FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

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• CHAPTER
• TWENTY-THREE
• Receivables and Inventory Management

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Learning Objectives

• 1. Discuss accounts receivable and inventories.
• 2. Name four major policy variables in the area
  of credit management.
• 3. Discuss the trade-offs between benefits from
  anticipated sales and the costs of carrying an
  account.
• 4. Compare the different types of insurance
  available against bad debts.
• 5. Explain the different benefits and costs
  involved in inventory control.

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Introduction

• Accounts receivables and inventories are usually
  the largest part of current assets for a firm
• Accounts receivables for the selling firm
  represents an account payable for the purchaser
• In this chapter we investigate
• credit analysis of individual accounts
• the setting of overall credit and collection
  policies
• the use of credit insurance
• the evaluation of receivables management
• the role of captive finance companies

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Credit Analysis of Individual Accounts

• The purpose of credit analysis is to assess the
  credit worthiness of potential customers and the
  corresponding risk of late payments or default
• Credit analysis consists of
• 1. gathering information about the potential
  customer
• 2. analysing the information to derive a credit
  decision about the payment terms and amount of
  trade credit granted
• Credit agencies provide credit ratings and
  reports on companies (Dun Bradstreet)

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Credit Analysis of Individual Accounts

• The credit decision is based on
• the evaluation of the applicant's liquidity and
  ability to meet short-term obligations
• the applicants attitude and character
• the economic trade-off

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Credit Policies

• A firms credit and collection policy is
  determined by the trade-off between higher
  profits from increased sales and the costs of
  having to finance investments in accounts
  receivable or bad debt losses
• Policy variables include
• length of the credit period
• 2/10 net 30
• quality of credit standards
• cash discounts
• collection procedures

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Credit Insurance

• Credit insurance
• is designed to indemnify a firms unexpected
  losses caused by non-performing customers
• is subject to limitations and exclusions such as
  co-insurance clauses
• co-insurance clauses requires the insured to
  bear a percentage of any loss incurred
• Export Development Corporation (EDC) helps
  facilitate the management of international
  customers for small and medium-sized Canadian
  companies

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Use of Credit Cards in Retailing

• By honouring major credit cards retailers
• can shift the risk of losses from bad debt to
  the sponsoring bank
• do not require invoicing or collection procedures
• eliminate receivables because it receives cash
  after depositing its sales slip with the bank
• The decision to honour credit cards has to weigh
  the costs against benefits

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Captive Finance Companies

• Captive finance companies
• are wholly owned subsidiaries of the parent
  company
• are common for companies that sell high- cost
  equipment (cars, planes)
• the assets of the finance subsidiary consist of
  financing contracts that provide predictable
  cash flow

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Inventory Management

• The main concern with inventory management is to
  balance the benefits and costs of carrying
  inventories
• Four approaches to inventory control include
• 1. The ABC approach involves dividing inventory
  into categories in relationship to their
  contribution to inventory value per unit
• 2. The economic order quantity (EOQ) model
  determines the optimal inventory level minimizing
  the total shortage and carrying costs

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Inventory Management

• 3. Materials requirement planning (MRP) a
  computer-based system for ordering and/or
  scheduling production of demand-dependent
  inventory items
• 4. Just-in-time (JIT) attempt to schedule
  delivery of raw materials and the completion of
  necessary work-in-progress components exactly
  when they are required in order to reduce
  inventory to its lowest possible level

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The Impact of Price-Level Changes on Inventories

• Price level changes can have a serious impact on
  inventories
• With rising price levels, inventory profits
  accrue and reported earnings may not reflect the
  firms profitability
• In Canada, the problem of inventory profits is
  magnified because the last-in, first-out method
  is not acceptable for tax purposes

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Summary

• 1. For most firms, account receivables and
  inventories are the most important categories of
  current assets. Management is concerned with
  reaching optimal levels where the marginal
  benefits of added investment just equal
  incremental costs.
• 2. Returns from investments in accounts
  receivable are realized through increased
  profitable sales. Costs include the expenses of
  financing and losses from bad debts.

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Summary

• 3. Credit information on individual accounts is
  available from credit rating agencies, banks,
  other suppliers, and from customers themselves.
• 4. The cost of short-term bank borrowing is
  usually the cost of financing receivables. The
  most difficult aspect of credit analysis is the
  assessment of the effects of altered credit
  policies on sales and the estimation of bad debts.

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Summary

• 5. Credit insurance is for accounts large enough
  that a default can cause serious financial
  difficulties for the supplying firm. For
  international sales, the Export Development
  Corporation provides export insurance and other
  assistance. In retailing, acceptance of general
  credit cards sponsored by banks provides
  insurance against losses from bad debts and a
  reduced investment in accounts receivable.
  Captive finance companies are wholly owned
  subsidiaries set up by firms producing high-cost
  equipment in industries where extended credit is
  customary.

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Summary

• 6. The main costs of inventories include
  warehousing, handling, insurance, obsolescence,
  spoilage, and financing. Price level changes can
  have a serious impact on inventories.