Chapter 20 – Credit and Inventory Management
Chapter 20
CREDIT AND INVENTORY MANAGEMENT
CHAPTER WEB SITES
Section Web Address
20.1 www.treasury.pncbank.com
www.treasurystrat.com
www.insidearm.com
20.2 www.nacm.org
20.4 www.creditworthy.com
20.5 www.dnb.com
20.7 www.simba.org
CHAPTER ORGANIZATION
20.1 Credit and Receivables
Components of Credit Policy
The Cash Flows from Granting Credit
The Investment in Receivables
20.2 Terms of the Sale
The Basic Form
The Credit Period
Cash Discounts
Credit Instruments
20.3 Analyzing Credit Policy
Credit Policy Effects
Evaluating a Proposed Credit Policy
20.4 Optimal Credit Policy
The Total Credit Cost Curve
Organizing the Credit Function
20.5 Credit Analysis
When Should Credit Be Granted?
Credit Information
Credit Evaluation and Scoring
20.6 Collection Policy
Monitoring Receivables
Collection Effort
20-1
Chapter 20 – Credit and Inventory Management
20.7 Inventory Management
The Financial Manager and Inventory Policy
Inventory Types
Inventory Costs
20.8 Inventory Management Techniques
The ABC Approach
The Economic Order Quantity Model
Extensions to the EOQ Model
Managing Derived-Demand Inventories
20.9 Summary and Conclusions
Appendix 20A More about Credit Policy Analysis
A. Two Alternative Approaches
B. Discounts and Default Risk
ANNOTATED CHAPTER OUTLINE
1. Credit and Receivables
A. Components of Credit Policy
Terms of sale – define credit period and any available discounts
Credit analysis – estimate probability of default for individual
customers to determine who receives credit and at what terms
Collection policy –steps that will be taken to collect on
receivables, particularly when customers are late with their
payment
B. The Cash Flows from Granting Credit
Float plays an important role in credit granting process.
C. The Investment in Receivables
The investment in receivables depends upon the average collection
period and the level of average daily credit sales.
Accounts receivable = average daily sales * average collection
period
20-2
Chapter 20 – Credit and Inventory Management
Lecture Tip: Some students might question why the amount of
investment in accounts receivables is the daily sales times ACP,
since “sales” contains cost plus profit, but the out-of-pocket
investment required would be the cost of the receivables, excluding
the profit reflected in the receivables balance. Point out that the
analysis refers to the funds committed to this balance. If the
receivables balance could be reduced by ten days, these ten days’
receivables would be immediately freed up. Therefore, the
investment in receivables should be viewed in terms of the funds
that are tied up.
2. Terms of the Sale
Credit period – amount of time allowed for payment
Cash discount and discount period – percent of discount allowed if
payment is made during the discount period
Type of credit instrument
A. The Basic form
The terms 2/10 net 60 mean you receive a 2% discount if you pay
in 10 days, with the total amount due in 60 days if the discount is
not taken. In this example, the 60 days is the credit period, the 10
days is the discount period, and the 2% is the cash discount
amount.
The invoice date is the date for which the credit period starts. This
is normally the shipping date, but some companies may post date
the invoice to encourage customers to order early.
B. The Credit Period
Credit Period – the length of time before the borrower is supposed
to pay
Two components: net credit period and discount period
Invoice date – begins the credit period, usually the shipping or
billing date
ROG – receipt of goods
EOM – end-of-month (invoice date is the end of the month)
20-3
Chapter 20 – Credit and Inventory Management
Seasonal dating – invoice date corresponds to the “season” of the
goods
Length of the credit period depends on:
-Buyer’s inventory and credit cycle
-Perishability and collateral value
-Consumer demand
-Cost, profitability and standardization
-Credit risk
-Size of the account
-Competition
-Customer type
C. Cash discounts
Offered by sellers to induce early payment. Not taking the discount
involves a cost of credit for the purchaser.
Cost of credit – the cost of not taking discounts offered (this is a
benefit to the company granting credit)
Periodic rate = (discount %) / (100 – discount %)
Number of periods per year = m = 365 / (net period – discount
period)
APR = m(periodic rate)
EAR = (1 + periodic rate)m – 1
Example: Consider terms of 1/15, net 45 (assume payment is made
on time in 45 days when the discount is forgone)
Periodic rate = 1/99 = .0101
Number of periods per year = m = 365 / (45 – 15) = 12.166667
APR = 12.166667(.0101) = 12.2896%
EAR = (1.0101)12.166667 – 1 = 13.0056%
Lecture Tip: When a company does not take advantage of discount
terms, such as those given above, it is effectively borrowing the
invoice amount at 1% for 30 days. Some students will want to use
the total time period (45 days); so it is important to emphasize that
the company is only borrowing the money at the discount rate for
the period between the end of the discount period and the net
period.
20-4
Chapter 20 – Credit and Inventory Management
Offering discounts generally reduces the average collection period
and thus the cash cycle. This reduces the amount of financing
required, but the company loses sales in the amount of the discount
taken. Consequently, the firm needs to look at the size and timing
of the expected cash flows to determine what, if any, discount
should be offered.
D. Credit instruments
Evidence of indebtedness
Open account – invoice only
Promissory note – basic IOU, may be used when the order is large
or the purchasing firm has a history of late payments
Commercial draft – request for funds sent directly to the
purchaser’s bank
Sight draft – payable immediately
Time draft – payment required by some future date
Trade acceptance – buyer accepts draft with agreement to pay
in the future
Bankers’ acceptance – bank accepts draft and guarantees
payment
International Note: Various investments have been developed to
shift the risk of non-payment of receivables in international
transactions from the seller to a financial institution. For example,
the banker’s acceptance is an irrevocable letter of credit issued by
a bank guaranteeing payment of the face amount. A letter of credit
is simply a promise from the buyer’s bank to make payment upon
receipt of the goods by the buyer. Point out that while these
guarantee arrangements add to the cost of doing business their
existence greatly facilitates international trade.
3. Analyzing Credit Policy
A. Credit Policy Effects
Revenue effects – price and quantity sold may be increased
Cost effects – the cost of running a credit plan and collecting
receivables
Cost of debt – firm must finance receivables
20-5
Chapter 20 – Credit and Inventory Management
Probability of nonpayment – always get paid if you sell for cash
Cash discount – affects payment patterns and amounts
B. Evaluating a Proposed Credit Policy
Lecture Tip: It’s useful to point out that the process for
determining the NPV of a credit policy switch is the same as the
process for determining the NPV of a capital asset replacement (or
“switch”). The analysis involves a comparison of the marginal
costs with the marginal benefits to be realized from the switch. If a
company liberalizes credit terms, the present value of the marginal
profit is compared to the immediate investment in a higher
receivables balance. If a company tightens credit, lower sales
should be expected. The present value of the reduction in profit is
compared to the cash realized from the lower amount invested in
receivables.
Define:
P = price per unit
v = variable cost per unit
Q = current quantity sold per period
Q = new quantity expected to be sold
R = periodic required return (corresponds to the ACP)
Benefit of switching is the change in cash flow
(P – v)Q – (P – v)Q = (P – v)(Q – Q)
Periodic benefit is the gross profit * change in quantity. The PV of
switching is:
PV = [(P – v)(Q – Q)] / R
The cost of switching is the amount uncollected for the period +
additional variable costs of production:
Cost = PQ + v(Q – Q)
Finally, the NPV of the switch is:
NPV = -[PQ + v(Q – Q)] + (P – v)(Q – Q)/R
A break-even application – what change in quantity would produce
a $0 NPV?
20-6
Chapter 20 – Credit and Inventory Management
Q – Q = PQ/[(P-v)/R – v]
4. Optimal Credit Policy
An optimal credit policy is one in which the incremental cash
flows from sales are equal to the incremental costs of carrying the
increased investment in accounts receivable.
A. The Total Credit Cost Curve
Credit policy represents the trade-off between two kinds of costs:
Carrying costs:
-the required return on receivables
-the losses from bad debts
-the costs of managing credit and collections
Opportunity costs:
-potential profit from credit sales lost
B. Organizing the Credit Function
Credit operations may be outsourced due to the cost of managing
such operations.
Those that manage credit operations internally either self-insure
against bad debts or purchase credit insurance.
A final alternative is to set up a subsidiary that handles the credit
operations.
Lecture Tip: As noted in the text, separating the finance and non-
finance lines of business by creating a captive finance subsidiary
may lower the firm’s overall cost of debt. Dennis E. Logue
suggests that this is due, in part, to the fact that “different levels of
assets can support varying degrees of leverage.” Put another way,
this suggests that the standards an analyst would apply to the
financial statements of the parent should reflect the parent’s main
line(s) of business, while the standards applied to the statements of
the subsidiary should reflect the fact that it is a finance company.
(See Dennis E. Logue, The Handbook of Modern Finance, second
edition, Warren, Gorham, and Lamont, 1990.)
5. Credit Analysis
20-7
Chapter 20 – Credit and Inventory Management
Lecture Tip: Students receive a large number of credit card offers
during their college career. This can provide a good example of
why credit analysis and assessing borrowing rates are so
important. The default rate is generally higher among college
students; however, companies can charge 18% to 21% on unpaid
balances. Since college students are also more likely to carry a
balance, the marginal benefit of the interest earned outweighs the
marginal cost of defaults. The bank also controls the risk of default
by providing lower credit limits to college students than to
individuals that have been working for several years.
A. When Should Credit Be Granted?
One-Time Sale
Let be the percentage of new customers who default
NPV = -v + (1 – )P / (1 + R)
The firm risks –v to gain P a period later.
Repeat Business
NPV = -v + (1 – )(P – v)/R
B. Credit information:
-Financial statements
-Credit reports (i.e., Dun and Bradstreet)
-Banks
-Customer’s payment history
C. Credit Evaluation and Scoring
Credit evaluation – trying to estimate the probability of default
Five Cs of Credit
Character – evidence of willingness to pay
Capacity – ability to pay out of operating income
Capital – financial reserves
Collateral – assets that can be pledged as security
Conditions – economic conditions that may affect the firm’s ability
to pay
20-8
Chapter 20 – Credit and Inventory Management
Lecture Tip: You may wish to emphasize here that full-blown
credit analysis contains both quantitative and qualitative aspects.
As any loan officer will tell you, using the five C’s to evaluate a
potential borrower reflects both types of considerations. For
example, capacity and capital are measured primarily by
examination of the borrower’s financial statements, while
character is measured by both the borrower’s prior credit history,
as well as by the lender’s (often highly unscientific) assessment of
the borrower’s integrity. Complicating the decision is that the most
difficult C to assess, character, is often said to be the most
important determinant of repayment. After all, if a borrower is
unwilling to repay, what difference do the other characteristics
make?
Credit scoring – assigning a numerical rating to customers based
on credit history
Ethics Note: Credit scoring models were initially introduced in the
1940s and became widespread in the 1960s. Companies that use
scoring models need to use great care to make sure that the factors
that determine the credit score do not depend on race, gender,
geographic location, or any other criteria that could be considered
discriminatory. Failure to take the proper precautions is not only
unethical but can lead to substantial legal problems, customer ill
will, and lost sales. This is one of the reasons that many companies
use the credit scores provided by the large credit agencies, such as
Equifax.
20-9