CMA P3 Finance 4

© Sameh Y. El lithy CMA , CIA . E-mail: [email protected]

---- 1FinanceFinanceFinanceFinance

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©©©© Sameh Y. El Sameh Y. El Sameh Y. El Sameh Y. El lithylithylithylithy ,,,, CMA, CIA .CMA, CIA .CMA, CIA .CMA, CIA .FinanceFinanceFinanceFinance

Receivable ManagementReceivable ManagementReceivable ManagementReceivable ManagementReceivable ManagementReceivable ManagementReceivable ManagementReceivable Management

The objective of managing accounts receivable is to have both the optimal

amount of receivables outstanding and the optimal amount of bad debts.

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�This balance requires a trade-off between the benefits of credit sales, such as more sales, and the costs of accounts receivable, e.g., collection, interest, and bad debt costs.

�The optimal credit policy does not seek merely to �maximize sales (for example, by lowering credit standards,

offering longer discount periods, or charging lower interest) or� to minimize default risk .

� Thus, a company should extend credit until the marginal benefit (profit) of an additional sale is zero (considering opportunity costs of alternative investments).



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�Credit standards, credit periods, collection policies, discounts, and other terms are frequently determined by competitive factors . A company often must match inducements offered by rivals to make sales.

�Companies often use a statistical technique called credit scoring to determine whether to extend credit to a specific customer. �Credit scoring assigns numerical values to the

elements of credit worthiness, such as income.

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Receivables management seeks to maximize the accountsaccountsaccountsaccounts----receivablereceivablereceivablereceivable----turnover ratioturnover ratioturnover ratioturnover ratio,

that is, to shorten the average time receivables are held

Receivables management seeks to maximize the accountsaccountsaccountsaccounts----receivablereceivablereceivablereceivable----turnover ratioturnover ratioturnover ratioturnover ratio,

that is, to shorten the average time receivables are held



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�The receivables turnover ratio equals net credit sales divided by average accounts receivable.

net credit sales

average accounts receivable.�This ratio measures the

efficiency of accounts receivable collection.

�A high turnover is preferable.

�The number of days of receivables (days’ sales in average receivables, also called the average collection period) equals the number of days in the period divided by the receivables turnover ratio.

365,360,or 300(business days)

Receivables turnover ratio�This ratio is the average

number of days to collect a receivable.

Accounts Receivable RatiosAccounts Receivable Ratios

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� The number of days of receivables�may also be computed as

average accounts receivable divided by average daily sales.�Average daily sales are net

credit sales divided by the number of days in the period.

� The number of days' sales in receivables is a measure of liquidity because these statistics show how long it will take to turn inventory into cash.�The number of days of

receivables should be compared with the firm’s credit terms to determine whether the average customer is paying within the credit period.

� The accounts receivable turnover. will decrease if a company lengthens the credit period or the discount period because the denominator will increase as receivables are held for longer times.



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�Average gross receivables equals average daily sales times the average collection period.�This ratio should be compared with the seller’s credit terms to

determine whether most customers are paying on time.

�A firm's average gross receivables balance =average daily sales X average collection period (da ys' sales outstanding).

�orAnnual credit sales

Accounts-receivable turnoverAverage balance of the A/R =

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Summary Of Receivables RatiosSummary Of Receivables RatiosSummary Of Receivables RatiosSummary Of Receivables RatiosSummary Of Receivables RatiosSummary Of Receivables RatiosSummary Of Receivables RatiosSummary Of Receivables Ratios

Net SalesNet SalesNet SalesNet Sales

Average ReceivablesAverage ReceivablesAverage ReceivablesAverage ReceivablesReceivables Turn Over =Receivables Turn Over =Receivables Turn Over =Receivables Turn Over =

1 Average Receivables =1 Average Receivables =1 Average Receivables =1 Average Receivables =

Net SalesNet SalesNet SalesNet Sales

Receivables Turn OverReceivables Turn OverReceivables Turn OverReceivables Turn Over

Rec. T. Over =Rec. T. Over =Rec. T. Over =Rec. T. Over =

360360360360

ACPACPACPACP

ACP = ACP = ACP = ACP =

360360360360

Receivables Turn Over Receivables Turn Over Receivables Turn Over Receivables Turn Over

Then Average Receivables =Then Average Receivables =Then Average Receivables =Then Average Receivables =Net SalesNet SalesNet SalesNet Sales ****

ACPACPACPACP

360360360360

2 Average Receivables =2 Average Receivables =2 Average Receivables =2 Average Receivables = Daily SalesDaily SalesDaily SalesDaily Sales **** ACPACPACPACP



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THE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLESTHE ACCUMULATION OF RECEIVABLES

� The total amount of accounts receivable outstanding at any given time is determined by two factors:

1. The volume of credit sales and 2. The average length of time between sales

and collections.( ACP )

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Example Example Example Example Example Example Example Example

�For example, suppose Boston Lumber Company (BLC), a wholesale distributor of lumber products, opens a warehouse on January 1 and, starting the first day, makes sales of $1,000 each day. For simplicity, we assume that all sales are on credit, and customers are given 10 days to pay.�At the end of the first day, accounts receivable will be $1,000;

they will rise to $2,000 by the end of the second day; and by January 10, they will have risen to 10($1,000) = $10,000.

�On January 11, another $1,000 will be added to receivables, but payments for sales made on January 1 will reduce receivables by $1,000, so total accounts receivable will remain constant at $10,000.



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ExampleExampleExampleExampleExampleExampleExampleExample

�In general, once the firm’s operations have stabilized, this situation will exist:

�If either credit sales or the collection period changes, such changes will be reflected in accounts receivable.

�Notice that the $10,000 investment in receivables must be financed.

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� To illustrate, suppose that when the warehouse opened on January 1, BLC’s shareholders had put up $800 as common stock and used this money to buy the goods sold the first day. The $800 of inventory will be sold for $1,000, so BLC’s gross profit on the $800 investment is $200, or 25 percent. In this situation, the beginning balance sheet would be as follows



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� To remain in business, BLC must replenish inventories. To do so requires that $800 of goods be purchased, and this requires $800in cash. Assuming that BLC borrows the $800 from the bank, the balance sheet at the start of the second day will be as follows:

� At the end of the second day, the inventories will have been converted to receivables, and the firm will have to borrow another $800 to restock for the third day.

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� This process will continue, provided the bank is willing to lend the necessary funds, until the beginning of the 11th day, when the balance sheet reads as follows:

� From this point on, $1,000 of receivables will be collected every day, and $800 of these funds can be used to purchase new inventories.



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� This example makes it clear 1) that accounts receivable depend jointly on the level of credit

sales and the collection period, 2) that any increase in receivables must be financed in some

manner, but 3) that the entire amount of receivables does not have to be

financed because the profit portion ($200 of each $1,000 of sales) does not represent a cash outflow.

� In our example, we assumed bank financing, but, as we discuss later in the next topic, there are many alternative ways to finance current assets.

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Credit ManagementCredit Management



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Component of Credit PolicyComponent of Credit PolicyComponent of Credit PolicyComponent of Credit PolicyComponent of Credit PolicyComponent of Credit PolicyComponent of Credit PolicyComponent of Credit Policy

�Terms of the sale. A firm must decide on certain conditions when selling its goods and services for credit. For example, the terms of sale may specify the credit period, the cash discount, and the type of credit instrument.�Discounts given for early payment, including the

discount percentage and how rapidly payment must be made to qualify for the discount.

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

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�Credit analysis. When granting credit, a firm tries to distinguish between customers that will pay and customers that will not pay. Firms use a number of devices and procedures to determine the probability that customers will pay.�Credit standards, which refer to the required financial

strength of acceptable credit customers.



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�Collection policy. Firms that grant credit must establish a policy for collecting the cash when it becomes due.�which is measured by its toughness or laxity in

attempting to collect on slow-paying accounts.

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�Firms that sell on credit have a credit policy that includes certain terms of credit.

�For example, Microchip Electronics sells on terms of 2/10, net 30 , �meaning that it gives its customers a 2 percent

discount if they pay within 10 days of the invoice date, but the full invoice amount is due and payable within 30 days if the discount is not taken.

�Note that the true price of Microchip’s products is the net price, or 0.98 times the list price, because any customer can purchase an item at that price as long as the customer pays within 10 days.



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�Now consider Personal Compute Company (PCC), which buys its memory chips from Microchip. One commonly used memory chip is listed at $100, so the “true” price to PCC is $98.

�Now if PCC wants an additional 20 days of credit beyond the 10-day discount period, it must incur a finance charge of $2 per chip for that credit.

�Thus, the $100 list price consists of two components:

�List price = $98 true price + $2 finance charge.

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�The question PCC must ask before it turns down the discount to obtain the additional 20 days of credit from Microchip is this: �Could we obtain credit under better terms from some

other lender, say, a bank? �In other words, could 20 days of credit be obtained

for less than $2 per chip?



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�The following equation can be used to calculate the nominal cost, on an annual basis, of not taking discounts, illustrated with terms of 2/10, net 30:

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The Costs of Granting CreditThe Costs of Granting CreditThe Costs of Granting CreditThe Costs of Granting CreditThe Costs of Granting CreditThe Costs of Granting CreditThe Costs of Granting CreditThe Costs of Granting Credit

Carrying costs

are the costs associated with granting credit and making an investment in receivables. Carrying costs include the delay in receiving cash, the losses from bad debts, and the costs of managing credit.

Opportunity costs are the lost sales from refusing to offer credit. These costs drop as credit is granted



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Steps to Calculate the cost of carrying the investment in Steps to Calculate the cost of carrying the investment in Steps to Calculate the cost of carrying the investment in Steps to Calculate the cost of carrying the investment in additional receivables. additional receivables. additional receivables. additional receivables.

Steps to Calculate the cost of carrying the investment in Steps to Calculate the cost of carrying the investment in Steps to Calculate the cost of carrying the investment in Steps to Calculate the cost of carrying the investment in additional receivables. additional receivables. additional receivables. additional receivables.

1. Calculate average Receivables under Old Policy ( AC P ) .2. Calculate average Receivables under New Policy ( AC P ) .3. Calculate the additional Receivables which is the d ifference between

the average Receivables under New Policy and the av erage Receivables under Old Policy .

4. Calculate the investment in additional receivables which is the variable cost portion representing the cash outflow for addi tional inventory while the profit portion in the receivables does no t represent a cash outflow .

5. The cost of carrying the investment in additional r eceivables istherefore the required return on investment in addi tional receivables , which represents an opportunity cost as this requir ed return has been lost due tying that investment in additional recei vables.

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�he following information regarding a change in credit policy was assembled by the Wilson Wax Company. The company has a required rate of return of 10% and a variable cost ratio of 60%

Old Credit Old Credit Old Credit Old Credit PolicyPolicyPolicyPolicy

New Credit New Credit New Credit New Credit PolicyPolicyPolicyPolicy

Sales $3,600,000 $3,960,000Average collection period 30 days 36 days

Calculate the cost of carrying the additional Calculate the cost of carrying the additional Calculate the cost of carrying the additional Calculate the cost of carrying the additional investment in receivables.investment in receivables.investment in receivables.investment in receivables.



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The first step is to determine the average The first step is to determine the average The first step is to determine the average The first step is to determine the average investment in receivables under each policyinvestment in receivables under each policyinvestment in receivables under each policyinvestment in receivables under each policy

The first step is to determine the average The first step is to determine the average The first step is to determine the average The first step is to determine the average investment in receivables under each policyinvestment in receivables under each policyinvestment in receivables under each policyinvestment in receivables under each policy

�Under the old policy, average daily sales are $10,000 ($3,600,000/360 days).

�Given a 30-day average collection period, the average receivables balance is $300,000($10,000 x 30 days).

�Under the new policy, average daily sales are $11,000 ($3,960,000/360 days),

� and the average receivables balance is $396,000 ($11,000 x 36 days).

Hence, the average balance is $96,000 Hence, the average balance is $96,000 Hence, the average balance is $96,000 Hence, the average balance is $96,000 higher under the new policy. but it is not the extra inv.higher under the new policy. but it is not the extra inv.higher under the new policy. but it is not the extra inv.higher under the new policy. but it is not the extra inv.

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Calculate The Extra InvestmentCalculate The Extra InvestmentCalculate The Extra InvestmentCalculate The Extra InvestmentCalculate The Extra InvestmentCalculate The Extra InvestmentCalculate The Extra InvestmentCalculate The Extra Investment

�Hence, the average balance is $96,000 higher under the new policy.

�Because the company's incremental (variable) costs are 60% of sales, the extra investment is only $57,600 (60% x $96,000).

�The interest rate, or required rate of return, is 10%. Thus, the incremental carrying cost is $5,760 (10% x $57,600).



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�Best Computers believes that its collection costs could be reduced through modification of collection procedures.

�This action is expected to result in a lengthening of the average collection period from 28 days to 34 days; however, there will be no change in uncollectible accounts.

�The company's budgeted credit sales for the coming year are $27,000,000, and short-term interest rates are expected to average 8%.

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To make the changes in collection procedures cost beneficial,

What should be the minimum savings in collection costs for the coming year?



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Minimum SavingsMinimum Savings

�Given sales of $27,000,000, the average amount of daily sales must be $75,000 ($27,000,000/360 days).

�The increased accounts receivable balance is therefore $450,000 (6 days x $75,000). �With an additional $450,000 of capital invested in

receivables, the company's interest cost will increase by $36,000 per year (8% x $450,000).

�Thus, the company must save at least $36,000 per year to justify the change in procedures.

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�A company plans to tighten its credit policy. �The new policy

�will decrease the average number of days in collection from 75 to 50 days and

�will reduce the ratio of credit sales to total revenue from 70% to 60%.

�The company estimates that projected sales will be 5% less if the proposed new credit policy is implemented.

�If projected sales for the coming year are $50 million, calculate the dollar impact on accounts receivable of this proposed change in credit policy. Assume a 360-day year.



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The Dollar Impact on Accounts ReceivableThe Dollar Impact on Accounts Receivable

� If sales are $50 million, 70% of which are on credit, total credit sales will be $35 million.

� The receivables turnover equals 4.8 times per year (360 days/75-day collection period).

�Receivables turnover equals net credit sales divided by average receivables.

� Accordingly, average receivables equal $7,291,667 ($35,000,000/4.8).

� Under the new policy, sales will be $47.5 million (95% x $50,000,000), and credit sales will be $28.5 million (60% x $47,500,000).

� The collection period will be reduced to 50 days, resulting in a turnover of 7.2 times per year (360/50).

� The average receivables balance will therefore be $3,958,333 ($28,500,000/7.2),

A reduction of $3,333,334 ($7,291,667 A reduction of $3,333,334 ($7,291,667 A reduction of $3,333,334 ($7,291,667 A reduction of $3,333,334 ($7,291,667 ---- $3,958,333).$3,958,333).$3,958,333).$3,958,333).

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�A company with $4.8 million in credit sales per yea r plans to relax its credit standards, projecting tha t this will increase credit sales by $720,000.

�The company's average collection period for new customers is expected to be 75 days, and the payment behavior of the existing customers is not expected to change. �Variable costs are 80% of sales. The firm's opportu nity

cost is 20% before taxes.

�Assuming a 360-day year, what is the company's benefit (loss) on the planned change in credit terms?



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The Net Benefit of The Planned Change In The Net Benefit of The Planned Change In The Net Benefit of The Planned Change In The Net Benefit of The Planned Change In Credit TermsCredit TermsCredit TermsCredit Terms

The Net Benefit of The Planned Change In The Net Benefit of The Planned Change In The Net Benefit of The Planned Change In The Net Benefit of The Planned Change In Credit TermsCredit TermsCredit TermsCredit Terms

The Difference betweenThe Difference betweenThe Difference betweenThe Difference between

The cost of the investment The cost of the investment The cost of the investment The cost of the investment in additional receivablesin additional receivablesin additional receivablesin additional receivables

The incremental increase The incremental increase The incremental increase The incremental increase In the CMIn the CMIn the CMIn the CM

The incremental sales will produce an increased contribution margin of $144,000 (20% x $720,000).

=Inv. In additional receivables (the average investment in receivables*) XThe firm's opportunity cost

(20% opportunity cost x $120,000)=$24000

*The variable costs associated with the incremental sales are $576,000 (80% x $720,000). Given a 75-day credit period

the average investment in receivables equals $120,000 [$576,000 x (75/360)].

$120,000$120,000$120,000$120,000

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INVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENT



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INVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENTINVENTORY MANAGEMENT

� The firm should minimize total inventory costs. They include� Ordering costs , the costs of placing and receiving orders.� Carrying costs , the costs of1) Storage,2) Insurance,3) Security,4) Inventory taxes,5) Depreciation or rent of facilities,6) Interest,7) Obsolescence and spoilage, and8) The opportunity cost of inventory investment.

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The firm must also minimize the sum of the costs of stockoutsand safety stock.

The firm must also minimize the sum of the costs of stockoutsand safety stock.

�Stock out costs are incurred when an entity does not have products demanded by customers. Lost sales and customer goodwill are stockoutcosts. �Expediting costs (additional ordering and

transportation costs) may be incurred to avoid loss of sales.

�Safety stock is the quantity held for sale during the lead time.�1) Lead time is the period between when an order is

placed and when it is received.



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Order PointOrder PointOrder PointOrder PointOrder PointOrder PointOrder PointOrder Point

�The order point is the time an order should be placed to insure receiving the inventory before stock out occurs.

�For example, if the firm uses 20 units per day and the lead time is 3 days, an order should, in the absence of safety stock, be placed when the inventory level reaches 60 units.

�In practice, firms often allow for disruptions in delivery by carrying some safety stock. If the safety stock were 25 units, the order would be placed when the inventory level is reduced to 85 units [(3 days × 20 units) + 25 units of safety stock].

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Economic Order QuantityEconomic Order QuantityEconomic Order QuantityEconomic Order QuantityEconomic Order QuantityEconomic Order QuantityEconomic Order QuantityEconomic Order Quantity

�The traditional inventory management approach uses the basic economic order quantity (EOQ) model to minimize the sum of ordering and carrying costs.�Demand is assumed to be known and constant

throughout the period. �Order cost per order and unit carrying costs are also

assumed to be constant.�Because demand is assumed to be deterministic,

there are no stock out costs.



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EOQEOQEOQEOQEOQEOQEOQEOQ

� Increases in the numerator (demand or ordering costs) will increase the EOQ,

� whereas decreases in demand or ordering costs wi ll decrease the EOQ.

� Similarly, a decrease in the denominator (carrying costs) will increase the EOQ.

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� The following information regarding inventory polic y was assembled by the JRJ Corporation. The company uses a 50-week year in all calculations.

�Sales 10,000 units per year�Order quantity 2,000 units�Safety stock 1,300 units� Lead time 4 weeks

� The reorder point is

� A. 3,300 units.

� B. 2,100 units.

� C. 800 units.

� D. 1,300 units.



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Answer (B) is correct.Answer (B) is correct.Answer (B) is correct.Answer (B) is correct.Answer (B) is correct.Answer (B) is correct.Answer (B) is correct.Answer (B) is correct.

�The reorder point is the inventory level at which an order should be placed.

�This level is the inventory to be sold during the lead time plus any safety stock.

�If weekly sales are 200 units (10,000/50 weeks) and the lead time is 4 weeks, sales during the lead time should be 800 units.

�Adding the 800 units of expected sales to the 1,300 units of safety stock produces a reorder point of 2,100 units.

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JUSTJUSTJUSTJUST----ININININ----TIME MANUFACTURINGTIME MANUFACTURINGTIME MANUFACTURINGTIME MANUFACTURINGJUSTJUSTJUSTJUST----ININININ----TIME MANUFACTURINGTIME MANUFACTURINGTIME MANUFACTURINGTIME MANUFACTURING

�Modern inventory planning favors the just-in-time (JIT) model.

�JIT limits output to the demand of the subsequent operation. Reductions in inventory levels result in less money invested in idle assets ; reduction of storage space requirements; and lower inventory taxes, pilferage, and obsolescence risks.

�Minimization of inventory is a goal because many inventory-related activities are viewed as nonvalue-added.

�JIT is a pull system ; items are pulled through production by current demand, not pushed through by anticipated demand.



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kanbankanbankanbankanbankanbankanbankanbankanban

�The Japanese term kanban and JIT have often been confused. JIT is the total system of purchasing, production, and inventory control. Kanban is one of the many elements in the JIT system as it is used in Japan.

�Kanban means ticket . Tickets (also described as cards or markers) control the flow of production or parts so that they are produced or obtained in the needed amounts at the needed times.

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CMA P3 Finance 4