The size of the investment in accounts receivable varies from industry to industry and is affected by several factors including the percentage of creditsales to total sales, the level of
Trang 1CHAPTER OUTLINE
I Accounts receivable
A Typically, accounts receivable account for just over 20 percent of a firm's
assets
B The size of the investment in accounts receivable varies from industry to
industry and is affected by several factors including the percentage of creditsales to total sales, the level of sales and the credit and collection policies,more specifically the terms of sale, the quality of customers and collectionefforts
C Although all these factors affect the size of the investment, only the credit
and collection policies are decision variables under the control of thefinancial manager
D The terms of sale are generally stated in the form a/b net c, indicating that
the customer can deduct a percentage if the account is paid within b days; otherwise, the account must be paid within c days.
Trang 2E If the customer decides to forgo the discount and not pay until the final
payment date, the annualized opportunity cost of passing up this a% discount and withholding payment until the cth day is determined as follows:
discount
theforgoingof
cost opportunity
annualized
=
a1
a
x
bc
360
Example: Given the trade credit terms of 2/10, net 30, what is the annualizedopportunity cost of passing up the 2 percent discount and withholdingpayment until the 30th day?
Solution: Substituting the values from the example, we get
36.73% =
02.01
02.0
x
1030
360
F A second decision variable in determining the size of the investment in
accounts receivable in addition to the trade credit terms is the type ofcustomer
1 The costs associated with extending credit to lower-quality
customers include:
a Increased costs of credit investigation
b Increased probability of customer default
c Increased collection costs
G Analyzing the credit application is a major part of accounts receivable
management
1 Several avenues are open to the firm in considering the credit rating
of an applicant Among these are financial statements, independentcredit ratings and reports, bank references, information from othercompanies, and past experiences
2 One commonly used method for credit evaluation is called credit
scoring and involves the numerical evaluation of each applicant inwhich an applicant receives a score based upon the answers to asimple set of questions The score is then evaluated relative to apredetermined standard, its level relative to that standard determiningwhether or not credit scoring should be extended to the applicant.The major advantage of credit scoring is that it is inexpensive andeasy to perform
H The key to maintaining control over the collection of accounts receivable is
the fact that the probability of default increases with the age of the account
1 One common way of evaluating the current situation is ratio
analysis
a examining the average collection period
b ratio of receivables to assets
Trang 3c ratio of credit sales to receivables (accounts receivable
turnover ratio)
d amount of bad debts relative to sales over time
e aging of accounts receivable schedule
I Once delinquent accounts have been identified, the third and final variable is
determined by the firm’s collection policies A direct trade-off does existbetween collection expenses and lost goodwill on one hand andnoncollection of accounts on the other, and this trade-off is always part ofmaking the decision
J Credit should be extended to the point that marginal profitability on
additional sales equals the required rate of return on the additional costs wehave to consider investment in inventories + receivables + change in cost ofcash discount to generate those sales
II Inventory
A Typically, inventory accounts for about four to five percent of a firm's
assets
B The purpose of carrying inventories is to uncouple the operations of the
firm; that is, to make each function of the business independent of eachother function
C As such, the decision with respect to the size of the investment in inventory
involves a basic trade-off between risk and return
D The risk comes from the possibility of running out of inventory if too little
inventory is held, while the return aspect of this trade-off results becauseincreased inventory investment costs money
E There are several general types of inventory
1 Raw materials inventory consists of the basic materials that have
been purchased from other firms to be used in the firm's productionoperations This type of inventory uncouples the production functionfrom the purchasing function
2 Work in process inventory consists of partially finished goods that
require additional work before they become finished goods This type
of inventory uncouples the various production operations
3 Finished goods inventory consists of goods on which the production
has been completed but the goods are not yet sold This type ofinventory uncouples the production and sales function
4 Stock of cash inventory, already discussed in some detail in
preceding chapters, serves to make the payment of bills independent
of the collection of accounts due
F In order to effectively manage the investment in inventory, two problems
must be dealt with: the order quantity problem and the order point problem
G The order quantity problem involves the determination of the optimal order
size for an inventory item given its expected usage, carrying, and orderingcosts
Trang 4H The economic order quantity (EOQ) model attempts to determine the order
size that will minimize total inventory costs The EOQ is given as
Q* =
where C = carrying cost per unit
O = ordering cost per order
S = total demand in units over the planning periodQ* = the optimal order quantity in units
I The order point problem attempts to answer the following question: How
low should inventory be depleted before it is reordered?
J In answering this question two factors become important:
1 What is the usual procurement or delivery time and how much stock
is needed to accommodate this time period?
2 How much safety stock does the management desire?
K Modification for safety stocks is necessary since the usage rate of inventory
is seldom stable over a given timetable
L This safety stock is used to safeguard the firm against changes in order time
and receipt of shipped goods
M The greater the uncertainty associated with forecasted demand or order time,
the larger the safety stock
1 The costs associated with running out of inventory will also
determine the safety stock levels
2 A point is reached where it is too costly to carry a larger safety stock
given the associated risk
N Inflation can also have an impact on the level of inventory carried
1 Goods may be purchased in large quantities in anticipation of price
rises
2 The cost of carrying goods may increase, causing a decline in Q*,
the optimal order quantity
O The just-in-time inventory control system is more than just an inventory
control system; it is a production and management system
1 Under this system, inventory is cut down to a minimum, and the time
and physical distance between the various production operations isalso minimized
Trang 52 Actually the just-in-time inventory control system is just a new
approach to the EOQ model which tries to produce the lowestaverage level of inventory possible
3 Average inventory is reduced by locating inventory supplies in
convenient locations and setting up restocking strategies that cuttime and thereby reduce the needed level of safety stock
III TQM and Inventory Purchasing management
A The concept of total quality management has led to strong customer-supplier
relationships in an effort to increase quality
B In many cases firms that only a few years ago placed an upper limit of 10 or
20 percent on the purchases of any part from a single supplier now rely on a
single supplier using the single-sourcing relationship.
C Single sourcing ties the interests of the supplier to the firm to which it
supplies and allows the supplier to provide input on production techniquesthat might improve quality
D Financially, the TQM view argues that higher quality will result in increased
sales and market share and as a result the traditional economic analysis ofinventory management is flawed
ANSWERS TO END-OF-CHAPTER QUESTIONS
20-1 The size of the investment in accounts receivable is determined primarily by these
factors:
(1) The percentage of credit sales to total sales While this factor plays a major
role in determining the investment in accounts receivable, it is generally notwithin the control of the financial manager In essence, the nature of thebusiness tends to determine the blend between credit sales and cash sales (2) The level of sales As sales increase, so will accounts receivable Again,
this is not an effective decision tool
(3) Credit and collection policies Specifically the terms of sale, the quality of
customer, and collection efforts are determinants of the level of investment
in receivables that are under the control of the financial manager
20-2 (a) 1/20 net 50 means a 1 percent discount can be taken if the account is paid
within 20 days; otherwise, it can be paid within 50 days
(b) 2/30 net 60 means a 2 percent discount can be taken if the account is paidwithin 30 days; otherwise, it must be paid within 60 days
(c) Net 30 means there are no discounts offered and the account must be paidwithin 30 days
Trang 6(d) 2/10, 1/30 net 60 means a two percent discount can be taken if the account ispaid within 10 days, and if paid after 10 days but before and up to 30 days, aone percent discount can be taken; otherwise, the account must be paid within
60 days
20-3 The purpose of an aging account is to provide a breakdown both in dollars and
percentage terms of the proportion of receivables that are past due The samefunction could essentially be handled through ratio analysis, provided accountsreceivable were broken down according to when they were due However, an agingaccount provides control over past due accounts in an extremely efficient manner.20-4 If a credit manager experienced no bad debt losses over the past year, then credit
was probably not extended to enough customers Ideally credit should be extended
to the point where marginal revenue from added sales due to increased credit isequal to the marginal costs associated with increased bad debts, costs ofinvestigation, costs of collection, and increased required rate of return Obviouslythe credit manager was nowhere near this level if no bad debts were incurred.20-5 Credit scoring involves the numerical evaluation of credit applicants based upon
their answers to simple questions This score is then evaluated relative to apredetermined standard, many times generated through the use of multiplediscriminant analysis; its level relative to the standard determining whether or notcredit should be extended to the applicant The major advantage of credit scoring isthat it is inexpensive and easy to perform Once standards are set, a computer orclerical worker without specialized training can easily evaluate applicants
20-6 The returns associated with a more liberal credit policy come from the fact that
extending credit to weaker customers or liberalizing the trade credit terms willprobably increase sales, resulting in a larger profit level The risks involved largelyresult from the increased possibility of extending credit that will eventually becomebad debts
20-7 The logic behind marginal analysis is to examine the incremental or marginal
benefits, and incremental costs associated with any change in the credit policy; and
if this change produces more benefits than costs, the change should be made If,however, the incremental costs are greater than the incremental benefits, theproposed change should be dropped
20-8 The purpose of carrying inventories is to uncouple the operations of the firm; that
is, to make each function of the business independent of each other's function Byuncoupling the various operations of the firm, delays or shutdowns in one area nolonger affect the production and sale of the final product Raw materials inventory,for example, uncouples the production function from the purchasing function.Work in process inventory uncouples the various production operations
20-9 Yes The stock of cash carried by a firm is simply a special type of inventory In
terms of uncoupling the various operations of the firm, the purpose of holding cash
is to make the payment of bills independent of the collection of accounts due
Trang 720-10 In order to effectively control the investment in inventory, the firm must: (1)
determine the optimal order size for the inventory item, given its expected usage,carrying, and ordering costs; (2) determine how low inventory should be allowed todeplete before it is reordered
20-11 The major assumptions of the EOQ model include:
(1) Constant or uniform demand
(2) Constant unit price regardless of amount ordered
(3) Constant carrying costs per unit
(4) Constant ordering costs per order regardless of the size of the order
(5) Instantaneous delivery
(6) Independent orders
20.12 The risk associated with the inventory investment is that if the level of inventory is
too low, the various functions of business will not be effectively uncoupled, anddelays in production and customer delivery will result The return aspects of thistrade-off result because increased inventory investment costs money As the size ofthe inventory increases, the storage and handling cost, in addition to the requiredrate of return on capital invested in inventory, will rise Thus, the more inventorythe firm holds, the less risk they run of stocking out of inventory and the greater aretheir inventory expenses
20.13 Inflation affects the EOQ model by increasing carrying costs (C) which results in a
small EOQ level In addition, if inflation is accompanied by major periodic priceincreases, this may cause the EOQ model to lose its applicability and be replaced by
a policy of anticipatory buying; that is, buying in anticipation of a price increase inorder to secure the goods at a lower cost
20-14 With single-sourcing, a company uses very few suppliers or, in many cases, a single
supplier as a source for a particular part or material In this way the company has amore direct influence and control over the quality performance of a supplier, sincethe company accounts for a larger proportion of the supplier's volume Thecompany and supplier can then enter into a partnership where the supplier agrees tomeet the quality standards of the customer In this way the supplier can be broughtinto the TQM program of the customer
20-15 The TQM view argues that the traditional analysis is flawed in that it ignores the
fact that increased sales and market share result from better quality products andthat this increase in sales will more than offset the higher costs associated withincreased quality In effect, it is argued that the benefits from quality improvementare underestimated
Trang 8SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
20-1A
bc
360
x a1
a
where a = amount of the discount
b = the discount period
c = the net period
02.01
02.0
x
1050
360
= 18.37%
20-2A
bc
360
x a1
a
where a = amount of the discount
b = the discount period
c = the net period
02.01
02.0
x
2030
360
= 73.47%
20-3A
bc
360
x a1
a
where a = amount of the discount
b = the discount period
c = the net period
(a)
01.01
01.0
x
1020
360
= 36.36%
(b)
02.01
02.0
x
1030
360
= 36.73%
(c)
03.01
03.0
x
1030
360
= 55.67%
(d)
03.01
03.0
x
1060360
= 22.27%
Trang 903.01
03.0
x
1090
360
= 13.92%
(f)
05.01
05.0
x
1060
Z = 3.3(0.2) + 1.0(0.8) + 0.6(1.0) + 1.4(0.3) + 1.2(0.8)
Z = 0.66 + 0.8 + 0.6 + 0.42 + 0.96
Z = 3.44 > 2.7 thus, acceptApplicant #3
Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.4)
Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.48
Z = 2.62 < 2.7 thus, rejectApplicant #4
(a)
Sales
soldgoodsofcost Sales
= Gross Profit Margin
$600,000
soldgoodsofCost
$600,000
= 0.10Cost of goods sold = $540,000
Trang 10soldgoodsofCost
= Inventory turnover ratio
inventoryAverage
$540,000
= 6Average inventory = $90,000
(b) Inventory turnover ratio =
PeriodCollectionAverage
360
Inventory turnover =Inventory turnover ratio = 9 times
inventoryAverage
soldgoodsofCost
= 9 times
inventoryAverage
$480,000
= 9 timesAverage inventory = $53,333
(c)
inventoryAverage
soldgoodsofCost
= Inventory turnover ratio
inventoryAverage
$1,150,000
= 5Average inventory = $230,000(d) (1 - Gross profit margin) (Sales) = (0.86)($25,000,000)
Cost of Goods Sold = $21,500,000 cost of goods
Inventory turnover ratio =
45
360
= 8 times
inventoryAverage
0
$21,500,00
= 8 timesAverage inventory = $ 2,687,50020-6A Step 1: Estimate the Change in Profit
Trang 11= ($666,667 + $50,000) 15
= $107,500Step 3: Estimate the change in the cost of the cash discount
= $0 (no change)Step 4: Compare incremental revenues with incremental costs
= Step 1 - (Step 2 + Step 3)
= $120,000 - $107,500
= $12,500The policy should be adopted
20-7A Step 1: Estimate the Change in Profit
= ($1,500,000 x 20) - ($1,500,000 x 09)
= $300,000 - $135,000
= $165,000Step 2: Estimate the cost of additional investment in accounts receivable
Trang 12= ($645,833 + $75,000) 15
= $108,125Step 3: Estimate the change in the cost of the cash discount
= $0 (no change)Step 4: Compare the incremental revenues with the incremental costs
= Step 1 - (Step 2 + Step 3)
= $165,000 - $108,125
= $56,875The policy should be adopted
20-8A
(a) Q* =
C2SO
=
10.0
10)3000(2
SO
Order one time: =
3000
$10
= $37.50 + $40
= $77.50
Trang 13Order five times: =
3000
$10
= $10 + $150
= $160(c) (1) constant or uniform demand
(2) constant unit price(3) constant carrying costs(4) constant ordering costs(5) instantaneous delivery(6) independent orders20-9A
(a) Q* =
C2SO
=
25.0
50)000,20(2
= 2828 boxes(b) It assumes among other things that the rolls are not perishable Other