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Current Asset Management
Accounts Receivable
and Inventory
Overview of Accounts Receivable
Management
 Seek to identify the impact of decisions on accounts
receivable and how to de...
Why do firms accumulate accounts
receivable and inventory?
 Assuming credit is to be offered, what standards will
be appl...
Definitions
 Accounts receivable
– Money owed to a business for goods or services
sold in the ordinary course of business...
Why do firms accumulate accounts
receivable and inventory?
 Given that accounts receivable and inventory are
assets that ...
Finding the Optimum Level of
Accounts Receivable
 Accounts Receivable represent your money sitting in
someone else’s bank...
Benefits and Costs of Granting
Credit
 Benefits
– Increased sales.
 Costs
– Opportunity cost of investment.
– Cost of ba...
Credit Policy
 Credit policy’ refers to a supplier’s policy on whether credit
will be offered to customers and the terms ...
Credit Policy

 Selection of credit-worthy customers

cont..

– Company’s past experience with customer.
– Use of decisio...
Credit Policy

 Limit of credit extended

cont..

– Setting limits — about risk management.
– The more sales on credit, t...
Collection Policy
 ‘Collection policy’ refers to the efforts made to collect
delinquent accounts either informally or by ...
Five Cs of Credit
 Character – willingness to meet financial obligations
 Capacity – ability to meet financial obligatio...
Accounts Receivable - Terms
 The terms of sale are generally stated in the
form X / Y, n Z
 This means that the customer...
Average Collection Period (ACP)
 Old Policy; 2/10, n30
– 35% of customers pay in 10 days
– 62% of customers pay in 30 day...
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...
Analysis of Accts. Receivable
Changes to Credit Policy
 Develop pro forma financial statements for
each policy under cons...
Analysis of Accts. Receivable Changes
 Example:
ABC Corporation is considering a credit policy change from
offering no cr...
Analysis of Accts. Receivable Changes
 Assume the Net Incremental Cash Flows associated
with ABC’s new credit policy are ...
Analysis of Accts. Receivable Changes
 Calculate the NPV of the change (k = 12%):
 PV of the expected inflows of $3,900 ...
Methods of Collection
Most firms use some of the following:

 Send reminder letters.
 Make telephone calls.
 Hire colle...
Inventory Management
 Typically, inventory accounts for about four to five
percent of a firm's assets. In manufacturing f...
Inventory Mangement
 In order to effectively manage the investment in
inventory, two problems must be dealt with: how
muc...
Inventory Management
 Determining Optimal Inventory (where total
costs are minimized)
Total
Inventory
=
Costs

Total
Carr...
Inventory Costs
 Carrying Costs
Warehouse rent, insurance, security costs,
utility costs, maintenance costs, property tax...
The EOQ Model assumes the firm orders a
fixed amount (Q) at equal intervals.
Inventory
Level
(units)
Order
Quantity
Q

Tim...
The EOQ Model
Inventory
Level
(units)

Average inventory =

Order
Quantity
2

Order
Quantity
Q

Time
Total
Total
Inventory = Carrying +
Costs
Costs
Total
Inventory =
Costs

(

Total
Ordering
Costs

OQ
S
) CC + ( OQ ) OC
2

...
Ordering Costs = ( S )OC
OQ

Cost
($)

Ordering Costs, per unit

Ordering costs per unit
go down as order size
increases. ...
Ordering Costs = ( S )OC
OQ
Carrying Costs = ( OQ ) CC
2

Cost
($)

Carrying Costs
Carrying costs increase
as the size of ...
Ordering Costs = ( S )OC
OQ

Cost
($)

Carrying Costs = ( OQ ) CC
2
Total Costs = Carrying Costs + Order Costs
Total Cost ...
Inventory Management
Determining Optimal Inventory
– The ordering quantity that minimizes the total
costs of inventory.
O...
Inventory Management
Determining Optimal Inventory
– Economic Order Quantity (EOQ)
Example:
Awesome Autos expects to sell...
Solution:
2 x S x OC
CC

OQ =

=

2(1560)40
50

= 49.96

50 cars

33
Inventory Management
 Determining Optimal Inventory
– Economic Order Quantity (EOQ)
Example:
Awesome Autos expects to sel...
Solution:
 OQ
autos in each order
 Place 1,560/ 50 = 31.2 orders each
year
 Order cost = 31.2 x $40 = $1,248

35
Answer :

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

36
Inventory
High Levels

Benefit:
• Happy customers
• Few production delays (always
have needed parts on hand)
Cost:
• Expen...
Accounts Receivable
High Levels (favourable credit
terms)

Low Levels
(unfavourable terms)

Benefit:
• Happy customers
• H...
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Account receivable and Inventory Management lecture 11,12,13

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Account receivable and Inventory Management

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Account receivable and Inventory Management lecture 11,12,13

  1. 1. Current Asset Management Accounts Receivable and Inventory
  2. 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. 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. 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. 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. 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. 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. 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. 9. Credit Policy  Selection of credit-worthy customers cont.. – 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. 10. Credit Policy  Limit of credit extended cont.. – 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. 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. 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. 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. 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. 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. 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. 17. Analysis of Accts. Receivable Changes  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
  18. 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. 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. 20. Methods of Collection Most firms use some of the following:  Send reminder letters.  Make telephone calls.  Hire collection agencies.  Sue the customer.  Settle for a reduced amount.  Write off the bill as a loss.
  21. 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. 22
  23. 23. Inventory Management  Determining Optimal Inventory (where total costs are minimized) Total Inventory = Costs Total Carryin + g 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. 24
  25. 25. The EOQ Model assumes the firm orders a fixed amount (Q) at equal intervals. Inventory Level (units) Order Quantity Q Time
  26. 26. The EOQ Model Inventory Level (units) Average inventory = Order Quantity 2 Order Quantity Q Time
  27. 27. Total Total Inventory = Carrying + Costs Costs Total Inventory = Costs ( Total Ordering Costs OQ S ) CC + ( OQ ) OC 2 Where: OQ = Order Size (order quantity) S = Annual Sales Volume CC = Carrying Cost per Unit OC = Ordering Cost per Order
  28. 28. Ordering Costs = ( S )OC OQ Cost ($) Ordering Costs, per unit Ordering costs per unit go down as order size increases. Assumes ordering costs are relatively fixed. Order Size (units)
  29. 29. Ordering Costs = ( S )OC OQ Carrying Costs = ( OQ ) CC 2 Cost ($) Carrying Costs Carrying costs increase as the size of the inventory increases. Order Size (units)
  30. 30. Ordering Costs = ( S )OC OQ Cost ($) Carrying Costs = ( OQ ) CC 2 Total Costs = Carrying Costs + Order Costs Total Cost = OQ x CC + S x OC 2 OQ Y The economic order quantity is the intersection of the X and Y points where total inventory cost is minimized X Order Size (units)
  31. 31. Inventory Management Determining Optimal Inventory – The ordering quantity that minimizes the total costs of inventory. OQ = 2 x S x OC CC
  32. 32. 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?
  33. 33. Solution: 2 x S x OC CC OQ = = 2(1560)40 50 = 49.96 50 cars 33
  34. 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 autos in each order  Place 1,560/ 50 = 31.2 orders each year  Order cost = 31.2 x $40 = $1,248 35
  36. 36. Answer : (If sales are $1M per day, this will cost $7.4M!) 36
  37. 37. Inventory High Levels Benefit: • Happy customers • Few production delays (always have needed parts on hand) Cost: • Expensive • High storage costs • Risk of obsolescence Low Levels Cost: • Shortages • Dissatisfied customers Benefit: • Low storage costs • Less risk of obsolescence 37
  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 38

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