FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

Sixth Canadian Edition
Lusztig, Cleary, Schwab
Receivables and Inventory
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
4. Compare the different types of insurance
available against bad debts.
5. Explain the different benefits and costs
involved in inventory control.
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
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)
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 applicant’s attitude
and character
the economic trade-off
Credit Policies
A firm’s 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
Credit Insurance
Credit insurance
is designed to indemnify a firm’s 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
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
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
Captive Finance Companies
Captive finance companies
are wholly owned subsidiaries of the
parent company
are common for companies that sell highcost equipment (cars, planes)
the assets of the finance
subsidiary consist of financing
contracts that provide
predictable cash flow
Inventory Management
The main concern with inventory management
is to balance the benefits and costs of carrying
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
Inventory Management
3. Materials requirement planning (MRP) – a
computer-based system for ordering
and/or scheduling production of demanddependent 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
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 firm’s profitability
In Canada, the problem of inventory profits is
magnified because the last-in, first-out
method is not acceptable for tax purposes
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.
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.
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 highcost equipment in industries where extended credit
is customary.
6. The main costs of inventories include
warehousing, handling, insurance,
obsolescence, spoilage, and financing. Price
level changes can have a serious impact on