TOPIC 11: ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT

ACCOUNTS RECEIVABLE MANAGEMENT AND ITS OBJECTIVE

Acccounts receivable (AR) are the balance of money due to a firm for goods or services
delivered or used but not yet paid for by customers.

This type of credit basically takes two forms:

1. Trade or commercial credit. Is a type of commercial financing in which a customer is
allowed to purchase goods or services and pay the supplier at a later scheduled date

2. Consumer or retail credit. Is a type of personal finance product you can use to pay for
goods and services.

The goal of accounts receivable management is to ensure that the firm’s investments in
accounts receivable is appropriate and contributes to shareholder wealth maximization.

It is therefore the responsibility of the Finance officer to;

 Evaluate the pertinent costs and  Implement the firm’s credit policy
benefits related to credit extension
 Enforce collection
 Finance the firm’s investment in
accounts receivable

What is credit policy?

Credit Policy is a set of guidelines for extending credit to customers. It a set of terms that lays
out how your company will issue credit to its clients and collect unpaid debts

It generally covers the following variables:

1. Credit Standards 3. Collection Policy

2. Credit Terms 4. Delinquency and Default

1. Credit Standards- Includes the required financial strength a customer must possess to
qualify for credit.

Setting credit standards implicity requires a measurement of a credit quality, which is defined in
terms of the probability of a customer's default. The probability estimate for a given customer is
for the most part a subjective judgement.

How to measure credit quality and customer's credit worthiness? The following areas are
generally evaluated using 5C's.
1. Character- Refers to the probability that the customers will pay their debts or obligations.
This includes background information on people and firms past performances from a firms
bankers, their other suppliers, their customers, and even their competitors.

2. Capacity- Refers to the judgement of customers abilities to pay. It is determined in part by

the customers pass records and business methods.

3. Capital- Measured by the general financial condition of a firm as indicated by an analysis of

its financial statements.

4. Collateral which is represented by assets that customers may offer as security in order to
obatain credit. When dealing with a high-risk customer, it’s advisable to ask for collateral to
minimize the likelihood of bad debts.

5. Conditions are terms established by a company based on its policies, economic conditions,
or prevailing regulations in the customer’s operational region.

2. Credit terms- It involve both the length of the credit period and the discount given

 Credit period is the length of time buyers are given to pay for their purchases.

 Discounts are price reductions for early payment.

Example: 2/10 n30 means a 2% discount is given if the bill is paid on or before the 10th day after
the date of invoice; payment is due by the 30th day. (Credit period is 30 days) the credit period if
lengthened generally results to an increased in product demand and vice versa.

3. Collection policy- Refers to the procedures the firm follows to collect past-due accounts. It is
a set of guidelines that govern the accounts receivable team’s procedures and helps to create a
more consistent, systematic treatment strategy.

Example: A letter will be sent to customers when a bill is 10 days past due; a more severe letter,
followed by a telephone call may be used if payment is not received within 30 days. And the
account may be turned over to collection agency after 90 days.
4. Delinquency and Default- Delinquency means the account payment was not made on or
before the payment due date. Default signifies the account terms were not met and the lender
has determined the debt will not be paid; at that point the lender likely will send the debt to
collection.

Again, the optimal credit policy that should be adopted is the one that provides the greatest
marginal benefit.

COST ASSOCIATED WITH INVESTMENT IN ACCOUNTS RECEIVABLE

1. Credit analysis, accounting and collection costs- is a review conducted by an outside party
on a business or individual to judge the subject's ability to repay debt. This analysis typically
involves a review of credit scores, cash flows, income, and the presence of sufficient collateral
to pay back debt.
2. Capital costs- Are one-time expenses paid for things used in the production of goods or
service. A good example of a capital costs is the purchase of fixed assets, like new buildings or
business tools. It could also include the costs of intangible assets, like patents and other forms
of technology.

3. Delinqency costs- These costs are incurred when the customer is late in paying. This delay
adds collection costs above those associated with a normal collection.

Delinquency also creates an oppurutnity for any additional time the funds are tied up after the
normal collection period.

4. Default costs (Bad Debts)- The firm incurs default costs when the customer fails to pay at all.

In addition to the collections, capital cists and delinquency costs incurred up to this point, the
firm losses the cost of goods and osld not paid for. It has to write off the enture sales once it
decides the delinquent account has defaulted an dis no longer collectible.

ANALYZING PROPOSED CHANGES IN CREDIT POLICY

If a business enterprises eases its credit policy either by way of lengthening the credit period,
relaxing credit standards and collection policy, or offering cash discounts, then its sales should
increase. Cost will also rose because of increase in production costs. Likewise, additional
investment in accounts receivables will increase carrying costs and bad-debt and/or discount
expenses may also rise.

MARGINAL OR INCREMENTAL ANALYSIS OF CREDIT POLICIES

MARGINAL analysis is performed in terms of a systematic comparison of the incremental

returns and the incremental costs resulting from a change in the firm’s credit policy. Whenever
the incremental of profit from a proposed change in the management of accounts receivable
exceeds the required return or incremental costs of the additional investment, the change
should be implemented. All the things being equal, the decision concerning the change in credit
policy is made using the following rules:

If:

1) Incremental profit > Incremental cost ; then accept the change

contribution in credit policy

2) Incremental profit < Incremental cost ; then reject the change in

contribution credit policy

3) Incremental profit = Incremental cost ; then be indifferent to the

contribution change in credit policy
Illustrative Case I. Relaxation of Credit Policy

ABC coporation’s products sells for P10 a unit of which P7 represents variable cost before
taxes including credit department cost. Current annual credit sales are P2.4 million. The firm is
considering a more liberal extension of credit, which will result in a slowing in the average
collection period from one month to two months.The relaxation in credit standards is expected
to produce a 25% increase in sales. Assume that the firm’s required rate of return investment is
20% before taxes. Bad debt losses will be 5% of incremental sales and collection expenses will
increase by P20,000.00

REQUIRED: Should the company liberalize its credit policy?

Solution:
Incremental contribution margin from

Additional units (60,000 x P3) P180,000

Less: Bad debts (600,000 x 5%) 30,000

Collection expenses 20,000

Total P50,000

Net Incremental profit P130,000

Required return on additional investment:

Conclusion:

In as much as the profit on additional sales of P130,000, exceeds the required return on the
additional investment of P42,000, the firm would be well-advised to relax its credit standard.

Illustrative Case II. Change in Credit Terms

The Roman Shades company has 12% opportunity cost of capital and currently sells on terms
n/20. It has current sales of P10 Million, 80% of which are on credit. Current average collection
period is 60 days. It is now considering to offer terms of 2/10, n/30 in order to reduce the
collection period. It expects 60% of its customer to take advantage of the discount and the
collection period to be reduced to 40 days.

REQUIRED: Should the company change its terms from n/20 to 2/10, n/30?
Solution:

Present Proposed

Opportunity cost

(Return on investment x Average receivables)

Present (12% x P1.333M) P160,000

Proposed (12% x P0.888M P106,667

Sales Discount

(P8M x 60% x 2%) 96,000

Total P160,000 P202,667

Conclusion:

The company would be better off by maintaining the present credit terms and policy of not
granting cash discount because of the lesser costs involved as shown above.

ANALYZING THE CREDIT APPLICANT

Sources of Information
The company must weigh the amount of information needed versus the time and expenses
required.

 Financial Statement  Trade checking

 Credit ratings and reports  Company’s own experience

 Bank checking

Three (3) Steps followed by banks for credit analysis:

1. Collecting information about the applicant: The first step in credit analysis is to collect
information of the applicant regarding his/her past record of loan repayment, character,
individual and organizational reputation, financial solvency, ability to utilize the loan (if granted)
etc. Collecting information about the business for which loan is required: The loan officer
should know the purpose of the loan, the amount of the loan and if it is possible to implement
the project by that amount

Collecting information about the recovery process: The loan officer should collect information
about the sources from which the borrower would repay the loan.

Collecting additional information if necessary: When the loan under consideration is for a large
amount a bank may find it necessary to gather additional information like the overall business
activities in the economy, probable political and economic condition of the country, efficiency
and candidness of the management team, likely effect of local and international competition on
the project etc.

2. Steps During the Information Analysis Stage

Analyzing the accuracy of information: The information given in and along with the application
are analyzed to judge their accuracy.

Analyzing the financial ability of the applicant: Analyzing the financial ability of the applicant: In
this stage, the financial ability of the applicant is taken into consideration. The financial
solvency of the applicant and his skill and capability are important factors in this regard.

Analyzing the effectiveness of the project: aspect of credit analysis is the analysis of quality,
purpose, and future prospect of the project for which loan has been applied. The banker will be
at ease to grant loans if the project is productive, expandable, and of course profitable.

Analyzing the possibility of loan repayment: analyst looks into what effect the proposed loan will
have on increasing the liquidity and income of the applicant.

3. Decision Making Stage

Depending on the analysis the analyst identifies and measures the credit risk associated with a
loan application and determines whether the level of risk inherent is acceptable or not.

If the analyst is satisfied that the risk is acceptable and is convinced that the loan will be repaid,
he/she prepares and submits a recommendation to the appropriate loan approval authority for
sanctioning the loan.

CREDIT ANALYSIS

Credit analysis is the process of evaluating an applicant’s loan request or a corporation’s debt
issue in order to determine the likelihood that the borrower will live up to his/her obligations.

In other words, credit analysis is the method by which one calculates the creditworthiness of an
individual or organization.
CREDIT DECISION AND LINE OF CREDIT

Credit Decision means a preliminary or final assessment, analysis or determination with respect
to: whether to make, purchase or sell a Loan, whether the making, purchasing or selling of a
Loan satisfies certain criteria, or a policy or rule, or the credit worthiness of applicant for a Loan

Line of credit

All LOCs consist of a set amount of money that can be borrowed as needed, paid back, and
borrowed again. The amount of interest, size of payments, and other rules are set by the lender.
Some LOCs allow you to write checks (drafts), while others include a type of credit or debit card.
A line of credit can be secured(by collateral) or unsecured, with unsecured LOCs, typically
subject to higher interest rate

Examples of Lines of Credit:

 Personal Line of Credit  Securities-Based Line of Credit

 Home Equity Line of Credit (HELOC)  Business Line of Credit

 Demand Line of Credit

Unsecured vs. Secured LOCs

Most LOCs are unsecured loans. This means that the borrower does not promise the lender any
collateral to back the LOC. One notable exception is a Home Equity Line of Credit (HELOC),
which is secured by the equity in the borrower’s home. From the lender’s perspective, secured
LOCs are attractive because they provide a way to recoup the advanced funds in the event of
nonpayment

Revolving vs. Non-Revolving Lines of Credit

An LOC is often considered to be a type of revolving account, also known as an open-end credit
account. This arrangement allows borrowers to spend the money, repay it, and spend it again in
a virtually never-ending, revolving cycle. Revolving accounts such as LOCs and credit cards are
different from installment loans such as mortgages and car loans.

OUTSOURCING CREDIT AND COLLECTIONS

Four key things to Consider Before Outsourcing Credit, Collections Functions

 1. Quality of Service

What is often overlooked is that the credit or collections group, whether they are
company employees in a different location or a fully independent third-party organization,
working for a company in an abroad location actually become the face of the
organization

2. Turnover

Other than the quality of service, perhaps the most overlooked factor in an outsourcing
decision is rapidly rising wages. Once these, often young, employees receive training,
they often have many other options because areas of outsourcing tend to attract more
and more operations doing the same for other companies

3. Public Relations

Outsourcing runs a high risk of having to clean up unwanted public relations messes.
High unemployment breeds contempt in any country, and it’s even more so if “their” jobs
are being sent elsewhere.

4. Artificial Cost Savings

All three reasons listed above add up in varying ways to what can be its own fourth
category: that outsourcing can be, in the end, artificial cost-savings. Short-term gains are
all well and good, but what’s the point if they cannot be sustained. Poor quality of service
means customers, whether consumer or business based, might look elsewhere for
product. High turnover means retraining new staffers, often with little or no experience,
and dealing with potentially costly mistakes as these newbies get their proverbial feet
wet.

What Is Inventory Management?

Inventory management manages the process of ordering, storing and using inventory, both at
the level of the raw materials used as well as finished goods. Inventory management helps
businesses identify which stock to order, how much to order and when.

The main classifications of inventories are:

For manufacturing firms:

 Raw Materials the primary materials used to make finished goods. Suppliers may either
purchase this type of stock from another company or produce it directly. For example, a
furniture-making company might have a stock of raw wood bought from a supplier. The
wood is their raw materials inventory.There are two types of raw materials
inventory: direct and indirect.
 1. Direct raw materials make up the parts of the final product. The wood in the
example above is a direct raw material.

2. Indirect raw materials are materials that don’t appear in the finished product but are
consumed during production. In the example above, with furniture making, any
disposable tools, cleaning products, fuel, etc., would be considered indirect raw
materials.

 Goods-in-process- is one of three manufacturing inventory classifications and can be

described as an intermediate state between the other two: raw materials and finished
goods. Inventory, a current asset on the company's balance sheet, is the total of the
three states of production.

 Finished product - can come from the raw materials and work-in-progress supply chain,
or a company might purchase them. In accounting, finished goods are combined with
raw materials and WIP inventory to produce the complete inventory line. Finished goods
are short-term assets, assuming that the supplier can sell them reasonably quickly once
ready.

 Factory supplies- include maintenance materials, janitorial supplies, and items that are
considered incidental to the production process. They are usually charged to expense as
incurred, in which case the supplies expense account is included within the cost of
goods sold category on the income statement

For trading firms:

 Merchandise-Merchandise inventory includes the amount the retailer or other reseller

paid for the items themselves, as well as additional costs incurred by the company such
as shipping, insurance and storage. Merchandise inventory includes all unsold stock that
is ready for sale, whether it's located in stores or warehouses.

FUNCTION OF INVENTORIES

1. Pipeline or transit inventories -this are the inventories which are being moved or
transported from one location to another and they fill the supply pipelines between
stages of the entire production-distribution system.

2. Organizational or decoupling inventories- These are the inventories that are maintained
to provide each link in the production-distribution chain a certain degree of
independence from the others.

3. Seasonal or anticipation stock-These are built up in anticipation of the heavy selling

season or in anticipation of price increase or as part of promotional sales campaign.

4. Batch or lot-size inventories-These are inventories that are maintained whenever the
user makes or buys materials in larger lots than are needed for his immediate purposes.

5. Safety or buffer stock- These inventories are maintained to protect the company from
 uncertainties such as unexpected customer demand, delays in delivery of goods ordered,
etc.

COST ASSOCIATED WITH INVESTMENT IN INVENTORY

1. Carrying Costs

 Cost of capital tied up in inventory  Depreciation and obsolescence

 Storage and handling cost  Administrative costs (e.g accounting,

etc.)
 Insurance

 Property taxes

2. Ordering, shipping and receiving cost

 Cost of placing orders including production and setup costs

 Shipping and handling costs

3. Costs of running short

 Loss of sales  Description of production schedules

 Loss of customer goodwill

INVENTORY MANAGEMENT TECHNIQUES

INVENTORY PLANNING

Inventory planning involves the determination of what inventory quality, quantity, timing, and
location should be in order to meet future business requirements.The approach and
mathematical thecniques that may be used in determining inventory order size, timing,etc.

There are Three (3) Method of Inventory Planning:

1. EOP Economic Order Quantity

2. Safety Stock Inventory

3. Just-in-Time Management (JIT)

EOP Economic Order Quantity- this model is used in inventory management by

calculating the number of units a company should add to its inventory with each batch
order to reduce the total costs of its inventory while assuming constant consumer
demand.
 FORMULA:

EXAMPLE:
Illustrative Case III. Economic Order Quantity Determinaton

Assume that the local gift shop is attempting to determinge how many sets of wine glass to
order. The store feels it will sell approximately 800 sets in the next year at a price of P18 per set.
The wholesale price that the store pays per set is P12. Cost of carrying one set of wine glasses
are estimated at P1.50 per year while ordering costs are estimated ar P25.

a) Determine the economic order quantity for the sets of wine glasses.

Answer:

EOQ = √2 x 800 x P25

P1.50

EOQ = 163 units per order

b) Determine the annual inventory costs for the firm if it orders in this quantity.

Answer: Total inventory costs = P244.95

Illustrative Case IV. EOQ, Reorder point determination

The following inventory information and relationships for the Baguio Corporation are available:

1) Oders can be placed only if multiples of 100 units

2) Annual unit usage is 300,000. (Assume a 50-week year in your calculations.)

3) The carrying cost is 30 percent of the purchase price of the goods

4) The purchase price is P10 per unit

5) The ordering cost is P50 per order

6) The desired safety stock is 1,000 units. (This does not include delivery – time stock)

7) Delivery time is two weeks.

Given this information:

a) What is the optimal EOQ level?

b) How many orders will be places annually?

c) At what inventory level should a reorder be made?

Solution:
1. EOQ = √ 2 x 300,000 x ₱50
10 x 0.30
EOQ = 3,162 units but since orders must be placed in multiples of 100 units, the effective EOQ
becomes 3,200

2. Number of orders = 300,000

3,200
Number of orders = 93.75 orders per year

3. Reorder Point = Lead Time Usage + Safety Stock

Reorder point = (300,00050 x 2) + 1,000

Reorder Point = 13,000 units

Safety stock inventory-sometimes called buffer stock, is the level of extra stock that is
maintained to mitigate risk of run-out for raw materials or finished goods due to uncertainties in
supply or demand.
The general formula - this the most simple and commonly used method to calculate safety
stock. It calculates the average safety stock the company needs to hold during a stockout
scenario, but it doesn’t consider the seasonal fluctuations of demand.

Formula:

Example:
Ronald’s company sells an average of 10 products per day, and your lead time is about 14 days.
However, during peak periods, you sell up to 15 products per day, and delays in inventory
shipment mean it takes up to 18 days for products to arrive at your warehouse.

Just-in-Time Management (JIT)- The method allows companies to save significant amounts of
money and reduce waste by keeping only the inventory they need to produce and sell products.

Steps in Cycle of Continuous Improvement for JIT Inventory

  The financial manager should see that only an optimum amount is invested in inventory.
He should be familiar with the inventory control techniques and ensure that inventory is
managed well. He should introduce the policies which reduce the lead time, regulate
usage and thus, minimise safety stock.

LEVEL MONITORING AND INVENTORY CONTROL SYSTEMS

Inventory control is the regulation of inventory within predetermined limits. Effective inventory
management should provide adequate stocks to meet the requirements of the business, while
at the same time keeping the required investment to a minimum. Various systems and
techniques have been developed to provide effective control over inventories.

Some of the more generally-known inventory control systems are as follows:

1. Fixed Order Quantity System This a system wherein each time the inventory goes down
to a pre-determined level known as the re-order point, an order for a fixed quantity is
placed. The system requires the use of perpetual inventory records or the continuous
monitoring of the inventory level.

2. Fixed Reorder Cycle System- This is also known as the periodic review or the
replacement system where orders are made after a review of inventory levels has been
done at regular intervals. An order is placed if at the time of the review the inventory level
had gone down since the preceding review. The quantity order under this system is
variable depending on usage or demand during the review period.

a. Replenishment level is computed by the following formula:

b. M = B + D ( R+L)

c. where M = Replenishment level in units

d. B = Buffer stock in units

e. D = Average demand per day

f. R = Time interval in days, between reviews

g. L = Lead time In days

3. Optional Replenishment System-The system represents a combination of the important

control mechanisms of the two system described above.

Replenishment level is computed by the use of the following equation:

P = B+D (L+R/2)
 Where:

P = Reorder point in units

B = Buffer stock in units

D = Average daily demand in units

L = Lead time in days

R = Time between review in days

4. ABC Classification System- Under this system, segregation of materials for selective
control is made. Inventories are classified into "A" or high-value items, "B" or major cost
items, and "C" or low cost items.

Control may be exercised on these items as follows.

1. A items- highest possible controls, including most complete, accurate records, regular
review by top supervisor, blanket orders with frequent deliveries from vendor, close
followup through the factory deliveries from vendor, close follow-up through the factory
to reduce lead time, etc.

2. B items- normal controls involving good records and regular attention; good analysis for
EOQ and order point but reviewed quarterly only or when major changes occur.

3. C items- simplest possible controls such as periodic review of physical inventory with no
records or only the simplest notations that replenishment stocks have been ordered; no
EOQ or order point calculation.