Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

21. Credit and Inventory
    Management

(^734) © The McGraw−Hill
Companies, 2002

CHAPTER

21

Credit and Inventory

Management

By mid-2000, Gillette’s stock pricewas down almost 50 percent from its high

the previous year. One reason given by market analysts was poor management

of inventories and credit. Receivables had reached the equivalent of 106 days of

sales, while competing companies such as Colgate and Procter & Gamble had 65

and 29 days’ sales outstanding. The issue became so serious that the CEO of

Gillette, Michael Hawley, made working capital reduction a priority. Apparently,

he had some success. Gillette reduced its working capital by $400 million in the

first quarter of 2000, with a further goal of a full $1 billion reduction before the

end of the year. As this example suggests, the proper management of credit and

inventory can have a significant impact on the profitability of a company and the

value investors place on it.

hen a firm sells goods and services, it can demand cash on or before the de-

livery date or it can extend credit to customers and allow some delay in pay-

ment. The next few sections provide an idea of what is involved in the firm’s

decision to grant credit to its customers. Granting credit is making an invest-

ment in a customer, an investment tied to the sale of a product or service.

Why do firms grant credit? Not all do, but the practice is extremely common. The ob-

vious reason is that offering credit is a way of stimulating sales. The costs associated

with granting credit are not trivial. First, there is the chance that the customer will not

pay. Second, the firm has to bear the costs of carrying the receivables. The credit policy

decision thus involves a trade-off between the benefits of increased sales and the costs

of granting credit.

From an accounting perspective, when credit is granted, an account receivable is cre-

ated. Such receivables include credit to other firms, called trade credit, and credit

granted consumers, called consumer credit.About one-sixth of all the assets of U.S. in-

dustrial firms are in the form of accounts receivable, so receivables obviously represent

a major investment of financial resources by U.S. businesses.

W

707

CREDIT AND RECEIVABLES

21.1