Finance Topic #5

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McGraw-Hill/Irwin

Credit and Inventory Management

Chapter 28

Key Concepts and Skills

Understand the key issues related to credit management
Understand the impact of cash discounts
Be able to evaluate a proposed credit policy
Understand the components of credit analysis
Understand the major components of inventory management
Be able to use the EOQ model to determine optimal inventory ordering

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Chapter Outline

28.1 Credit and Receivables

28.2 Terms of the Sale

28.3 Analyzing Credit Policy

28.4 Optimal Credit Policy

28.5 Credit Analysis

28.6 Collection Policy

28.7 Inventory Management

28.8 Inventory Management Techniques

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Credit Management: Key Issues

Granting credit generally increases sales
Costs of granting credit
Chance that customers will not pay
Financing receivables
Credit management examines the trade-off between increased sales and the costs of granting credit

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Components of Credit Policy

Terms of sale
Credit period
Cash discount and discount period
Type of credit instrument
Credit analysis – distinguishing between “good” customers that will pay and “bad” customers that will default
Collection policy – effort expended on collecting receivables

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The Cash Flows from Granting Credit

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Credit Sale Check Mailed Check Deposited Cash Available

Cash Collection

Accounts Receivable

Obviously, the timeline is not drawn to scale, and the distance between each point would differ across companies.

Terms of Sale

Basic Form: 2/10 net 45
2% discount if paid in 10 days
Total amount due in 45 days if discount not taken
Buy $500 worth of merchandise with the credit terms given above
Pay $500(1 - .02) = $490 if you pay in 10 days
Pay $500 if you pay in 45 days

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Example: Cash Discounts

Finding the implied interest rate when customers do not take the discount
Credit terms of 2/10 net 45
Period rate = 2 / 98 = 2.0408%
Period = (45 – 10) = 35 days
365 / 35 = 10.4286 periods per year
EAR = (1.020408)10.4286 – 1 = 23.45%
The company benefits when customers choose to forgo discounts

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Cash discounts are designed to shorten the receivables period; however, you reduce your net sales level when discounts are taken, unless the discount entices new customers to purchase.

The last statement on the slide implicitly assumes that the customer eventually pays and does so on time.

Credit Policy Effects

Revenue Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales
Cost Effects
Cost of the sale is still incurred even though the cash from the sale has not been received
Cost of debt – must finance receivables
Probability of nonpayment – some percentage of customers will not pay for products purchased
Cash discount – some customers will pay early and pay less than the full sales price

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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 1,000 units per month. Under the proposed policy, the company expects to sell 1,050 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?

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Example: Evaluating a Proposed Policy – Part II

Incremental cash inflow
(100 – 40)(1,050 – 1,000) = 3,000
Present value of incremental cash inflow
3,000/.015 = 200,000
Cost of switching
100(1,000) + 40(1,050 – 1,000) = 102,000
NPV of switching
200,000 – 102,000 = 98,000
Yes, the company should switch

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100*1000=amount of immediate CF needed to cover the extension in time to pay.

Total Cost of Granting Credit

Carrying costs
Required return on receivables
Losses from bad debts
Costs of managing credit and collections
Shortage costs
Lost sales due to a restrictive credit policy
Total cost curve
Sum of carrying costs and shortage costs
Optimal credit policy is where the total cost curve is minimized

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Figure 28.1

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Credit Analysis

Process of deciding which customers receive credit
Gathering information
Determining Creditworthiness
5 Cs of Credit
Credit Scoring

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Credit scoring is less subjective than the five Cs, but firms have to be careful with the information they choose to include in the score. For example, race, gender and geographic location cannot be included in the score.

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 = -50 + (1-.15)(110)/(1.01) = 42.57
What is the break-even probability?
0 = -50 + (1 - )(110)/(1.01)
 = .5409 or 54.09%

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V = variable cost per unit

 = probability of default

Example: Repeat Customers

NPV = -v + (1-)(P – v)/R
In the previous example, what is the NPV if we are looking at repeat business?
NPV = -50 + (1-.15)(110 – 50)/.01 = 5,050
Repeat 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 price
If a customer defaults once, you don’t grant credit again

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Credit Information

Financial statements
Credit reports with customer’s payment history to other firms
Banks
Payment history with the company

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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

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Collection Policy

Monitoring receivables
Keep an eye on average collection period relative to your credit terms
Use an aging schedule to determine percentage of payments that are being made late
Collection policy
Delinquency letter
Telephone call
Collection agency
Legal action

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If 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 across the board or if there are a few customers that are paying really late.

Inventory Management

Inventory can be a large percentage of a firm’s assets
There can be significant costs associated with carrying too much inventory
There can also be significant costs associated with not carrying enough inventory
Inventory management tries to find the optimal trade-off between carrying too much inventory versus not enough

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Types of Inventory

Manufacturing firm
Raw material – starting point in production process
Work-in-progress
Finished goods – products ready to ship or sell
Remember that one firm’s “raw material” may be another firm’s “finished goods”
Different types of inventory can vary dramatically in terms of liquidity

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Inventory Costs

Carrying costs – range from 20 – 40% of inventory value per year
Storage and tracking
Insurance and taxes
Losses due to obsolescence, deterioration, or theft
Opportunity cost of capital
Shortage costs
Restocking costs
Lost sales or lost customers
Consider both types of costs, and minimize the total cost

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Inventory Management - ABC

Classify inventory by cost, demand, and need
Those items that have substantial shortage costs should be maintained in larger quantities than those with lower shortage costs
Generally maintain smaller quantities of expensive items
Maintain a substantial supply of less expensive basic materials

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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)

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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. (See the IM for a derivation.)

CC/2 – FT/Q2 = 0

CC/2 = FT/Q2

Q2 = 2TF/CC

Figure 28.3

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Example: EOQ

Consider 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?

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Total carrying costs = (2,582/2)(1.50) = 1,936.50

Total restocking costs = 50(100,000)/2,582 = 1,936.48

Extensions

Safety stocks
Minimum level of inventory kept on hand
Increases carrying costs
Reorder points
At what inventory level should you place an order?
Need to account for delivery time
Derived-Demand Inventories
Materials Requirements Planning (MRP)
Just-in-Time Inventory

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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?

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