chapter 17 management of accounts receivable and inventory
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Chapter 17 Management of Accounts Receivable and Inventory Receivables Management For a firm to grant credit to its customers: Establish Credit and Collection Policies Evaluate Individual Credit Applications Credit Management as a Career Accounts Receivable A/R

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receivables management
Receivables Management
  • For a firm to grant credit to its customers:
    • Establish Credit and Collection Policies
    • Evaluate Individual Credit Applications
  • Credit Management as a Career

Finance 312

accounts receivable a r
Accounts Receivable A/R
  • Large investment for most companies
  • Essentially an investment decision
  • Extend credit whenever the marginal returns from extending credit exceed the marginal costs
  • Liberal credit policy provides returns in the form of increased sales and gross profit, but...
  • Costs

Cost of funds Costs of credit checking Collection costs Increase in bad debts

  • Trade credit/ Consumer credit

Finance 312

credit policy
Credit Policy
  • Credit standards
    • Criteria used to screen credit applications
    • Controls the quality of accounts
  • Credit terms
    • Conditions under which credit extended must be repaid (including discounts)
    • Use of Electronic Data Interchange (EDI)
  • Collection efforts
    • Methods employed in an attempt to collect payment on past due accounts
    • Think of the picture “Rocky I”
  • Credit line

Finance 312

credit standards
Credit Standards
  • Quality
    • Time a customer takes to repay
    • Probability a customer will fail to repay
      • Default risk - Dun & Bradstreet Rating
  • Measures of quality
    • Average collection period
    • Bad-debt ratio
  • Balance between too lenient and too strict
    • Too restrictive a policy - lost sales and profits
    • Too lenient a policy - Higher investigation costs, Bad debt losses, collection costs, high investment in A/R

Finance 312

net change in pretax profits associated with granting credit
Net Change in Pretax profits Associated With Granting Credit
  • Marginal profitability of additional sales = Profit contribution ratio X Additional sales
  • Additional investment =

Additional ave daily sales X Ave collection period

  • Cost of additional investment in A/R = Additional investment in A/R X Pretax required return
  • Additional bad-debt loss = Bad- debt loss ratio X Additional sales
  • Additional collection expenses
  • Cost of additional investment in inventory = Additional inventory X Pretax required return
  • Net change in pretax profits = Marginal returns - Marginal costs

Finance 312

credit terms
Credit Terms
  • Credit period
    • Time allowed for payment
      • e.g. 30 days
  • Cash discount
    • Allowed if payment is made within a specific period of time
    • Specified as % of the invoiced amount
    • Granted to speed up collection of A/R
    • e.g. 2/10, n/30; 2/10 EOM, n/30
    • Kinked demand curve if oligolopistic competition exists and everyone changes their terms.

Finance 312

credit terms concluded
Credit Terms (Concluded)
  • Seasonal dating (Not a “Social Event”)
    • Offered to retailers on seasonal merchandise
    • Accept delivery well ahead of peak season
    • Pay shortly after peak sales
      • Advantages
        • Promotes sales - goods are on hand
        • Reduces manufacturing inventories
        • Allows producers to smooth production and distribution
        • Assists retailers in financing inventory
        • e.g. O.M. Scott

Finance 312

collection efforts
Collection Efforts
  • Methods employed to attempt to collect payments on past due accounts
    • Letters
    • Telephone Calls
    • Personal Visits
    • Collection Agencies
    • Legal Proceedings
  • Balance between leniency and alienating customers

Finance 312

collection efforts concluded
Collection Efforts (Concluded)
  • Monitoring status
    • Average Collection Period
    • Aging of Accounts Analysis
      • Classifying accounts into categories according to the number of days they are past due
      • Changes in the age composition of accounts may reveal changes in the quality of A/R
    • Both methods are affected by fluctuations in sales

Finance 312

analysis of a change in credit policy
Analysis of a Change in Credit Policy
  • Increase in the credit period
    • Increase the quantity of goods sold
    • Increase in profits
    • Cost increases from additional investment in A/R, collection costs, bad debt costs
  • Liberalization of cash discount
    • Increase in sales & pretax profit contribution
    • Reduction in A/R balance
      • Additional income from alternative investments
      • Decrease in cost of funds
      • Reduction in cash revenue

Finance 312

analysis of a change in credit policy concluded
Analysis of a Change in Credit Policy (Concluded)
  • Increase in collection effort
    • Reduced sales and pretax profit contribution
    • Increased collection expenses
    • Possible reduced bad-debt losses
  • Size of Credit Line
    • Limits are not as enforced as rejection
    • How large a line?

Finance 312

evaluation of credit applications
Evaluation of Credit Applications
  • Gathering information
    • Experience with customer
    • Credit reporting agencies - e. g. Equifax
    • Banks
    • Financial statements submitted by applicant
    • Personal visits
  • How much does the analysis cost ?
    • Begin with the least costly and time consuming source
    • Is it worth it to proceed further?

Finance 312

evaluation of credit applications concluded
Evaluation of Credit Applications (Concluded)
  • Numerical scoring system
    • Multiple Discriminant Analysis (MDA)
    • Expert systems
  • Six C’s of credit
    • Character
    • Capacity
    • Capital
    • Collateral
    • Conditions
    • Country

Finance 312

inventory inv
Inventory ( INV )
  • Buffer in the procurement-production-sales cycle
  • Role of Electronic Data Interchange (EDI)
  • Flexibility
    • Timing the purchase of raw materials
    • Scheduling production facilities & employees
    • Meeting fluctuating & uncertain demand
  • Investment of funds
  • Benefits & costs of holding inventory
  • Collaborative Forecasting And Replenishment
    • Parties exchange data electronically(such as details of future sales promotions, analysis of sales trends)

Finance 312

types of inventory
Types of Inventory
  • Raw materials inventory
    • Stores of items used in production
    • Quantity discounts
    • Assure supply in times of scarcity
  • Work-in-process inventory
    • Items at some intermediate state of completion
    • Allows for asynchronous schedules
    • Size related to length and complexity of production cycle
  • Finished goods inventory
    • Items ready and available for sale
    • Permits prompt filling of orders
    • Economies of scale

Finance 312

costs associated with an inventory policy
Costs Associated with an Inventory Policy
  • Ordering costs
    • Costs of placing and receiving an order of goods
  • Carrying costs
    • Costs of holding inventory for a given period of time
    • Expressed as
      • Cost per unit per period
      • A % of the inventory value per period (e.g. 20%)
  • Stockout costs
    • Incurred when a firm is unable to fill an order
    • Involves:
      • Lost sales
      • Rescheduling production
      • Placing and expediting special orders

Finance 312

inventory control models
Inventory Control Models
  • ABC Inventory Classification
  • Basic EOQ Model
    • Deterministic Model
    • Assumes:
      • Annual demand or usage is known with certainty
      • Usage is constant - no seasonality
      • Orders to replenish are instantaneously filled
      • No need for safety stocks

Finance 312

eoq q
EOQ ( Q* )
  • Total costs = Ordering costs + Carrying costs
  • Total costs = ( # of orders per year X Cost per order ) +

( Ave INV X annual carrying cost per unit )

  • Total costs = ( D/ Q X S ) + ( Q/ 2 X C )
  • Q* = 2SD / C
  • T* =

Q*

365 X Q*

or

D /365

D

Finance 312

inventory control models concluded
Inventory Control Models (Concluded)
  • Reorder Point
    • Defined as the inventory level at which an order should be placed for replenishment of an item
  • Extensions of Basic EOQ Model
    • Nonzero lead time
    • Probabilistic inventory control methods
  • Just-in-time inventory systems

n

= X D

365

Finance 312

conclusion
Conclusion
  • Receivables Management
    • Credit Policy
      • Credit Standards
      • Credit Terms
      • Collection Efforts
      • Credit Line
    • Evaluation of Credit Application
  • Inventory Management
    • Inventory costs
    • EOQ

Finance 312

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