Working capital management – at a glance

Credit and collection policies encompass several decisions: (1) the quality of accounts accepted; (2) the length of the credit period; (3) the size of the cash discount (if any) for early payment; (4) any special terms, such as seasonal dates; and (5) the level of collection expenditures. In each case, the decision involves a comparison of the possible gains from a change in policy with the cost of the change. To maximize profits arising from credit and collection policies, the firm should vary these policies jointly until it achieves an optimal solution.

The firm’s credit and collection policies, together with its credit and collection procedures, determine the magnitude and quality of its receivable position.

In evaluating a credit applicant, the credit analyst (1) obtains information on the applicant, (2) analyzes this information to determine the applicant’s creditworthiness and (3) makes the credit decision. The credit decision, in turn, establishes whether credit should be extended and what the maximum amount of credit, or line of credit, should be.

Inventories form a link between the production and sale of a product. Inventories give the firm flexibility in its purchasing, production scheduling, and servicing of customer demands.

In evaluating the level of inventories, management must balance the benefits of economies of production, purchasing and marketing against the cost of carrying the additional inventory. Of particular concern to the financial manager is the cost of funds invested in inventory.

Firms often classify inventory items into groups in such a fashion as to ensure that the most important items are reviewed most often. One such approach is called the ABC method of inventory control.

The optimal order quantity for a particular item of inventory depends on the item’s forecasted usage, ordering cost, and carrying cost. Ordering can mean either the purchase of the item or its production. Ordering costs include the costs of placing, receiving, and checking an order. Carrying costs represent the cost of inventory storage, handling, and insurance and the required return on the investment in inventory.

The economic order quantity (EOQ) model affirms that the optimal quantity of an inventory item to order at any one time is that quantity that minimizes total inventory costs over our planning period.

An inventory item’s order point is that quantity to which inventory must fall to signal a reorder of the EOQ amount.

Under conditions of uncertainty, the firms must usually provide for a safety stock, owing to fluctuation in demand for inventory and in lead times. By varying the point at which orders are placed, one varies the safety stock that is held.

Just-in-time (JIT) inventory control is the result of a new emphasis by firms on continuous process improvement. The idea is that inventories are acquired and inserted in production at the exact times they are needed.