altered credit policies on sales and the estimation of bad debts.

Summary 5. Credit insurance is for accounts large enough that a default can cause serious financial difficulties for the supplying firm. For international sales, the Export Development Corporation provides export insurance and other assistance. In retailing, acceptance of general credit cards sponsored by banks provides insurance against losses from bad debts and a reduced investment in accounts receivable. Captive finance companies are wholly owned subsidiaries set up by firms producing high- cost equipment in industries where extended credit is customary.

Summary 6. The main costs of inventories include warehousing, handling, insurance, obsolescence, spoilage, and financing. Price level changes can have a serious impact on inventories.