Account receivable and Inventory Management lecture 11,12,13

Account receivable and Inventory Management

1. Current Asset Managemen t Accounts Receivable and Inventory

2. 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?

3. 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?

4. 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

5. 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.

6. 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

7. 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.

8. 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?

9. 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

10. 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

11. 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

12. 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

13. 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.

14. 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

15. 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 ?? 15

16. 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).

17. 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

18. 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.

19. 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

20. 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:

21. 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

22. 22 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.

23. Inventory Management Determining Optimal Inventory (where total costs are minimized) Total Inventory Costs = Total Carrying Costs Total Ordering Costs + Note: We are not talking about the cost of the Inventory itself, but costs of holding and maintaining the inventory

24. 24 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 costs Clerical expense, telephone, Material Resource Planning (MRP) system, management time, receiving costs, etc.

25. Time Order Quantity Q Inventory Level (units) The EOQ Model assumes the firm orders a fixed amount (Q) at equal intervals.

26. Time Order Quantity Q Inventory Level (units) The EOQ Model Average inventory = Order Quantity 2

27. = Total Inventory Costs ( ) CC + ( ) OC OQ 2 S OQ Where: OQ = Order Size (order quantity) S = Annual Sales Volume CC = Carrying Cost per Unit OC = Ordering Cost per Order Total Inventory Costs = Total Carrying Costs Total Ordering Costs +

28. Order Size (units) Cost ($) Ordering Costs, per unit = ( )OC S OQ Ordering Costs Ordering costs per unit go down as order size increases. Assumes ordering costs are relatively fixed.

29. Carrying Costs Order Size (units) Cost ($) Carrying Costs = ( ) CC OQ 2 = ( )OC S OQ Ordering Costs Carrying costs increase as the size of the inventory increases.

30. Total Costs = Carrying Costs + Order Costs Total 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

31. Inventory Management The ordering quantity that minimizes the total costs of inventory. Determining Optimal Inventory OQ = 2 x S x OC CC

32. 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

33. 33 Solution: OQ = 2 x S x OC CC = = 49.96  50 cars 2(1560)40 50

34. 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?

35. 35 Solution: OQ 50 autos in each order Place 1,560/ 50 = 31.2 orders each year Order cost = 31.2 x $40 = $1,248

36. Answer : (If sales are $1M per day, this will cost $7.4M!) 36

37. 37 Inventory High 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 customers Benefit: Low storage costs Less risk of obsolescence

38. 38 Accounts Receivable High Levels (favourable credit terms) Low Levels ( unfavourable terms) Benefit: Happy customers High sales Cost: Expensive High collection costs Increases financing costs Cost: Dissatisfied customers Lower Sales Benefit: Less expensive