INVENTORY

MANAGEMENT AND
SHORT-TERM FINANCES
FOR FINANCING
CURRENT ASSETS

Presented by Group 4
 Inventory Management

Inventories are an essential par t of vir tually all

business operations and must be acquired ahead of
sales. The main classifi cations of inventories are:

For manufacturing fi rms For Trading Firms

a. Raw Materials a. Merchandise

b. Goods-in-process

c. Finished Goods

d. Factor y supplies

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Functions of Inventories

1. Pipeline or Transit Inventories

2. Organizational or Decoupling Inventories

3. Seasonal or Anticipation Stock

4. Batch or Lot-Size Inventories

5. Safety or Buffer Stock

I n v e n t o r y M a n a g e m e n t a n d S h o r t -Te r m F i n a n c e s f o r F i n a n c i n g C u r r e n t A s s e t s 3
 I. Carrying Cost
Cost of capital tied up in inventory
Cost Storage and handling cost
Insurance
Associated Property Taxes
Depreciation and obsolescence
With Administrative costs (e.g., accounting, etc.)
II. Ordering, shipping and receiving costs
Investment Cost of placing orders including production and setup
costs
Inventory Shipping and handling costs

III. Costs of running short

Loss of sales
Loss of customer goodwill
Description of production schedules

I n v e n t o r y M a n a g e m e n t a n d S h o r t -Te r m 4
Finances for Financing Current Assets
Inventory Management Techniques

• Inventory Planning

• Level Monitoring and Inventory Control Systems

I n v e n t o r y M a n a g e m e n t a n d S h o r t -Te r m F i n a n c e s f o r 12/10/2023 5
Financing Current Assets
 1. Economic Order Quantity (EQO) =

a.) Total Inventory Costs =

Total Ordering Costs + Total Carrying Costs

b.) Total Ordering Costs =

x Ordering Costs per Orders
Inventory c.) Total Carrying Costs =
Planning Average Inventory x Carrying Costs Per Unit

d.) Average Inventory =

2. Reorder Point = Lead Time Usage + Safety Stock

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Finances for Financing Current Assets
Illustrative Case I.

Assume that a local gif t shop is attempting to determine how many sets of wine
glass to order. The store feels it will sell approximately 800 sets in the next year
at a price of P18 per set. The wholesale price that the store pays per set is P12.
Costs of carrying one set of wine glasses are estimated at P1.50 per year while
ordering costs are estimated at P25.

Required:

a. Determine the economic order quantity for the sets of wine glasses.

b. Determine the annual inventory costs for the fi rm if it orders in this quantity.

Inventor y Management and Shor t-

Te r m F i n a n c e s f o r F i n a n c i n g 7
Current Assets
 Illustrative Case II. EOQ, Reorder Point Determination

The following inventory information and relationships Re q u i r e d :

f o r t h e B a g u i o C o r p o ra t i o n a r e a va i l a b l e :
a. W h a t i s t h e o p t i m a l E O Q l e ve l ?
1. Orders can be placed only in multiples of 100 units
b. H o w m a ny o r d e r s w i l l b e p l a c e d m a n u a l l y ?
2. Annual unit usage is 300,000. (Assume a 50-week
c. At w h a t i nve n t o r y l e ve l s h o u l d a r e o r d e r b e
y e a r i n y o u r c a l c u l a t i o n s .)
made?
3. The carrying cost is 30 percent of the purchase
price of the goods.

4. The purchase price is P10 per unit.

5. T h e o r d e r i n g c o s t s i s P 5 0 p e r o r d e r.

6. The desired safety stock is 1,000 units. (This does

n o t i n c l u d e d e l i v e r y- t i m e s t o c k .)

7. Delivery time is two weeks.

Inventor y Management and Shor t-

Te r m F i n a n c e s f o r F i n a n c i n g 8
Current Assets
 Illustrative Case III. Cost associated with Safety Stock

Hard Hat Inc. operates a chain of hardware stores in Metro Manila. The controller wants to determine
the optimum safety stock levels for an air purifier unit. The inventory manager has compiled the
following data.

• The annual carrying cost of inventory approximates 20 percent of the investment in inventory.
• The inventory investment per unit average P50.
• The stockout cost is estimated to be P5 per unit.
• The company orders inventory on the average of ten times per year.
• Total cost = carrying cost + expected stockout cost.
• The probabilities of a stockout per order cycle with varying levels of safety stock are as follows:
Units
Safety Stock Stockout Probability
200 0 0%
100 100 15
0 100 15
0 200 12 9
 Illustrative Case II. EOQ, Reorder Point Determination

Re q u i r e d :

• W h a t i s t h e t o t a l c o s t o f s a f e t y s t o c k o n a n a n n u a l b a s i s w i t h a s a f e t y s t o c k l e ve l o f 1 0 0 u n i t s ?

Inventor y Management and Shor t-

Te r m F i n a n c e s f o r F i n a n c i n g 10
Current Assets
 1. Fixed Order Quantity System

2. Fixed Reorder Cycle System

M = B + D(R + L)
Level Where: M = Replenishment level in units
B = Buffer stock in units
Monitoring D = Average demand per day
R = Time interval in days, between reviews

and Inventory L = Lead time in days

Control
3. Optional Replenishment System
P = B + D(L + R/2)
Where: P = Reorder point in units
Systems B = Buffer stock in units
D = Average demand per day
R = Time between review in days
L = Lead time in days

4. ABC Classification System

1. A items – highest possible controls
2. B items – normal controls
3. C items – simplest possible controls
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Finances for Financing Current Assets
Illustrative Problem: Fixed Order Quantity System
Following data has been provided for an inventory. Find the economic order quantity and the
reorder point:

Annual Demand: 1,000 units

Ordering Cost: P5.00 per order
Holding Cost: P1.25 per unit per year
Cost per unit: P12.50
Lead Time: 5 days
Average daily demand: 1,000/365

I n v e n t o r y M a n a g e m e n t a n d S h o r t -Te r m F i n a n c e s f o r F i n a n c i n g C u r r e n t A s s e t s 12
Illustrative Problem: ABC Classification System
Maxus book binding divides inventory items into three classes according to their peso usage.
Calculate the usage values of the following inventory items and determine which is most likely to
be classified as an A item:
Part Number Description Qty used per year Unit Value

1 Boxes 500 P3.00

2 Cardboard (square feet) 18,000 P0.02

3 Cover stock 10,000 P0.75

4 Glue (gallons) 75 P40.00

5 Inside Covers 20,000 P0.05

6 Reinforcing tape (meters) 3,000 P0.15

7 Signatures 150,000 P0.45

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 Shor t-Term Sources for Financing Current Assets

Shor t- te rm fi n a nc in g ref ers to debt ori g i na l l y s c hedul ed

f or repayment w i thi n one yea r. It i s us ed to fi na nc ed al l
or pa r t of the fi rm’s w orki ng c a pi ta l requi rements a nd
s ometi mes to meet perma nent fi na nc i ng needs .

Tw o Ba s i c P robl ems i n Shor t- term F i na nc i ng:

1. Determi ni ng the l evel of s hor t- term fi na nc i ng the fi rm

s houl d us e

2. Sel ec ti ng the s ourc e of s hor t- term fi na nc i ng

I n v e n t o r y M a n a g e m e n t a n d S h o r t -Te r m F i n a n c e s f o r F i n a n c i n g C u r r e n t A s s e t s 14
 Factors in Selecting a Source of Short-term Funds

1. Effective cost of credit,

2. Availability of credit in the amount needed for the period of time when
financing is required,

3. Influence of the use of a particular credit source on the cost and availability
of other sources of financing, and

4. Any additional covenants of the loans that are unique to the sources
mentioned previously.

I n v e n t o r y M a n a g e m e n t a n d S h o r t -Te r m F i n a n c e s f o r F i n a n c i n g C u r r e n t A s s e t s 15
 a. Accruals

b. Cost of Trade Credit

-Implicit/Hidden Costs
-Opportunity Costs/Missed Cash Discount
Estimating
Cost of Short- c. Cost of Bank Loans
1. Simple Interest
Term Credit 2. Discount Interest
3. Add-on Interest
4. Simple Interest with Compensating
Balance
5. Discount Interest with Compensating
Balance

d. Cost of Commercial Paper

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Finances for Financing Current Assets
Accruals

Accruals are current liabilities for services received but for which
complete payments have not been made as of reporting date. These are interest-
free sources of financing and do not involve either implicit of explicit costs.
Accruals includes:
• Wages
• Taxes
• Rent
• Interest Payable

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Accruals

Illustrative Problem:
XYZ Corp. is considering a change in its payroll period, from biweekly to
bimonthly. The biweekly payroll is normally P400,000. Assuming wages accrue at
a constant rate, the average level of the accrued wages account is currently
P200,000 (P400,000/2). XYZ has an opportunity cost of 12 percent.

Change in Average = Net Average - Current Average

Accrued Wages Accrued Wages Accrued Wages

=
= P200,000

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Accruals

Savings by
Changing the = Opportunity Cost x Changes in
Payroll Period accrued wages

= (0.12)(P200,00)

= P24,000

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Cost of Trade Credit

Credit received during the discount period is sometimes called free trade credit.
The view that trade credit is free may be misleading. There are costs associated
with trade credit such as interest costs. These are some example of this cost:

• Implicit/Hidden Costs – suppliers of trade credit incur the costs of operating a

credit department and financing account receivables.

• Opportunity costs/missed cash discount – an opportunity cost is incurred

because the buyer forgoes an opportunity to pay less for the purchases.

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Cost of Trade Credit

Formula Used:

Nominal Discount Percent 360 days

Annual = Discount x Days credit is Discount
Cost (ANC) 100 - Percent outstanding - Period

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Cost of Trade Credit

Illustrative Problem:

Calculate the nominal annual cost of non-free trade credit under each of the
following terms:

1. 2/10, n/60

2. 2/10, n/30

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Cost of Trade Credit

Solution

1. 2/10, n/60

= 14.69%

2. 2/10, n/30

= 36.73%

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 Cost of Bank Loans

1. Simple Interest
Formula to Compute the effective annual rate:

2. Discount Interest
Formula to compute the effective annual rate:

3. Add-on Interest
Formula to compute the approximate annual rate:

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 Cost of Bank Loans

4. Simple Interest with Compensating Balance

Formula for computing effective annual rate:

or

5. Discount Interest with Compensating Balance

Formula for computing effective annual rate

Or =

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 Cost of Bank Loans

Examples: Simple Interest

Compute the effective annual interest rate for one year loan of P100,000 at 12%
annual interest per year payable at maturity.

If the loan had a term of less than 1 year, like 90 days, the effective annual rate would be
calculated as follows:

= 12.56%

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 Cost of Bank Loans

Examples: Discount Interest

On a 1-year P100,000 loan with a 12% (nominal) rate, the discount basis, the
effective annual rate is:

If the loan had a term of less than 1 year, like 90 days, the effective annual rate would be
calculated as follows:

= 66.71%

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 Cost of Bank Loans

Examples: Add-on Interest

Determine the effective interest rate on a P100,000 loan on an add-on basis at a
nominal rate of 12% payable in 12 monthly installments.
a. Approximate annual interest rate:

B. Effective Annual Interest Rate is obtained as followed:

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 Cost of Bank Loans

Examples: Add-on Interest

Using the PV of an annuity of P1 table, n = 12, the effective interest rate ill fall between 1 to 2% per
period.
Effective interest
Rate per period

Effective annual interest rate –1

12

= 23.8%

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 Cost of Bank Loans

Examples: Simple Interest with Compensating Balance

Assume that the banks offers to lend the company P100,000 for 1 year at 12%
simple rate but the company must maintain a compensating balance equal to 10%
of the loan amount. What is the effective annual rate of the loan?

Solution

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 Cost of Bank Loans

Examples: Discount Interest with Compensating Balance

Assume that the banks offers to lend the company P100,000 for 1 year at 12%
simple rate but the company must maintain a compensating balance equal to 10%
of the loan amount. What is the effective annual rate of the loan?

Solution

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 Cost of Commercial Paper

Formula Used:

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 Cost of Commercial Paper

Illustrative Problem:
The Pepcoke Company uses commercial paper regularly to support its needs for
short-term financing. The firm plans to sell P100 Million 270-day-maturity paper on
which it expects to have to pay discounted interest at an annual rate of 12 percent
per annum. In addition, Pepcoke expects to incur a cost of approximately P100,000
in a dealer placement fees and other expenses of issuing the paper. What is the
effective cost of credit of Pepcoke?

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 Cost of Commercial Paper

Solution:

= 13.35%

= P9 million

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 Short-term funds can be obtained either unsecured
credit or secured loas. They are either spontaneous
or negotiated.

Sources of Unsecured Credit includes all those sources that

have as their security only the lender’s faith in the
Short – Term ability of the borrower to repay the funds when
due. This is an obligation without specific assets
Funds pledged as collateral.
Collateral – the asset that the borrower pledges to
a lender until a loan is repaid.

Secured loans involve the pledge of specific assets

as collateral in the event the borrower defaults in
payment of principal or interest.

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Finances for Financing Current Assets
 Spontaneous Short-Term Financing versus
Nonspontaneous /Negotiated Short-term Financing

Spontaneous source of short-term financing are sources that arise automatically

from ordinary business transaction. They do not require special effort or negotiation
o the part of the finance officer. Spontaneously generated funds will be provided by
accounts payable and accruals.

Nonspontaneous/negotiated short-term financing are sources that require special

effort or negotiation. The major source of negotiated short-term credit effort or
negotiation. The major sources of negotiate short-term credit are bank loans,
commercial paper and accounts receivable/inventory loan.

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 Sources of Short-Term Funds

Accruals
These sources of financing arise spontaneously with the firm’s sales. These accrued
expense items provide the firm with automatic spontaneous sources of financing.

Trade Credit
Trade credit provides one of the most flexible sources of financing available to the
firm. It is also a primary source of spontaneous financing because it arises from
ordinary business transactions. The major advantage of trade credit lies in its rather
quick availability.

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 Sources of Short-Term Funds

Short-Term Bank Loans

Commercial banks are second in importance to trade credit as a source of short-
term financing. Banks provide nonspontaneous funds. As a firm’s financing needs
increase, it requests additional funds from banks.
When a bank loan is approved, the agreement is executed by signing a promissory
note. The note specifies the
1. Amount borrowed,
2. Percentage interest rage,
3. Repayment schedule, any collateral that might have to be put up as security for
the loan, and
4. Any other terms and conditions to which the bank and the borrower may have
agreed.
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 Sources of Short-Term Funds

Line of Credit
If the firms does not withs to borrow until the working capital is actually required, it
amy arrange a credit arrangement with a large commercial ban. These
arrangements often take either of the two forms:

1. The line of credit which is generally an informal arrangement in which a bank

agrees to lend up to maximum amount of funds during a designated period.
2. Revolving credit agreement which is a legal commitment by the bank to extend
credit up to some maximum amount for a few months or several years.

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 Sources of Short-Term Funds

Commercial Paper
This is an unsecured short-term promissory note sold in the money market
by highly credit-worthy firms. Approval of the SEC is necessary before such
promissory notes can be issued. Commercial paper costs lower than most bank
loans and are not subject to the possibly restrictive covenants contained in many
bank loans. Some potential disadvantages of commercial paper relative to trade
credit are:
1. The fixed maturity date which raises the liquidity risk, and
2. Its lack of user availability except for very large firms.

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 Sources of Short-Term Funds

Secured sources of short-term credit have certain assets of the firm pledged as
collateral to secure the loan. Short-term Financing is obtainable through:

1. Pledging or assignment of accounts receivable

2. Factoring of accounts receivable
3. Inventory loans with
a. Floating or blanket lien
b. Chattel mortgage
c. Field warehouse financing agreement
d. Terminal warehouse receipt

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 Pledging or Assignment of Accounts Receivable

Under the pledging arrangement the borrower simply pledges or assigns accounts
receivables as security for a loan obtain from either a commercial bank or a finance
company. If the lender has no control on the pledged accounts receivable, the
loanable value is set to 75% or lower. However, if the lender could assess the
creditworthiness of each individual account, the loan value might reach 85% to 90%
of the face value.

Cost of Financing
A disadvantage associated with this method of financing is its relatively high cost
owing to the interest rate charged on loans which is 2% to 5% higher than the
bank’s prime rate and processing or handling fee of about 1% to 2% on pledged
accounts.
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 Pledging or Assignment of Accounts Receivable

Illustrative Problem:
The XYZ company sells plumbing supplies to building contractors on terms of net
60. the firm’s average monthly sales are P200,000; thus its average account
receivable is P400,000, based on the two months credit period. The company
pledges all its receivable to a local bank, which in turn advances up to 70% of the
receivables at 3% over prime and with a 1% processing charge on all receivables
pledged. XYZ company follows a practice of borrowing the maximum amount
possible. The current prime rate is 12%.

What is the effective cost of using this source of financing for a full year?

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 Pledging or Assignment of Accounts Receivable

Solution

= 23.57%

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 Factoring Accounts Receivable

Factoring receivables involves the outright sale of the firm’s accounts receivables to
the finance company.

Cost of Financing
For assuming the risk, the factoring firm is generally charged a fee or commission
ranging from 1% to 3% of the invoices accepted. In addition, it charges interest on
funds advanced to the seller of the accounts.

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 Factoring Accounts Receivable

Example
If P200,000 in receivable s factored which carry 30 day credit terms, a 1% factor’s
fee, a 6% reserve, an interest at 1% per month on advances, then the proceeds the
firm can receive is computed as follows:

Face Amount of Receivables Factored P200,000

Less: Fee (1% x P200,000) (2,000)
Reserve (6% x P200,000) (12,000)
Interest (1% x P200,000) (2,000)
Net Proceeds P184,000

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 Factoring Accounts Receivable

Example

= 26.09%

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 Inventory Financing

A firm may also borrow against inventory to acquire funds. The extent to which
inventory financing may be employed is based on the marketability of the pledged
goods, their associated price stability, and the perishability of the product.

Some of the typical arrangements by which inventory can be used to secure short-
term financing are:

1. Blanket inventory lien – this gives the lender a general lien or claim against the
inventory of the borrower.
2. Trust receipts/ Chattel mortgage agreement – it is an instrument acknowledging
that the borrower golds the inventory and proceeds from sales in trust for the
lender.
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 Inventory Financing

3. Warehousing – under this arrangement goods are physically identified,

segregated and stored under the direction of an independent warehousing. The
warehousing firm issues a receipt for the merchandise which carries the title to the
goods represented therein. The receipt may be negotiable where the title can be
transferred and nonnegotiable if the title remains with the lender.

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 Inventory Financing

Illustrative Problem:

The EBC International Product follows a practice of obtaining short-term credit

based on its seasonal finished goods inventory. The firm builds up to its inventories
of furniture and other household fixtures from July to October for sale in November
and December. Thus, for the two-month period ended October, it uses the
production of furniture as collateral for a short-term bank loan. The bank lends up
to 70% of the value of the inventory at 14% interest plus a fixed fee of P2,000 to
cover the costs of field warehousing agreement. During this period, the firm usually
has about P200,000 in inventories, which are used as collateral for the loan.

What is the effective annual cost of the short-term credit?

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 Inventory Financing

Solution

= 22.57%

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 Thanks for
Listening

Members:
Fatimay Bernardo
Krztel Evangelista
Shamier Buklasan
John Paul Mendoza
John Ace Garcia
Abubakar Wahab
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