College Papers

Customers 2006, p. 814; Preve & Allende, 2010).

Customers are normally required to pay upfront for the purchases or services but provision of goods or services on credit are also a part of regular course of business. These credit sales to the customers are named as “account receivables” or “trade receivables” in balance sheet (Allen, Myers, & Brealey, 2006, p. 814; Preve & Allende, 2010). The time allowed for the payment is normally in days, that’s why account receivables are taken as current assets (Preve & Allende, 2010). According to Allen, Myers, and Brealey (2006), accounts receivable management includes the recovery of cash of credit sales. Efficient management of accounts receivable postulates that how quickly a firm can recover its accounts receivables. Accounts receivable days can be measured as             Sales ACR =         Accounts receivables   x  365 The nature of industry influences the allowed payment period (Allen, Myers, & Brealey, 2006). For example, perishable goods dealers usually allow seven days for the payment of invoices to their customers while pharmaceutical firms allow one month to pay the bills (Allen, Myers, & Brealey, 2006).Why do non-financial firms provide trade credit whilst bank provide the same services? The answer to this question could be that firms want to increase their market share by providing the facility to pay afterwards to their customers. Firms can also provide trade credit to their customers if they want to increase sales (Peterson & Rajan, 1997; Preve & Allende, 2010). Credit sales are also used as a technique to persuade customers for purchasing. Credit sales can be expensive for business as it requires inspection of potential customers for recovery of funds before credit sales. It is worth to obtain some information about customers by asking them to fill out the application form for credit sales (Skousen & Walther, 2009). Customer’s credit history is an important factor that can be used to filter and select customers for credit sales. Furthermore, proper supervision of collection period and collection activities are prerequisite of accounts management of receivables. The effective collection monitoring activities can lead to avoid the loss of receivables and bad debts (Skousen & Walther, 2009). According to Merville and Tavis (1973), credit policy is a considerable factor that can majorly affect a product’s demand. Credit policy is a combination of credit standards, cash discount, credit period and collection procedures (Merville & Tavis, 1973). Management attitudes and industrial standards are of great importance as they define the potential credit range for different product units. A lenient credit policy is expected to increase account receivables which results in high profits, while stranded credit policy can lead to decrease in receivables which would eventually affect the profit level (Bierman, Chopra, & Thomas, 1975). A number of studies have found inverse relation between accounts receivable and profitability (Deloof, 2003; Teruel & Solano, 2007). Deloof (2003) and Teruel & Solano, (2007) suggested that longer collection period is not good for firm’s profitability. They argued that longer period for the collection of credit sales could be an outcome of a firm’s strategy to improve sales or increasing their market share by facilitating customers for the payment of the invoices (Deloof, 2003; Teruel & Solano, 2007). They also suggested that decrease in collection days can improve firm’s profitability (Deloof, 2003; Teruel & Solano, 2007). Several techniques can be used to shorten the days accounts receivables. For instance, debtor collection period can be shortened by offering early payment discounts (Allen, Myers, & Brealey, 2006; Kolay, 1991). It encourages the customers to pay on time, thus more cash would be available for working capital and it would reduce the need of external funds to meet the requirement of current liabilities (Kolay, 1991). The more effective the debt collection efforts are, the less the chances of loss of money (Kolay, 1991). Credit provider should also consider to benefit from the owed money by debtors if they fail to pay with in time. If the customers are unable to pay on time, interest can be charged as penalty for the late payment fee (Skousen & Walther, 2009). If the customer is broke and goes bankrupt then the recovery of the payment becomes impossible and account receivable is treated as bad debts (Skousen & Walther, 2009, p. 60-68). 2.3.3 InventoryInventory is a said to be least liquid type of current assets (Allen, Myers, & Brealey, 2006). Goods retained to meet customers’ requirements are known as inventory (Albrecht et al, 2008, p. 286). Manufacturers and retailers both need to have a sufficient quantity of goods available for sale purpose (Skousen & Walther, 2009). Scholarly researchers (Albrecht et al, 2008; Skousen & Walther, 2009) have classified inventory into three main types of goods which are defined as following:a) raw material: it includes the substance and items that are required for the production of goods.b) work in process: goods that are being produced but some work still needs to be done (Albrecht et al, 2008).c) finished goods: as the name identifies, goods that have been produced and ready for sale purpose (Skousen & Walther, 2009).According to Schwartzman (2013), there are generally two main reasons to hold inventories by companies. One reason could be that companies do not want to run out of stock when customers are buying or willing to buy their products. Companies also need to consider that raw material should always be available for production of goods so that production does not get affected due to deficiency of raw material (Schwartzman, 2013). Raw material purchase decisions can be affected by different factors including order lead times, change in price, material’s availability and quantity discounts (Meyersiek, 1981). Second reason relates to transportation cost of goods between different locations. As the distribution cost remains fixed so companies prefer to buy material in bulk for production purpose and deliver finished goods on a large scale to save extra distribution cost (Schwartzman, 2013).Goods on consignment is important issue to address as it relates to inventory’s ownership. Goods on consignment are the property of consignor as legal rights and ownership of goods are transferred to buyer and they are not considered as inventory in consignee’s account although goods are still in his possession (Skousen & Walther, 2009). It is consignee’s responsibility to look after the goods and take safety measures to keep them intact. In case of any loss, consignor bears loss being real owner of the goods (Skousen & Walther, 2009, p. 74).  According to Allen, Myers, and Brealey (2006), “days of inventory” is a great tool to measure firm’s speed of turning raw material into sales. The days of inventory varies in different industries (Preve & Allende, 2010). A firm’s inventory days are affected by a number of factors which includes size of firm, industry’s environment and the nature of the good (Preve & Allende, 2010). The days of inventory can be measured by the following formula: cost of goods sold Days of inventory =       average inventory     x   365 Inventory takes up a large portion of investments of working capital (Hill, 2013). The determination of adequate inventory level is essential to smoothly run the business (Singh, 2008). Inventory is maintained to detach the functional areas of business and to avoid the adverse scenarios such as scarcity of raw material etc. It also reduces the interdependency among sales, purchasing and production departments. All departments remain functional independently and do not get significantly affected by delay in any area (Singh, 2008). However, according to Watson and Head (2013), the other factors like utility charges, warehouse expenses and opportunity cost should also be considered along with the associated benefits of inventory. To create balance between inventory costs and benefits, the use of “the economic order quantity model” (EOQ) is common for inventory management. The model provides an optimum order size, that a company should order, with the considerations of all costs i.e. ordering and inventory holding costs. The assumptions of model includes the demand and costs to remain constant during the period. The model states that the total annual cost is the sum of  annual holding and ordering cost. Economic order quantity can be derived by following formula Here Q = order quantity in units H = holding cost per unit per year S = annual demand in units per year F = ordering cost per orderCompanies hold large number of goods to meet demand and supply requirements (Hill, 2013). Firms holding large number of inventory scarcely experience stock-outs which increase the sales and profit (Bierman, Chopra, & Thomas, 1975). Rafuse (1996) argues that large holdings of stock are not good for the firm as there are chances of stock not being sold or wasted out. Short inventory level is beneficial as it improves firm’s financial and operational effectiveness and reduces the chances of resources wasted out (Rafuse, 1996). Lower inventory level also provides more cash available for working capital. Firms do not need to take loan to meet working capital requirement (Kolay, 1991). Moreover, reduced inventory levels also save various costs like insurance, warehouse and security cost etc (Watson & Head, 2013). To decrease investment in current assets, inventory is usually taken critically. To overcome inventory and material related issues, companies tend to appoint material managers as a potential solution to implement inventory control system (Meyersiek, 1981). However, this solution does not seem practical as there are chances of conflicts between selling, production and purchasing departments due to different point of interest (Meyersiek, 1981). The proposed solution to avoid those conflicts among departments could be the management of material flow on a whole level as it would provide better perspective for inventory management (Meyersiek, 1981). Moreover, top management can handle inventory issues in a better way as they can get all necessary information by coordinating with first line managers of selling, production and purchasing departments (Meyersiek, 1981). Added to that, quality of raw material is also an important factor that can attain the attention of the management to control costs during working capital crisis (Kolay, 1991). The use of low quality material to overcome cost issues would affect the quality of finished product which results in low sales and low profits (Kolay, 1991).Companies are using different techniques to minimize their inventory levels. One of them is the use of “just-in-time” (JIT) approach which was introduced in Japan by Toyota (Allen, Myers, & Brealey, 2006). The company has been able to reduce their investment in inventory as the order is only made when auto-parts are needed (Allen, Myers, & Brealey, 2006). Moreover, multiple orders can be made and received during the day as the processing time to deliver the order is not long anymore (Allen, Myers, & Brealey, 2006). The JIT approach has been successful due to the strong supplier-based relations and company’s efficient contingency planning to overcome the unfavourable situations (Allen, Myers, & Brealey, 2006).