Intermediate Financial Management (with Thomson One)

Self-Test Question
734 • Part 6 Working Capital Management
occasionally some of the necessary components simply could not be located, while
in other instances the components were located but found to have been damaged
from long storage.
Then Trane adopted a new inventory policy—it began producing components
only after an order is received, and then sending the parts directly from the
machines that make them to the final assembly line. The net effect: Inventories fell
nearly 40 percent even as sales increased by 30 percent.
However, there are costs associated with holding too little inventory, and these
costs can be severe. Generally, if a business carries small inventories, it must
reorder frequently. This increases ordering costs. Even more important, firms can
miss out on profitable sales, and also suffer a loss of goodwill that can lead to
lower future sales if they experience stockouts. So, it is important to have enough
inventory on hand to meet customer demands.
What are some costs associated with high inventories? With low inventories?
RECEIVABLES MANAGEMENT
Firms would, in general, rather sell for cash than on credit, but competitive pressures
force most firms to offer credit. Thus, goods are shipped, inventories are
reduced, and an account receivable is created. 7 Eventually, the customer will pay
the account, at which time (1) the firm will receive cash and (2) its receivables will
decline. Carrying receivables has both direct and indirect costs, but it also has an
important benefit—increased sales.
Receivables management begins with the credit policy, but a monitoring system is
also important. Corrective action is often needed, and the only way to know whether
the situation is getting out of hand is with a good receivables control system.
Credit Policy
The success or failure of a business depends primarily on the demand for its
products—as a rule, the higher its sales, the larger its profits and the higher its
stock price. Sales, in turn, depend on a number of factors, some exogenous but
others under the firm’s control. The major controllable determinants of demand
are sales prices, product quality, advertising, and the firm’s credit policy. Credit
policy, in turn, consists of these four variables:
1. Credit period, which is the length of time buyers are given to pay for their
purchases. For example, credit terms of “2/10, net 30” indicate that buyers
may take up to 30 days to pay.
2. Discounts given for early payment, including the discount percentage and how
rapidly payment must be made to qualify for the discount. The credit terms
“2/10, net 30” allow buyers to take a 2 percent discount if they pay within
10 days. Otherwise, they must pay the full amount within 30 days.
7 Whenever goods are sold on credit, two accounts are created—an asset item entitled accounts receivable appears on
the books of the selling firm, and a liability item called accounts payable appears on the books of the purchaser. At this
point, we are analyzing the transaction from the viewpoint of the seller, so we are concentrating on the variables under
its control, in this case, the receivables. We examine the transaction from the viewpoint of the purchaser later in this
chapter, where we discuss accounts payable as a source of funds and consider their cost.