business finance

INVENTORY
MANAGEMENT

STATE THE CONCEPT
OF INVENTORY
DETERMINE THE
IMPORTANCE OF
INVENTORY CONTROL
CALCULATE THE COST
RELATED TO
INVENTORY

INVENTORY

Inventory is defined as a stock or store of goods.

These goods are maintained on hand at or near a
business's location so that the firm may meet demand and
fulfil its reason for existence. If the firm is a retail
establishment, a customer may look elsewhere to have his
or her needs satisfied if the firm does not have the
required item in stock when the customer arrives.

If the firm is a manufacturer, it must maintain some
inventory of raw materials and work-in process in order to
keep the factory running. In addition, it must maintain
some supply of finished goods in order to meet demand.

Sometimes, a firm may keep larger inventory than is
necessary to meet demand and keep the factory running
under current conditions of demand. If the firm exists in a
volatile environment where demand is dynamic (i.e., rises
and falls quickly), an on-hand inventory could be
maintained as a buffer against unexpected changes in
demand. This buffer inventory also can serve to protect
the firm if a supplier fails to deliver at the required time,
or if the supplier's quality is found to be substandard
upon inspection, either of which would otherwise leave the
firm without the necessary raw materials.

Other reasons for maintaining an unnecessarily large
inventory include buying to take advantage of quantity
discounts (i.e., the firm saves by buying in bulk), or
ordering more in advance

INVENTORY

Inventory types can be grouped into 3 classifications:-

1. Raw material

Raw materials are inventory items that are used in the manufacturer's conversion
process to produce components, subassemblies, or finished products. These
inventory items may be commodities or extracted materials that the firm or its
subsidiary has produced or extracted.

They also may be objects or elements that the firm has purchased from outside
the organization. Even if the item is partially assembled or is considered a
finished good to the supplier, the purchaser may classify it as a raw material if
his or her firm had no input into its production.

Generally, raw materials are used in the manufacture of components. These
components are then incorporated into the final product or become part of a
subassembly.

2. Work-in-process

Work-in-process (WIP) is made up of all the materials, parts (components),
assemblies, and subassemblies that are being processed or are waiting to be
processed within the system.

This generally includes all material—from raw material that has been released
for initial processing up to material that has been completely processed and is
awaiting final inspection and acceptance before inclusion in finished goods.

Any item that has a parent but is not a raw material is considered to be work-in-
process

3. Finished goods

Finished good is a completed part that is ready for a customer order. Therefore,
finished goods inventory is the stock of completed products. These goods have
been inspected and have passed final inspection requirements so that they can
be transferred out of work-in-process and into finished goods inventory.

From this point, finished goods can be sold directly to their final user, sold to
retailers, sold to wholesalers, sent to distribution centers, or held in anticipation
of a customer order.

INVENTORY

WHY KEEP INVENTORY

meet
demand

Lead Smoothing
time. requirements

why keep Quantity
inventory discount.

Keep
operations

running

Hedge.

Why would a firm hold more inventory than is currently necessary
to ensure the firm's operation? The following is a list of reasons
for maintaining what would appear to be "excess" inventory.

January February March April May June

Demand 50 50 0 100 200 200

Produce 100 100 100 100 100 100

Month-end 50 100 200 200 100 0
inventory

Table 1 : Inventory requirements

INVENTORY - WHY KEEP INVENTORY

MEET DEMAND.

In order for a retailer to stay in business, it must have the products
that the customer wants on hand when the customer wants them. If not,
the retailer will have to back-order the product. If the customer can
get the good from some other source, he or she may choose to do so
rather than electing to allow the original retailer to meet demand
later (through back-order). Hence, in many instances, if a good is not
in inventory, a sale is lost forever.

KEEP OPERATIONS RUNNING

A manufacturer must have certain purchased items (raw materials,
components, or subassemblies) in order to manufacture its product.
Running out of only one item can prevent a manufacturer from
completing the production of its finished goods.

LEAD TIME.

Lead time is the time that elapses between the placing of an order
(either a purchase order or a production order issued to the shop or
the factory floor) and actually receiving the goods ordered.

If a supplier (an external firm or an internal department or plant)
cannot supply the required goods on demand, then the client firm
must keep an inventory of the needed goods. The longer the lead
time, the larger the quantity of goods the firm must carry in inventory.

A just-in-time (JIT) manufacturing firm, such as Nissan in Smyrna,
Tennessee, can maintain extremely low levels of inventory. Nissan
takes delivery on truck seats as many as 18 times per day. However,
steel factory may have a lead time of up to three months. That means
that a firm that uses steel produced at the factory must place orders
at least three months in advance of their need. In order to keep their
operations running in the meantime, on-hand inventory of three
months’ steel requirements would be necessary.

INVENTORY - WHY KEEP INVENTORY

HEDGE.

Inventory can also be used as a hedge against price increases and
inflation. Salesmen routinely call purchasing agents shortly before a
price increase goes into effect. This gives the buyer a chance to
purchase material, in excess of current need, at a price that is lower
than it would be if the buyer waited until after the price increase
occurs.

QUANTITY DISCOUNT.

Often firms are given a price discount when purchasing large
quantities of a good. This also frequently results in inventory in excess
of what is currently needed to meet demand. However, if the discount
is sufficient to offset the extra holding cost incurred as a result of the
excess inventory, the decision to buy the large quantity is justified.

SMOOTHING REQUIREMENTS.

Sometimes inventory is used to smooth demand requirements in a
market where demand is somewhat erratic. Consider the demand
forecast and production schedule outlined in Table 1.

Notice how the use of inventory has allowed the firm to maintain a
steady rate of output (thus avoiding the cost of hiring and training
new personnel), while building up inventory in anticipation of an
increase in demand. In fact, this is often called anticipation inventory.
In essence, the use of inventory has allowed the firm to move demand
requirements to earlier periods, thus smoothing the demand.

INVENTORY

IMPORTANCE OF INVENTORY CONTROL

The main goal of the inventory management is to minimize costs that are
directly involved in the company. Balancing up the stock value is necessary
for companies in order to maximize return on sales, thus providing good
value to return on assets.

1. Companies should avoid excessive stocking because it will adversely
affect the company itself because the real level of sales cannot be
made.

2. The first step in the management of inventory is to identify all the costs
involved in purchasing and handling of inventory. This is to ensure that
companies are operating at minimum cost.

3. The costs involved are: a) Carrying Cost - cost arising starting from the
stock began to be in store until it is sold. - Example : cost of
warehousing, storage costs b) Ordering Cost - Costs involved in the
process of getting goods from suppliers.

SAFETY STOCK

REASONS FOR KEEPING SAFETY STOCK

Supplier may deliver their product late or not at all

The warehouse may be on strike

A number of items at the warehouse may be of poor quality and
replacements are still on order

A competitor may be sold out on a product, which is increasing the
demand for your products

Random demand (in reality, random events occur.)

Machinery breakdown

Unexpected increase in demand

INVENTORY

Factors Determine The Level Of Safety Stock:

i. There is uncertainty in the demand level or lead time for the product;
it serves as an insurance against stock outs.

ii. Lack of Inventory If companies do not want to be in a situation where
customer demand is not met, then the amount of safety stock that must
be retained by the company should be improved to avoid losing sales.

iii. Inventory carrying costs if companies have to pay a high carrying
cost, then the total safety stock should be reduced. With these
reductions, will lower the average inventory and inventory carrying
costs can be further reduced.

CALCULATION RELATED TO INVENTORY
1 Total Inventory cost (TIC)
TIC = TCC + TOC

** TCC – TOTAL CARRYING COST, TOC – TOTAL ORDER COST

DETERMINATION OF TOTAL CARRYING STOCK (TCC)
TCC is dependent on the average stock, the percentage of cost savings and
price for the stock. In other words, the calculation of the TCC are as follows:

TCC = C X P X A

C = the percentage of cost savings
P = purchase price of the stock
A = the average stock

INVENTORY

If a company requires S units of goods X, per year, and orders Q in
the same amount of N times a year, then:

Quantity ordered each time is, Q = S / N

Stock Average, A = Q / 2 or A = min level + max level
2

min level = safety stock ; max level = min level + Q

EXAMPLE:

If Company A requires 300,000 units of goods X per year, and
orders made 6 times a year, calculate the level of Q and
average stock. If the unit price of items X is RM3.00 with the
percentage of the cost savings is 11.25%, CALCULATE TCC

DETERMINATION OF TOTAL ORDERING STOCK (TOC)

Costs orders are fixed, it does not depend on the quantity
ordered.

TOC = O * N or Demand @ Sales X O

Q

O = order cost for each order ; N = number of each order per
year

EXAMPLE:

If the cost of each purchase is RM150 and the company needs
300,000 units a year with stocks of goods X is an average of
30,000 units, N = 6. Calculate the TOC

INVENTORY

DETERMINATION OF ANNUAL STOCK PRICES (TIC - TOTAL
INVENTORY COST)

TIC = TCC + TOC

TIC DETERMINATION WITH SAFETY STOCK:

Safety Stock:
- Stocks that exist to avoid the problem of loss of sales when the
customer requests can not be met.
- It is also kept to meet any requirements in the event of delay in
receiving order from the supplier.
- In other words, the safety stock is required when there is
uncertainty between the point of order and delivery time.
- If there is safety stock. It will affect the TCC and TIC:

A = Q / 2 + Safety Stocks

EXAMPLE:
Abu Lahab & Co. sells container to its customers. Company is
expected to sell 260,000 units of containers next year. The cost
per unit is RM6.20. Cost savings are estimated at 20% of the
value of the container. Ordering cost is RM100 for each order.
Calculate TIC for the company if the safety stock required is
1,000 units.

INVENTORY

Economic order quantity is the level of inventory that

minimizes the total inventory holding / carrying costs and
ordering costs.

ECONOMIC ORDER QUANTITY MODEL (EOQ)

Used to determine the minimum inventory cost. This is done
through determining the total quantity of each order made to
ensure that the total cost incurred is minimal.

EOQ = √ 2 X O X D @ S
C

EXAMPLE:
A company would like to know the amount should be ordered to
minimize the inventory cost. Sales made for one year is 12,000
units. The percentage of carrying costs is 30% of the purchase
value. The purchase price is RM12.00 per unit and the ordering
cost is RM130 per order.
Calculate:
a) EOQ
b) Number of orders
c) TIC
d) TIC if the safety stock required is 1,500 units.

INVENTORY

Reorder point/ re-order level

Inventory level of an item which signals the need for placement
of a replenishment order, taking into account the consumption of
the item during order lead time and the quantity required for the
safety stock.
Also called reorder level, reorder quantity, or replenishment
order quantity.
Reorder level depends on three factors:
Safety Stock The minimum stock level to be kept by the company.
Waiting time / lead time Waiting time refers to the length of
time needed to get supplies from a supplier.
rate of consumption Sales requirements by the company during
the operation of its business.
In general, the calculation of the TPS is as follows:

ROL = Safety Stock + (Waiting Time X Usage Rate)
Time in a year

EXAMPLE:

A company expects to sell 100,000 items X next year. Delivery
time is 6 days and safety stock is 1,200 units. Calculate ROL.

***(This means that if the remaining inventory in the store has reached X units, the
company will order again)

INVENTORY

DISCOUNTS QUANTITY:

Sometimes the supplier gives a discount to the company if order
is made in large quantities. In deciding whether to order the EOQ
level or at a quantity that allows discounts from suppliers,
companies should make decisions based on the excess profits of
the company.

ANALYSIS : 1.Calculate
EOQ

4. Make An 2. Calculate
Analysis TICEOQ

3.Calculate
TICSALES

Analysis
Annual saving= sales x (xx)discount………xx
Cost increase (TIC SALES-TIC EOQ)………….(xx)
+ve

Accept offer if positive analysis

RECEIVABLES
MANAGEMENT

Receivables Calculate
management effective cost
concept and
credit policy – as the
consequences

of giving
credit

Calculate the
cost of

changing the
credit policy

RECEIVABLES MANAGEMENT
CONCEPT AND CREDIT POLICY

Many firms sell on credit in order to get more customers and
expand the market. When goods are sold, the stock will decline
and account receivables will increase. Increase in account
receivables causes the company not to have cash surplus due to sales
are made on credit.

Cash can only be obtained when payment has been made by the
debtors.

The relationship between account receivables and cash is inverse.

Cash will be used to buy stock and then it will be sold on credit.

Due to that, cash will be reduced because of high credit sales.

Account receivables is dependent on 2
factors:

1 2

Average Level of
collection credit sales

period

AVERAGE COLLECTION PERIOD:

Is the average number of days needed to collect cash from credit
sales. For example, a company sells its products on credit and
offer credit terms "3/10 net 45".

3/10 net 45 – 3% discount if payment is made within 10 days. All
payment should be settled in 45 days
Example:
From the records kept by the company, 50% of customers will take the
discount, that is payment made on the 10th day, 40% of customers will
pay on day 45 and the remainder paid on day 50. Therefore the
calculation of the average collection period is as below:

ANSWER:
The average collection period
= 0.5 (10 days) + 0.4 (45 days) + 0.1 (50 days)
= 28 days.

If the credit sales of the company is RM9,000,000 per annum
(assuming 360 days per year), then the average company's accounts
receivable can be measured by using the equation below:

ANSWER:
AAR = Average daily credit sales * Average collection period

= 9,000,000/360 * 2
= RM700,000

LEVEL OF CREDIT SALES

Total credit sales are dependent on several factors, including:
i. The quality of the product
ii. Discount offered
iii. Effective promotion
iv. Credit policy either tight or loose

CREDIT POLICY
In the management of AR, the most important thing is CREDIT
POLICY. Credit policy is a policy that covers all aspects related to
the following elements:

1) Credit

Long or short period of time granted by the firm to customers to
settle debt.

2) Credit Standards:

Refers to the strength of the financial position of the customer
before they are eligible to receive a credit offer.

a) Character:
Referring to the honesty and trustworthy clients in meeting
the obligations that have been made. Through credit sales,
the company seems to lend to customers, so customers
need to pay within the prescribed time.

b) Capital:
Measured by the financial position of customers, acquired
through the analysis of financial statements. It is important
to measure the ability to repay debts.

c) Capacity:
Looking at the ability of customers in terms of resources
other than cash, such as total assets hold, available
technology or other factors that can be used as a gauge to
ensure the ability of customers to pay the amount of credit
sales made.

d) Collateral:
Is a form of customer’s guarantee to pay to the firm.

e) Condition:
Referring to the environmental impact to customers such as
the economic, geographical areas and government
policies.

3) Collection policy:

More focus on credit terms, whether tight or loose. It emphasizes the
timeliness of payments and state any penalty or action that can be
taken if late payment is received.

For example: When a company sells on credit terms of "net 60", what
steps can be taken by the company if payment is not received on day
61? Whether the policy proceeds are loose or tight depends on the
actions implemented. The measures taken may be as follows:

10 days overdue --------- send a reminder letter
20 days overdue --------- send warning letters
30 days overdue --------- phone calls and verbal warnings
> 60 days overdue -------accounts submitted to collection agencies or
legal action will be taken

4) The discount rate offered:

Refers to the discount rate that can be given to customers to encourage
them to pay quickly.

Credit terms will be given to the customer to identify any discounts that
may be offered to encourage early payment within a certain period
and this is known as the credit period. This term involves three
conditions, namely:

i. Term/period of credit
ii. Total cash discount for early payment
iii. Term/period discount
Credit terms are usually written as "a/b net c". This means customers
can reduce “a” percentage of payment from the invoice if payment is
made within “b” days (discount period) if not, payment should be
settled within “c” days (the credit).

Example:

With the credit terms of "3/10 net 30" and the invoice price of
RM500,000 on July 1, customers will only have to pay a total of
RM485,000 if they pay on or before July 11. [RM500,000 (1-0.03)].
But if the customer does not take the discount, a full payment must be
done no later than July 31.

ANALYSIS OF CHANGES IN CREDIT POLICY

From time to time, it is necessary for a firm to change their credit
policy to increase sales or for attracting new customers and retain
existing customers.

Changes in credit policy can be done by either tightening or loosen
it. Any change in credit policy will directly affect the amount of
profit and costs involved.

In general, the effect of changes in credit policy to the amount of
benefits and costs can be seen as follows:

The effect on Relaxed credit policy Tightening credit policy

Sales • level of credit sales will Credit sales decline
increase Profit declined
Total investment
in the AR • Gain increased Total AR reduce due to the
impact of decline in sales
Investment in AR will increase to
stocks accommodate the increased Investment in stocks can be
sales reduced because the demand
The probability for stock is low
of bad Investment in stocks had to Bad debts are low because of
debt be increased to meet higher the tight credit policy
customer demand
Cost of discount The company offers a low
Bad debt is high because of discount rate. Although sales
the high level of credit sales declined but the company will
The percentage of possible receive full payment from the
clients do not pay within the customer. Discount cost to be
prescribed period is also borne by company are low.
high

The company had to offer
attractive discount rates to
increase sales. This will
cause companies to incur
high cost of discounts to
customers

CHANGING THE CREDIT POLICY

A company will change its credit policy when they meet the following
goals:

1) Attracting new customers
2) Reduce the average collection period
3) Generate more profit from the increased costs

An analysis will be performed to see the impact on costs and
benefits resulting from changes in credit policy. This analysis is known
as Marginal Analysis.

This analysis will look at a possible comparison between the
contribution of additional profits generated from new sales level
with additional costs due to changes in credit policy.

When a credit policy is proposed to be changed, procedures
or methods for the analysis are as follows:

Estimate CHANGES IN PROFIT

1

Estimate the cost CHANGES IN AR INVESTMENT AND
STOCK

2

Estimate CHANGES IN CASH DISCOUNT

3

COMPARING THE COST OF ADDITIONAL BENEFITS

4

CHANGING THE CREDIT POLICY

a) Estimate CHANGES IN PROFIT:

Total profit will increase or decrease when the credit policy change is directly
related to the level of new sales.

Changes in = Increase x Margin - Increased cost on

Profit in sales contribution disposal of bad debt

b) Estimate the cost CHANGES IN AR INVESTMENT & STOCK:
i. Calculate the change in AR investment:

Change in AR = Level of expected sales x (Expected average sales –
Current sales) x Average collection period

ii. Calculate the increase in stock investment:

Increase in stock = Expected stock level – Current stock level

iii. Calculate the total increase in AR investment and stock:

Increased in AR and Stock = (Increase in AR + increase in stock )
x required rate of return

c) Estimate CHANGES IN CASH DISCOUNT:

The cost of changes = (level of expected sales x % expected discount x
% customer to take the discount) - (level of current sales x % current
discount x % customers take the current discount)

d) COMPARING THE COST OF ADDITIONAL BENEFITS:

Net changes in Changes in - Investment costs - Changes in

in pre tax profits = profits in AR and stock cash discount

(a) (b) (c)

MARGINAL ANALYSIS

RM RM
XXX
a) Changes in profits
(XX)
b) Increase investment in AR and stock: (XX)
XXX
i) The increase in AR XX

ii) The increase in stock XX

iii) Increase investment in AR and stock

b (i) + b (ii) x required rate of return

c) Change in cash discounts

d) Net changes in profit before tax

Example 1 :

Current policy (2/10, net 30) Proposed Policy (3/10 net 40)

Credit sales of RM50,000,000 Expected credit sales to
50% of customers take the discount RM65,000,000
30% pay on Day 30 60% of customers take the discount
20% pay on Day 40 30% pay on Day 40
Bad debt 1% of sale 10% pay on Day 50
Stock level of RM25,000,000 Bad debts 1% of sales
Stock level of RM28,000,000

Variable costs ratio is 80% and required rate of return is 12%. Is
this credit changes necessary? (assume there are 360 days in 1
year)

Example 2 :

Rich Ltd Company have a total annual credit sales of RM500,000. The
company proposes to increase total sales to RM750,000.

- Credit terms offered are 2/20 net 40. (The original terms of 1/10 net 20)

- 60% of customers will take the discount offered and the rest will be paid
at the end of the period (in the original terms 50% of customers take the
discount)

- Increased sales will result in increased bad debt expenses by 1% from
the sales and increase in stock of RM10, 000

- Total variable costs are 75% and the required rate of return is 12%

Assuming that one year equals to 360 days, should Rich Ltd Company
introduce the credit policy.

Example 3 :

MNO Company sells consumer goods. Price per unit is RM10 and RM6 per
unit of variable costs. The average sales for the year was at 1.5 million
with the average collection period of 40 days and the total cost of bad
debt is around 5% of sales.

The company has plans to change its credit policy. This change in policy
will increase the total sales by RM0.5 million per annum. However, the
average receivables collection period will increase to 60 days and cost of
bad debt will increase to 10%. Assume that the cost of capital is at 10%
(Assume 360 days per year).

You are required to advise whether the company should change its credit
policy or otherwise.

Example 4 :

Company Lim have listed a number of credit policy to be reviewed. During
the year the average sales for the company is about RM10 million and the
average collection period is 30 days. 15% of customers take the discount.
Current discount rate is 1%.

Bad debt expenses are estimated at 1% of sales. The policies below have
been shortlisted for the study:

Credit Policy A B CD
1.0 1.5 1.8 2.0
The increase in sales from current
sales levels (RM'000'000) 50 52 55 62
Average collection period (days) 2 2 33

Estimated bad debt expense 20 22 24 30
(% of total sales) 2 3 45
% customers taking discount

Discount rate (%)

Selling price is RM200.00 per unit and variable cost is RM150.00 per unit.
Cost of capital is 15% (1 year = 360 days)
State which credit policy is the best for the company.

QUESTION 1

ABC is a company that sells consumer products. Sales price per unit is
RM10 and RM6 per unit of variable costs. With credit terms 2/10 net
40, the average sales for the year is RM1,500,000 with an average
collection period of 40 days. The current level of stock holding is
RM30,000 and the amount of bad debt expense is approximately 5%
of total sales. 5% of the customers taking the discount.

Recently the company has plans to change its credit policy to 4/10
net 50.

This change in policy will result to:

i. Sales will increase to RM2,000,000 per annum
ii. 10% of customers will take the discount, 40% would pay within

credit terms and the remainder on day 60
iii. The level of stock holding increases by RM20,000

iv. Bad debt expenses increases to 6%

With the required rate of return of 10%, state whether the decision
of ABC to change its credit policy is profitable or otherwise. (1 year

= 360 days)

QUESTION 2

Jaya Bhd has credit terms of 2/10 net 30. During the year, average sales
for the company was RM10 million and the average collection period is 35
days with 5% of customers taking the discount. The level of current stock
holding is RM50,000 and bad debt expense is estimated to be 1% of gross
sales.

Recently, the company has listed a number of credit policy to be reviewed
by a higher authority. Information for those policies are as follows:

Credit Policy A B C D
Credit terms 3/10 net 30 4/10 net 40 5/10 net 50 6/10 net 60
Increase in
sales levels 2.0 2.5 2.8 3.0
('000,000)
50 60 90 144
Average
collection 10 15 20 25
period (days)
% of 15 20 25 30
customers
take discount 1 1 1 1
Increase of
stock from the
current
level (%)
Bad debt
expenses (%)

The selling price for the company’s product is RM200 per unit and
variable cost is RM150 per unit. With the required rate of return
of 20%, what is the best credit policy for Jaya Bhd. (1 year =

365 days)

QUESTION 3

AQSA Trading Sdn. Bhd. is considering to change its credit policy that
will result in average collection period from 30 days to 2/20 net 40
days. The relaxation in credit is expected to produce increase in sales.
It will estimated that 90% of its customers will take the discount offer
and the rest will pay on day 40. You are given the following additional
information :

Original credit sales - RM20,000,000

New credit sales - RM30,000,000

Contribution margin - 25%

Percentage of bad debt on additional sales - 5%

Additional inventory required - RM700,000

Required rate of return on investment - 15%

** Assume 360 day in a year

You are required to :

1. Calculate the change in credit policy based on the information
given

2. Should changes in credit policy be implemented ? Give your
comment.

QUESTION 4

GUGUDAN Corporation has an annual credit sales of RM16 million and
average collection period of 40 days. The level of bad debt is RM480,000
and the required rate of return before tax is 16%.

Assumed that GUGUDAN Corporation only produces one product, it has
variable cost of 70% of the cost price. The company is considering a
change in credit policy where customers are unable to pay within 20 days,
they would not get any discount and have to pay the full amount within 60
days.

It the change is implemented, it is expected that 40% of customers will take
the discount and pay on Day 20, while 60% will ignore the discount and
pay on day 60. This will increase the average collection period from 40
days to 44 days.

GUGUDAN Corporation is considering making changes because it is
expected to generate an additional sales credit of RM2 million. Besides
that, the increment in sales will also influence the increment in bad debts. It is
assumed that bad debt on the original sale is consistent and bad debt for
additional sales is 6%. In addition, the average inventory level is RM2
million currently. After the implementation of the plan, GUGUDAN
Corporation will have the average inventory level at RM2,050,000.

Using marginal analysis, calculate whether the proposed credit policy
changes should be implemented or otherwise.

QUESTION 5

Afiq Afiqah Sdn. Bhd. plans to change credit policy as mentioned
below.

Current policy (3/10 net 40) NEW policy (5/15 net 50)

Credit sales RM50,000 Credit sales RM80,000

40% customers take the cash 40% customers take the cash

discount discount

25% of the customers pay 30% of the customers pay on

on day 40 day 40

35% of the customers pay 30% of the customers pay on

on day 50 day 50

Bad debt RM17,500 Bad debt RM22,000

Inventory RM25,000 Inventory RM28,000

The variable cost is 75% of sales

Pre-tax required rate of return is 20%

Based on the above information, should the new credit
policy implemented? Show your calculation assuming

there are 360 days in a year.

QUESTION 6

MOLIMAU Jaya Sdn. Bhd. Is considering changing its credit policy that
will result in average collection period from 20 days to 2/20 net 30
days. The relaxation in credit is expected to produce increase in sales.
It will estimated that 80% of its customers will take the discount offer
and the rest will pay on day 30. You are given the following additional
information:

Original credit sales - RM10,000,000
New credit sales - RM20,000,000
Contribution margin - 25%
Percentage of bad debt on additional sales - 5%
Additional inventory required - RM500,000
Required rate of return on investment - 14%

** Assume 360 day in a year
You are required to:
1. Calculate the change in credit policy based on the information given.

2. Should changes in credit policy be implemented? Interpret your
answer.

CONGRATULATIONS, YOU HAVE
COMPLETED THE TOPIC

IF YOU HAVE ANY QUESTION,
FEEL FREE TO CONSULT THE

LECTURER

The end
Best of luck

CHAPTER 5
SHOT TERM AND LONG

TERM FINANCING
(CLO1)

- DESCRIBE SHORT TERM LOAN
- IDENTIFY THE RANGE OF SHORT TERM LOAN

RESOURCES OF FINANCE AVAILABLE TO BUSINESS
- CALCULATE EFFECTIVE COST
- DISTINGUISH BETWEEN ADVANTAGES AND

DISADVANTAGES OF SHORT TERM LOAN

SHORT TERM FINANCING

Introduction

Financing resource can be classified into short term and long term
financing. When a company is considering deciding on a financing, three
are 3 factor:
Credit effective cost when using a financing resource
Availability of the financing resource at required amount and time
The span of time a financing is needed.

Short-term financing is the decision analysis that affect current assets
and current liabilities. It can be defined as all sources of financing that
must be repaid within a year or less.

Short term financing can be split into:

1. Financing with no collateral

•Financing service which generally is chartered by bank and other
amenities without imposing collateral

•Loan approval is based on the personal assurance and guarantee from
the mortgagor.

•Ex : commerce paper, accrued and trade credit

2. Financing with collateral

•Service financing involves certain assets which is mortgaged to get loan

•If a mortgagor fails to accomplish the term agreed and meet the pay, the
mortgagee will have the right to claim for the first mortgaged assets as
agreed in the contract.

•Commerce banks, finance companies and factoriser companies will
normally be offering this sort of loan to their customers

•The main resources of collateral are account receivable and inventory

TYPES OF SHORT-TERM FINANCING:

A. SPONTANEOUS SOURCES OF FINANCING:

1) Accruals:

Accruals are the current liability formed because of the delay of
payment in two situations.
First, deliberately delaying the payment because the practice has
become a habit of.
For example, wages should be paid after a job is done. This means
that companies should pay the salaries of workers every day.
But being a widely accepted practice, most employers pay wages at
the end of the month. The company will use the salary expenses that
should have been paid, but deferred to the end of the month.
Salaries may be first used to pay operating expenses such as
payment providers, utility expenses and so forth.
Second, accruals which exist when the funds for certain fees have
been collected in advance even though the actual date of payment is
late. Example: Deduction must be on the employee's wages as a
contribution to the Employees Provident Fund (EPF). Funds can be
collected at the end of each month.
But the EPF provides that the payment will have to be paid at the end
of every month. Therefore, the company can use these funds as
additional funding if necessary for the next three weeks without
incurring any cost.

P/S*
Does short-term financing involves any cost? Sources of financing
through accruals are actually free as long as companies follow proper
management practices of financing.

TYPES OF SHORT-TERM FINANCING:

A. SPONTANEOUS SOURCES OF FINANCING:

2) Credit trading/ Trade credit:
Credit trading is a credit facility offered by a supplier to customers in
an effort to increase their sales. Usually the supplier does not require
any collateral. Source of funding is based on faith of providers to the
purchaser.
Credit terms commonly used is 2/10 net 30. This means buyers get a
discount of two percent if payment is made within 10 days. If the
discount is negligible, the payment must be made within 30 days.
There will be an effective cost to the buyer if there are discounts from
suppliers. This is because the buyer will have to bear high costs if the
discount is negligible.

Trade credit is :
Most flexible sources of short term financing
Credit effective cost, EC = × 360

1− −

Generally:
i. Effective cost exists only when discount is ignored. If payment is
made within the discounted period, the effective cost is equal to zero.
ii. Effective cost will increase if payment is made earlier.
iii. Effective cost will be reduced if the payment is delayed.

Example 1:
XYZ Company is given several credit terms from three suppliers:
1) 2 / 10 net 30
2) 2 / 10 net 60
3) 3 / 10 net 50
4) 3 / 10 net 55
Based on the above credit terms, provide the best option for XYZ
Company if payment is made at the end of the term.

TYPES OF SHORT-TERM FINANCING:

B. NEGOTIATED FUNDING SOURCES:

Negotiated funding sources that are obtained from different sources
are more formal and involves specific procedures which are usually
offered by commercial banks and licensed financial institutions.
Among the most important source of negotiated funding are:

1) Bank loans (short-term loans)
2) Commercial paper
3) Factoring of Accounts Receivable
4) Lease of Accounts Receivable

Estimating the cost of short-term financing (negotiated) in general:

The estimated cost of short-term financing is based on the basic
formula below:

=

P = principal

r = rates

t = times

Interest in the RM is the amount payable to the involved parties in
return for loans or advances that have been granted.
Example 2
Mr Ali applies for a loan for 6 months amounted up to RM 45,000 at
the rate of 10%. What is the interest that is imposed on Mr Ali.

TYPES OF SHORT-TERM FINANCING:

But the interest rates above are just an explicit costs and
do not reflect the actual cost for not taking other factors
that affect the cost of financing such as the present value
of money and expenses incurred to obtain financing.

In this chapter, we will obtain the actual value of the
interest rate to provide the most accurate picture of the
financing costs after taking into account other factors. It is
termed as the effective cost (EC). The calculation of cost
effective is as follows:

EC = Interest

Principal x Time

In determining the EC for bank loans are some important
factors, such as:

i. The amount borrowed (Principal)
ii. Interest Rates
iii. Loan Period
iv. Compensating Balance (CB) - an amount that should be
kept and maintained in the customer's bank account as the
balance of the loan period. It is the additional conditions
imposed by banks when customers fail to pay loan

TYPES OF NEGOTIATED FINANCING:

1. Bank Loan/ bank credit:

The banks usually provide facilities for a brief period. Bank differentiates
their services by offering many unique advantages to attract many
customers. Among the factors considered by company in selecting banks to
make loans are as follows:

i. Willingness to take risks:
The bank will impose a different policy before offering a loan to its
customers for instance by looking at financial records and so forth. The
bank offering loose loan terms is usually being selected by the customer.

ii. Guidance and counseling:
There are banks that offer advice and counseling to help design the
company's loans. The best advice would be selected by the company.

iii. Loyalty to customers:
Each bank is different in their willingness to provide support to the
activities of the borrower when the economic situation deteriorated. If
there are banks willing to provide assistance in resolving the crisis faced
by the company, it will be selected.

iv. Specialization:
There are banks that offer real estate related loans, agriculture, farming,
animal husbandry and so on. Selection of a loan from a bank will depend
on the type of business carried out by the company.

v. The maximum loan size:
The companies typically select the bank that can provide a higher loan
size which is normally offered by large and stable banks.

vi. Other services:
The friendly customer service, efficient service and ability to transfer funds
online, will usually be emphasized before choosing the right bank.

TYPES OF NEGOTIATED FINANCING:

1. Commercial paper

The usage of Commercial paper as a source of short-term financing in
Malaysia has not been widely spread. This is because only companies
with strong financial standing are able to produce CP. CP is issued by
the company to obtain short-term financing in a short period of time.

Commercial paper is a short-term promissory note, issued by big and
famous companies that have gained the confidence of investors who
believe the company's ability to repay them when redeeming their
commercial paper at maturity.

Typically, the commercial paper is issued at a discount. This means
that when sold to investors, the price will be deducted by the interest.
At maturity, the investor will redeem at face value. In this case, the
issuer of commercial paper is the borrower and the investor is the
lender.

An additional feature is the existence of the Commercial Paper
issuance costs as a third party (bank or service security company
operator) to distribute such Commercial Paper to the public in
addition to other costs that are directly involved in the issuance of
Commercial Paper. All these costs must be taken into account in
calculating the EC.

The calculation of EC for the issuance of commercial paper are as
follows:

EC = Total Cost
Net Loan x Time

Total cost = Issuance cost + Interest
Net Loan = Value of Commercial Paper - Total cost

CALCULATE THE EFFECTIVE COST OF
SHORT TERM LOAN

Simple interest

Example 3
Sharina wishes to borrow RM 20,000 for one year. The bank offers a
simple interest loan at 14% per annum. Calculate the effective annual
interest cost of the loan.

Example 4 - interest less than one year

Sharina wishes to borrow RM 20,000 for 6 month. The bank offers a
simple interest loan at 14% per annum. Calculate the effective annual
interest cost of the loan.

Example 5 - with compensating balance

Sharina wishes to borrow RM 20,000 for one year. The bank offers a
simple interest loan at 14% per annum and requires Sharina to
maintain a compensating balance of 20% of the loan amount.
Calculate the effective annual interest cost of the loan.

Example 6 - interest less than one year & with compensating
balance

Sharina wishes to borrow RM 20,000 for 6 month. The bank offers a
simple interest loan at 14% per annum and requires Sharina to
maintain a compensating balance of 20% of the loan amount.
Calculate the effective annual interest cost of the loan.

CALCULATE THE EFFECTIVE COST OF SHORT
TERM LOAN

The calculation of EC for a loan can be divided into two methods,
namely:

1) Simple Interest Method - interest is charged on the basis
amount borrowed , interest is paid when loan ends

Effective cost (EC) = × 100

( − )

2) Discounted Method - interest is charged on the basis amount
borrowed, interest is paid when loan begins

Effective cost (EC) = × 100

− −

CALCULATE THE EFFECTIVE COST OF
SHORT TERM LOAN

Discount interest

Example 7
Sharina wishes to borrow RM 20,000 for one year. The bank offers a
discount interest loan at 14% per annum. Calculate the effective
annual interest cost of the loan.

Example 8
Sharina wishes to borrow RM 20,000 for 6 month. The bank offers a
discount interest loan at 14% per annum. Calculate the effective
annual interest cost of the loan.

Example 9
Sharina wishes to borrow RM 20,000 for one year. The bank offers a
discount interest loan at 14% per annum and requires Sharina to
maintain a compensating balance of 20% of the loan amount .
Calculate the effective annual interest cost of the loan.

CALCULATE THE EFFECTIVE COST OF
SHORT TERM LOAN

TOTAL LOAN REQUIRE

Cause of loan have to be deduct by compensating balance and
interest, so total loan require not achieve amount that required by a
company. Company have to calculate the total loan required by a
company.

Simple interest

Total loan require =

1−%

Example 10

Sharina wishes to borrow RM 20,000 for one year. The bank offers a
simple interest loan at 14% per annum and requires Sharina to
maintain a compensating balance of 20% of the loan amount.
Calculate total loan require by Sharina.

Discount interest

Example 11

Sharina wishes to borrow RM 20,000 for one year. The bank offers a
discount interest loan at 14% per annum and requires Sharina to
maintain a compensating balance of 20% of the loan amount.
Calculate total loan require by Sharina.

Total loan require =

1−% −%

CALCULATE THE EFFECTIVE COST OF
COMMERCIAL PAPER

Example 12
Anjung Industries plans to sell RM 200,000,000 in 250 day maturity
paper which expected discount interest 10% per annum. The firm also
expects to incur RM 200,000 in dealer placement fees and other
expenses of issuing the paper

ADVANTAGES & DISADVANTAGES OF SHORT TERM FINANCING

Benefits of short-term financing:

i) Easy:
Does not require a thorough financial audit than long-term financing. It is
available in the near future or in other words as soon as possible.

ii) Cost of debt:
Financing costs (interest expense) of short term is lower than the long-term
financing. This is because the time value of money is insignificant. Long-
term financing usually involves a long period of time, and the company will
have to bear a greater rate because it takes into account the changing
value of money.

iii) Availability:
There are some short-term financing readily available to be used. This
situation exists automatically or spontaneously. For example, a creditor is
regarded as a short-term financing that is often used by companies.

iv) Flexibility:
The company can customize a short-term funding as necessary. If the
company only needs financing for a brief period, then the source of such
financing will be selected. For example, companies may make short-term
loans from banks for a period of three months or half a year only.

v) The freedom of management:
Short-term creditors usually will not impose strict conditions. Due to that, the
company will have freedom in managing and implementing strategies
related to financing.

Disadvantage of short-term financing:

i) Changes in the interest rate:
If company uses a long-term financing, interest rate is more stable because
the rate has been stipulated in the covenant that was made before it. But
for short-term financing, the interest rate will change quickly, sometimes to
a high level in accordance with the current state of financial markets.

ii) Risk:
If the company uses a lot of short-term financing, it is not possible to pay
back the loan within the specified period because of liquidity problems.
This caused the company to be exposed to the problem of bankruptcy.

CHAPTER 6
CAPITAL BUDGETING

(CLO1)

CAPITAL BUDGETING CONCEPT

WHAT IS CAPITAL BUDGETING

CAPITAL BUDGETING is one of the primary activities of a

company. Companies may expand or diversify to remain competitive
either by producing new product or entering a new business line
entirely, open a new branch, penetrate new market. So capital
budgeting is a process of selecting and evaluating longterm
investment, that is to make decision with respect to investments in
fixed asset.

It is crucial for company to make the right decision because these
projects require a huge amount of cash outflow committed for many
years. A right decision will increase the firm’s value as well as
shareholders’ wealth.

Independent projects

CAPITAL BUDGETING PROCESS

Involve the following:

Generating long-term investment proposals, which are consistent
with a firm’s long term objectives

Estimating the relevant after-tax incremental cash flow for these
project proposals

Evaluating these cash flows

Selecting the project that will maximize shareholders’ wealth

Re-evaluating these projects from time to time for control purposes
and carrying out post-audits for completed projects

CAPITAL BUDGETING CONCEPT

Types of projects:
Capital projects will include introduction of new product or expansion
of the existing products.
Projects can be divided into 2 groups:
1. Independent projects
Cash flow is independent or unrelated to one another, decision to
accept one project will not affect to accept another projects

2. Mutually exclusive
A decision is made to choose only one project from the many being
considered, a decision to accept one project will automatically reject
the others