HANDOUTS ON FUNDAMENTALS OF FINANCIAL
MANAGEMENT 1 (For Classroom Discussion)
Chapter 10: Accounts Receivable and Inventory
Management
(Reference: Van Horne and John M. Wachowicz,
Fundamentals of Financial Management, 13th
edition)
Chapter 19: Accounts Receivable and Inventory
Management
(Reference: Cabrera, Ma. Elenita Balatbat,
Financial Management (Principles and
Applications, vol. 1) 2015 edition)
A. ACCOUNTS RECEIVABLE MANAGEMENT
1. Accounts Receivable consists of money owed to
a firm for goods and services sold on credit. The
two types of credit are: a) trade or commercial
credit, which the firm extends to other firms; b)
consumer or retail credit, which the firm extends to
its final customers.
2. Objectives of Accounts Receivable Management
- to ensure that the firm’s investment in accounts
receivable is appropriate and contributes to
shareholder wealth maximization. Hence, the
finance officer has the responsibility to a) evaluate
the pertinent costs and benefits related to credit
extension; b) finance the firm’s investment in
accounts receivable; c) implement the firm’s credit
policy and d) enforce collection.
3. Credit Policy
a) This is a set of guidelines for extending credit to
customers.
b) Credit policy generally covers the following
variables:
(b.1) Credit Standards – refer to the minimum
financial strength of acceptable credit customer
and the amount available to different customers.
Optimal credit policy – would involve extending
trade credit more liberally until the marginal
profitability on additional sales equals the required
return on the additional investment in receivables.
Or it is a trade-off between the profits on sales that
give rise to receivables on one hand and the cost of
carrying these receivables plus bad debt losses on
the other.
(b.2) Credit Terms – 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 payments.
(b.3) Collection Policy – refers to the procedures
the firm follows to collect past-due accounts.
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Credit analysis is instrumental in determining the
amount of credit risk to be accepted. In turn, the
amount of risk accepted affects the slowness of
receivables and the resulting investment in
receivables, as well as the amount of bad debt
losses.
(b.4) Delinquency and Default – Whatever credit
policies a business firm may adopt, there will be
some customers who will delay and others who will
default entirely, thereby increasing the total
accounts receivable costs. The optimal credit policy
then, that should be adopted, is the one that
provides the greatest marginal benefit.
4. Costs Associated with Investment in Accounts
Receivable
a) Credit analysis, accounting and collection costs –
costs relative to the credit and collection personnel
who will carry out tasks relative to the function.
b) Capital costs – Once the firm extends credit, it
must raise funds in order to finance it. The interest
to be paid if the funds are borrowed or the
opportunity cost of equity capital will constitute
the cost of funds that will be tied up in the
receivables.
c) Delinquency costs – costs that 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
opportunity cost for any additional time the funds
are tied up after the normal collection period.
d) Default costs (bad debts) – costs that are
incurred when the customer fails to pay at all. In
addition to the collection costs, capital costs and
delinquency costs incurred up to this point, the
firm loses the cost of goods sold not paid for. It has
to write off the entire sales once it decides the
delinquent account has defaulted and is no longer
collectible.
5. Summary of Trade-offs in Credit and Collection
Policies
a) Relaxation of credit standards
Benefit: increase in sales and total contribution
margin
Cost: (1) increase in credit processing costs
(2) increase in collection costs
(3) higher default costs (bad debts)
(4) higher capital costs (opportunity costs)
b) Lengthening of credit period
Benefit: increase in sales and total contribution
margin
Cost: higher capital costs (opportunity cost of
higher investment in receivables)
c) Granting cash discount
Benefit(1) increase in sales and total contribution
margin
 (2) opportunity income on lower
investment in receivable
Cost: lesser profit
d) Intensified collection efforts
Benefit:(1) lower default costs (bad debts)
(2) lower opportunity cost or capital cost
Cost: (1) higher collection expenses
(2) lower sales
6. Analyzing Proposed Changes in Credit Policy
a) If a business enterprise 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.
(b) Cost will also rise because of increase in
production costs. Likewise additional investment in
accounts receivable will increase carrying costs and
bad debts and/or discount expenses may also rise.
7. Marginal or Incremental Analysis of Credit
Policies
a) 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.
b) Whenever the incremental or 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.
c) All things being equal, the decision concerning
the change in credit policy is made using the
following rules:
INCREMENTAL PROFIT INCREMENTAL
CONTRIBUTION COST
(1) “ > “ ACCEPT
(2) “ < “ REJECT
(3) “ = “ BE INDIFFERENT
to the change
B. INVENTORY MANAGEMENT
1. Inventories are an essential part of virtually all
business operations and must be acquired ahead of
sales. The main classification of inventories are:
a) For trading firms: Merchandise
b) For manufacturing firms: Raw materials; Goods-
in-process; Finished goods; Factory supplies
2. Objective of Inventory Management
a) Inventory is the stockpile of the product the firm
is offering for sale and the components that make
up the product.
b) It is the responsibility of the financial officer to
maintain a sufficient amount of inventory to ensure
the smooth operation of the firm’s production and
marketing functions and at the same time avoid
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tying up funds in excessive and slow-moving
inventory.
3. Functions of Inventories
a) Inventories are considered as the life-blood of
the production – distribution system.
b) The functions and uses of inventories are:
(1) Pipeline or transit inventories – 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 –
inventories that are maintained to provide each link
in the production-distribution chain a certain
degree of independence from the others. 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 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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