HANDOUTS ON FUNDAMENTALS OF receivables plus bad debt losses on the

FINANCIAL MANAGEMENT 1 (For Classroom other.

Discussion) (b.2) Credit Terms involve both the
(Ms. Carmelita U. de Guzman, CPA, MGM)
length of the credit period and the
Chapter 10: Accounts Receivable
discount given. Credit period is the
and Inventory Management
length of time buyers are given to pay for
(Reference: Van Horne and John M.
their purchases; Discounts are price
Wachowicz, Fundamentals of Financial
reductions for early payments.
Management, 13th edition)
(b.3) Collection Policy refers to the
(refer to the powerpoint presentations of Ms. Agripa, Mr. Naz procedures the firm follows to collect
and Mr. Orpilla) )
past-due accounts.
Chapter 19: Accounts Receivable Credit analysis is instrumental in
and Inventory Management determining the amount of credit risk to
(Reference: Cabrera, Ma. Elenita be accepted. In turn, the amount of risk
Balatbat, Financial Management accepted affects the slowness of
(Principles and Applications, vol. 1) 2015 receivables and the resulting investment
edition) in receivables, as well as the amount of
bad debt losses.
A. ACCOUNTS RECEIVABLE (b.4) Delinquency and Default
MANAGEMENT Whatever credit policies a business firm
may adopt, there will be some customers
1. Accounts Receivable consists of who will delay and others who will default
money owed to a firm for goods and entirely, thereby increasing the total
services sold on credit. The two types of accounts receivable costs. The optimal
credit are: a) trade or commercial credit, credit policy then, that should be
which the firm extends to other firms; b) adopted, is the one that provides the
consumer or retail credit, which the firm greatest marginal benefit.
extends to its final customers. 4. Costs Associated with Investment in
2. Objectives of Accounts Receivable Accounts Receivable
Management a) Credit analysis, accounting and
- to ensure that the firms investment in collection costs costs relative to the
accounts receivable is appropriate and credit and collection personnel who will
contributes to shareholder wealth carry out tasks relative to the function.
maximization. Hence, the finance officer b) Capital costs Once the firm extends
has the responsibility to a) evaluate the credit, it must raise funds in order to
pertinent costs and benefits related to finance it. The interest to be paid if the
credit extension; b) finance the firms funds are borrowed or the opportunity
investment in accounts receivable; c) cost of equity capital will constitute the
implement the firms credit policy and d) cost of funds that will be tied up in the
enforce collection. receivables.
3. Credit Policy c) Delinquency costs costs that are
a) This is a set of guidelines for incurred when the customer is late in
extending credit to customers. paying. This delay adds collection costs
b) Credit policy generally covers the above those associated with a normal
following variables: collection. Delinquency also creates an
(b.1) Credit Standards refer to the opportunity cost for any additional time
minimum financial strength of acceptable the funds are tied up after the normal
credit customer and the amount collection period.
available to different customers. d) Default costs (bad debts) costs that
Optimal credit policy would involve are incurred when the customer fails to
extending trade credit more liberally until pay at all. In addition to the collection
the marginal profitability on additional costs, capital costs and delinquency
sales equals the required return on the costs incurred up to this point, the firm
additional investment in receivables. Or loses the cost of goods sold not paid for.
it is a trade-off between the profits on It has to write off the entire sales once it
sales that give rise to receivables on one decides the delinquent account has
hand and the cost of carrying these defaulted and is no longer collectible.

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5. Summary of Trade-offs in Credit and management of accounts receivable
Collection Policies exceeds the required return or
a) Relaxation of credit standards incremental costs of the additional
Benefit: increase in sales and total investment, the change should be
contribution implemented.
margin c) All things being equal, the decision
Cost: (1) increase in credit processing concerning the change in credit policy is
costs made using the following rules:
(2) increase in collection costs INCREMENTAL PROFIT INCREMENTAL
(3) higher default costs (bad CONTRIBUTION COST
debts) (1) >
(4) higher capital costs ACCEPT
(opportunity costs) (2) <
b) Lengthening of credit period REJECT
Benefit: increase in sales and total (3) =
contribution BE INDIFFERENT
margin t
Cost: higher capital costs (opportunity o the change
cost of
higher investment in B. INVENTORY MANAGEMENT
receivables) 1. Inventories are an essential part of
c) Granting cash discount virtually all business operations and must
Benefit(1) increase in sales and total be acquired ahead of sales. The main
contribution classification of inventories are:
margin a) For trading firms: Merchandise
(2) opportunity income on lower b) For manufacturing firms: Raw
investment in receivable materials; Goods-in-process; Finished
Cost: lesser profit goods; Factory supplies
d) Intensified collection efforts 2. Objective of Inventory Management
Benefit:(1) lower default costs (bad a) Inventory is the stockpile of the
debts) product the firm is offering for sale and
(2) lower opportunity cost or the components that make up the
capital cost product.
Cost: (1) higher collection expenses b) It is the responsibility of the financial
(2) lower sales officer to maintain a sufficient amount of
6. Analyzing Proposed Changes in Credit inventory to ensure the smooth operation
Policy of the firms production and marketing
a) If a business enterprise eases its functions and at the same time avoid
credit policy either by way of lengthening tying up funds in excessive and slow-
the credit period, relaxing credit moving inventory.
standards and collection policy, or 3. Functions of Inventories
offering cash discounts, then its sales a) Inventories are considered as the life-
should increase. blood of the production distribution
(b) Cost will also rise because of system.
increase in production costs. Likewise b) The functions and uses of inventories
additional investment in accounts are:
receivable will increase carrying costs (1) Pipeline or transit inventories
and bad debts and/or discount expenses inventories which are being moved or
may also rise. transported from one location to another
7. Marginal or Incremental Analysis of and they fill the supply pipelines between
Credit Policies stages of the entire production-
a) Marginal analysis is performed in distribution system.
terms of a systematic comparison of the (2) Organizational or decoupling
incremental returns and the incremental inventories inventories that are
costs resulting from a change in the maintained to provide each link in the
firms credit policy. production-distribution chain a certain
b) Whenever the incremental or profit degree of independence from the others.
from a proposed change in the

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These will also take care of random
fluctuations in demand and/or supply.
(3) Seasonal or anticipation stock 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
inventories that are maintained
whenever the user makes or buys
material in larger lots than are needed
for his immediate purposes.
(5) Safety or buffer stock inventories
that are maintained to prevent the
company from uncertainties such as
unexpected customer demand, delays in
delivery of goods ordered, etc.
4. Cost Associated with Investment in
Inventory
a) To provide the inventories required to
sustain operations at the lowest possible
cost, it is necessary to identify all the
costs involved in acquiring and
maintaining inventory.
b) The following are generally the costs
associated with inventories which could
vary from time to time, from item to item
and also over time.
(b.1) Carrying Costs
Cost of capital tied up in inventory;
storage and handling cost; insurance;
property taxes; depreciation and
obsolescence; administrative costs
(accounting, etc.)
(b.2) Ordering, shipping and receiving
costs
Cost of placing orders including
production and setup costs; shipping and
handling costs
(b.3) Costs of running short
Loss of sales; loss of customer goodwill;
description of production schedules
5. Inventory Management Techniques
a) 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 techniques that may be
used in determining inventory order size,
timing, etc. include EOQ (Inventory
Economic Order Quantity) model, and the
Reorder Point.
b) Level Monitoring and Inventory
Control Systems
(1) Inventory control is the regulation of
inventory within predetermined limits.
(2) Effective inventory management
should provide adequate stocks to meet
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the requirements of the business, while
at the same time keeping the required
investment to a minimum.
(3) 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:
(3.a) Fixed Order Quantity System a
system wherein each time the inventory
goes down to a predetermined level
known as the reorder point, an order for
a fixed quantity is placed. This requires
the use or perpetual inventory records or
the continuous monitoring of the
inventory level.
(3.b) Fixed Reorder Cycle System 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.
(3.c) Optional Replenishment System
represents a combination of the
important control mechanisms of the
other two systems described in (3.a) and
(3.b).
(3.d) 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 medium 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 follow-up through the
factory deliveries from vendor, close
follow-up through the factory to reduce
lead time, etc.
Careful accurate determination of order
quantities and order point with frequent
review to reduce, if possible.
(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 on only the
simplest notations that replenishment
stocks have been ordered; no EOQ or
order point calculations.
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