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Slide 28.14 Example: One Time Sale
Repeat Business
NPV = -v + (1 - )(P – v)/R
Slide 28.15 Example: Repeat Customers
A. Credit information:
-Financial statements
-Credit reports (i.e., Dun and Bradstreet)
-Banks
-Customer’s payment history
Slide 28.16 Credit Information
B. Credit Evaluation and Scoring
Slide 28.17 The Five Cs of Credit
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
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
Lecture Tip: 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; it 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.
2. Collection Policy
A. Monitoring receivables
Keeping track of payments to try to spot potential problems (chronic late-
payers and possible defaults) to reduce losses.
Slide 28.18 Collection Policy
Aging schedule – a break-down of receivables accounts by age
Lecture Tip: Wilbur Lewellen and Robert Johnson demonstrate that two of
the traditional receivables monitoring tools – average collection
period and the aging schedule – are influenced by the pattern of
sales and may be misinterpreted by managers that are unaware of
this effect. Fortunately, eliminating this problem is
straightforward; use outstanding balances as a percentage of the original
sales that generated them. Their solution is discussed in detail in
“Better Way to Monitor Accounts Receivable,” Harvard Business
Review, May-June, 1972, pp. 101 – 109.
B. Collection Effort
The sequence of steps taken in collecting overdue accounts.
Typical steps:
-Send delinquency letter
-Call customer
-Employ collection agency
-Initiate legal proceedings
Lecture Tip: Health-care providers face unusual challenges in dealing with
collection policy. A correspondent on the financial management
listserv made the following comments regarding collection policy
and procedure for a multi-specialty physician’s group:
“When patients have to pay after all insurance has been collected, you
can either devote a staff person to make the laborious calls,
etc. or turn it over to an A/R firm. To reduce
staff time, have staff make one letter billing in 15 days and one call 15
days later.”
“If patient hasn’t paid in 30 days, turn it over to the A/R firm. This firm
contacts the patient for up to 60 days as a ‘billing agent’ NOT
COLLECTION FIRM to ask the patient to comply in a ‘soft’
manner – YOU DO NOT WANT TO UPSET PATIENTS!!”
(emphasis in original)
“After 60 days, the account turns into aggressive collection and the A/R
firm turns into an aggressive COLLECTION AGENCY with all
the powers to collect.”
In other words, the steps in the collection policy used at this firm progress
from mild to aggressive, as suggested in the text.
Lecture Tip: Securitization involves selling an expected series of cash flows
to investors. It works something like this: a company has accounts
receivable of $10 million with an average collection period of 45
days. The accounts receivable might be packaged as securities and
sold to investors at 95% of its value, or $9.5 million. When
customers make payments on their accounts, the money is
forwarded to the investors. The company receives its cash much
sooner, and the investor bears the risk of default on the accounts.
The larger the probability of default on the accounts, the larger the
discount the investor will require. Similar securities have been
developed for mortgages, student loans, etc., although the attractiveness of
such securities declined (temporarily) with the credit crisis in
2008.
3. Inventory Management
A. The Financial Manager and Inventory Policy
Many people, not just those in the finance function, influence the level of
inventory. Nonetheless, financial managers see the results of
inventory decisions in many places – ROA, inventory turnover and
Days’ Sales in Inventory ratios, to name a few.
Lecture Tip: Dell had one of the best inventory management systems in place.
There have been numerous articles written in the financial press
concerning their policies. The management at Dell believes that by
carrying low levels of inventory on hand, they are able to pass the
savings along to customers when component prices drop, which
happens regularly. They are also able to stay on top of the new
technology and offer it to customers as soon as it becomes
available instead of trying to get rid of out-dated equipment. In
fact, Dell was so effective at managing its inventory and
receivables, that it has historically had a negative cash cycle,
meaning that the firm is selling and collecting on inventory before
it is paying for it! Too bad this wasn’t enough to keep it at the top
of its industry.
Slide 28.19 Inventory Management
Slide 28.20 Types of Inventory
B. Inventory Types
For a manufacturer, inventory is classified into one of three categories:
-Raw materials
-Work-in-progress
-Finished goods
Classification into one of these categories depends on the firm’s business;
what are raw materials for one firm may be finished goods for
another. Inventory types have different levels of liquidity. Demand
for raw materials and work-in-progress depends on the demand for
finished goods.
C. Inventory Costs
There are two basic types of costs associated with current assets in general
and inventory in particular – carrying costs and shortage costs.
Slide 28.21 Inventory Costs
Lecture Tip: Boeing Corporation is one of the largest manufacturers of
military aircraft in the world. For many years, the firm has
employed hundreds of subcontractors not only to produce aircraft
components, but also to maintain stocks of raw materials inventory
for the firm. Inventory managers have found that it is often less
costly to pay someone to maintain these inventories.
4. Inventory Management Techniques
A. The ABC Approach
Inventory is subdivided into three (or more) groups and the groups are
analyzed to determine the relationship between inventory value
and quantity represented in each group.
Slide 28.22 Inventory Management – ABC
B. The Economic Order Quantity Model
EOQ – the restocking quantity that minimizes total inventory costs based on
the assumption that inventory is depleted at a steady pace.
Total carrying costs = (average inventory)(carrying cost per unit)
= (Q/2)(CC)
Total restocking costs = (fixed cost per order)(number of orders)
= F(T/Q)
Total costs = carrying costs + restocking costs
= (Q/2)(CC) + F(T/Q)
CC
TF
EOQ 2
The EOQ is the point where the total carrying costs just equal the total
restocking costs. This follows the model used to determine the
optimal cash balance in Appendix 27A.
Slide 28.23 EOQ Model
Lecture Tip: The EOQ model assumes that the firm’s inventory is depleted at
a constant rate until it hits zero. Firms with seasonal demand may
not be able to use the EOQ model without some adjustments. One
way to adjust the equation is to compute “T” based on the high
sales level and use that number to compute the EOQ during
periods of high sales. Conversely, during periods of low sales,
compute “T” based on the low sales figures and use that number
to compute EOQ. What will happen is that the “optimal” order
quantity will change depending on the seasonality in sales.
Another option is to develop a cost formula that accounts for the
seasonality and then use calculus to minimize the new cost
function.
Slide 28.24 Figure 28.3
Lecture Tip: If students have had calculus, you can point out that this is just
the quantity that minimizes the cost function and can be found by
taking the first derivative, setting it equal to zero and solving for
Q.
2
2
2
0
2
2
Q
FTCC
Q
FTCC
Q
TC
Q
T
FCC
Q
TC
CC
FT
Q
CC
FT
Q
2
2
2
Slide 28.25 Example: EOQ
C. Extensions to the EOQ Model
Safety stocks – minimum level of inventory that must be kept on hand;
inventory won’t actually reach zero; will increase the carrying cost
component above what is predicted by the EOQ model
Reorder points – place orders before inventory reaches a critical
level. Designed to account for delivery time
Slide 28.26 Extensions
D. Managing Derived-Demand Inventories
Materials Requirements Planning – computer based systems that manage the
manufacturing process to make sure that inventory will be
available when it is required
Just-in-Time Inventory – order inventory so that it will arrive when needed.
Reduces the cost of storing inventory.
Lecture Tip: The primary advantage of JIT systems is the reduction in
inventory carrying costs that, for a large manufacturer, can be
substantial. As with every financial decision, however, there is no
increase in return without an increase in risk. In this instance, the
risk is that an interruption in the supply of inventory items will
require the user to shut down production virtually immediately. As
part of a larger program to reduce costs, GM adopted a variant of
the JIT system, but found it necessary to temporarily halt
production of some models in early 1994 as a result of labor
strikes at a supplier’s plants.
Slide 28.27 Quick Quiz
To access Appendix 28A (More About Credit Policy Analysis) visit www.mhhe.com/rwj.
