Chapter 28
CREDIT AND INVENTORY MANAGEMENT
SLIDES
CHAPTER WEB SITES
Section Web Address
28.1 www.pnc.com
www.treasurystrat.com
www.insidearm.com
28.2 www.newyorkfed.org/education/addpub/credit.html
www.nacm.org
28.4 www.creditworthy.com
28.5 www.dnb.com
28.7 www.simba.org
28.1 Key Concepts and Skills
28.2 Chapter Outline
28.3 Credit Management: Key Issues
28.4 Components of Credit Policy
28.5 The Cash Flows from Granting Credit
28.6 Terms of Sale
28.7 Example: Cash Discounts
28.8 Credit Policy Effects
28.9 Example: Evaluating a Proposed Policy – Part I
28.10 Example: Evaluating a Proposed Policy – Part II
28.11 Total Cost of Granting Credit
28.12 Figure 20.1
28.13 Credit Analysis
28.14 Example: One Time Sale
28.15 Example: Repeat Customers
28.16 Credit Information
28.17 Five Cs of Credit
28.18 Collection Policy
28.19 Inventory Management
28.20 Types of Inventory
28.21 Inventory Costs
28.22 Inventory Management – ABC
28.23 EOQ Model
28.24 Figure 20.3
28.25 Example: EOQ
28.26 Extensions
28.27 Quick Quiz
CHAPTER ORGANIZATION
28.1 Credit and Receivables
Components of Credit Policy
The Cash Flows from Granting Credit
The Investment in Receivables
28.2 Terms of the Sale
The Basic Form
The Credit Period
Cash Discounts
Credit Instruments
28.3 Analyzing Credit Policy
Credit Policy Effects
Evaluating a Proposed Credit Policy
28.4 Optimal Credit Policy
The Total Credit Cost Curve
Organizing the Credit Function
28.5 Credit Analysis
When Should Credit Be Granted?
Credit Information
Credit Evaluation and Scoring
28.6 Collection Policy
Monitoring Receivables
Collection Effort
28.7 Inventory Management
The Financial Manager and Inventory Policy
Inventory Types
Inventory Costs
28.8 Inventory Management Techniques
The ABC Approach
The Economic Order Quantity Model
Extensions to the EOQ Model
Managing Derived-Demand Inventories
ANNOTATED CHAPTER OUTLINE
Slide 28.0 Chapter 28 Title Slide
Slide 28.1 Key Concepts and Skills
Slide 28.2 Chapter Outline
1. Credit and Receivables
Slide 28.3 Credit Management: Key Issues
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
Slide 28.4 Components of Credit Policy
B. The Cash Flows from Granting Credit
Slide 28.5 The Cash Flows from Granting Credit
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
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 opportunity cost.
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
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.
Slide 28.6 Terms of Sale
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)
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 = 13.0069%
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.
Slide 28.7 Example: Cash Discounts
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
By definition, a credit instrument is 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
Lecture 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
Probability of nonpayment – always get paid if you sell for cash
Cash discount – affects payment patterns and amounts
Slide 28.8 Credit Policy Effects
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.
Slide 28.9 Example: Evaluating a Proposed Policy – Part I
Slide 28.10 Example: Evaluating a Proposed Policy – Part II
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?
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
Slide 28.11 Total Cost of Granting Credit
Slide 28.12 Figure 28.1
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
Slide 28.13 Credit Analysis
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 v be the variable cost per unit and be the percentage of new customers who
default
NPV = -v + (1 – )P / (1 + R)
The firm risks –v to gain P a period later.