24.3: Inventory

Question 1

What is the trade-off involved in a firm’s decision about the level of inventory it will hold?

Answer 1

The trade-off involves balancing the benefits of holding inventory (such as minimizing disruptions in production and reducing lost sales) against the costs (including financing, storage, handling, insurance, spoilage, and obsolescence).

Question 2

What are the main benefits of holding inventory?

Answer 2

The main benefits include minimizing disruptions in the production process by ensuring sufficient levels of raw materials and maintaining adequate levels of finished goods to reduce lost sales and maintain customer goodwill.

Question 3

What are the costs associated with holding inventory?

Answer 3

Costs include financing, storage, handling, insurance, spoilage, and the risk of obsolescence.

These costs make inventory decisions critical to a firm’s performance.

Question 4

What is the ABC approach to inventory management?

Answer 4

The ABC approach divides inventory into categories based on

the value of the inventory items,

their overall level of importance to the firm’s operations,

and profitability.

Higher priority items receive more attention in their management.

Question 5

What does the Economic Order Quantity (EOQ) model determine?

Answer 5

The EOQ model determines the optimal inventory level that minimizes the total of shortage costs and carrying costs by balancing the benefits (e.g., reduced shortage costs) against the carrying costs (e.g., financing, storage, insurance, spoilage, obsolescence).

Question 6

What are the key assumptions of the EOQ model?

Answer 6

The EOQ model assumes that demand is uniform throughout the year, carrying costs are constant, and ordering costs are constant.

Additional costs and benefits, such as safety stock and delayed shipments, must be accounted for in the analysis.

Question 7

What is Materials Requirement Planning (MRP)?

Answer 7

MRP is a computerized system that orders inventory in conjunction with production schedules.

It determines the exact level of raw materials and work-in-process that must be on hand to meet finished-goods demand.

Question 8

What is Just-In-Time (JIT) inventory system?

Answer 8

JIT inventory systems fine-tune the receipt of raw materials so they arrive exactly when required in the production process, reducing inventory to its lowest possible level.

It requires close relationships with suppliers.

Question 9

Why is inventory management critical to a firm’s performance?

Answer 9

Inventory management is critical because it directly impacts the firm’s production process, cost management, and ability to meet projected sales levels.

Question 10

Why is inventory management critical to the success of most firms?

Answer 10

Inventory management is critical because it directly impacts a firm’s ability to control costs and meet production and sales demands. Poor inventory management can lead to high financing, storage, spoilage, and insurance costs, as well as increased risk of obsolescence.

Question 11

What are the two ratios commonly used to evaluate inventory management?

Answer 11

The two commonly used ratios are the inventory turnover ratio and the average days in inventory ratio.

High inventory turnover is generally seen as a positive indicator, while low or declining turnover can signal problems.

Question 12

What does a declining inventory turnover ratio indicate?

Answer 12

A declining inventory turnover ratio suggests that sales are declining, inventory levels are accumulating, or both.

This increases financing, storage, spoilage, and insurance costs, and heightens the risk of obsolescence.

Question 13

What are some limitations of the inventory turnover ratio?

Answer 13

The inventory turnover ratio does not account for shortage costs, financing costs, or the differences in inventory accounting methods (e.g., FIFO, average cost).

It also does not provide insight into the breakdown of inventory in terms of raw materials, work-in-process, and finished goods.

Question 14

What is the importance of considering inventory breakdown in evaluating inventory management?

Answer 14

The breakdown of inventory into raw materials, work-in-process, and finished goods is crucial for accurately determining the market value of inventory and understanding the different costs and benefits associated with each type.

Question 15

Identify the costs and benefits of holding inventory.

Answer 15

Costs: Financing, storage, handling, insurance, spoilage, and obsolescence.

Benefits: Minimizes disruptions in production, reduces lost sales, and maintains customer goodwill.

Question 16

What are the drawbacks to using the turnover ratio to measure inventory policy?

Answer 16

The turnover ratio does not measure shortage or financing costs, cannot be compared across companies using different inventory accounting methods, and fails to provide details on the inventory breakdown, which can affect the market value of inventory.

Question 17

What are the major sources of short-term financing?

Answer 17

Major sources of short-term financing include trade credit, bank loans, commercial paper, and lines of credit.

These sources help firms manage their cash flow and meet immediate financial obligations.

Question 18

Why is it important for firms to forecast their short-term financing needs accurately?

Answer 18

Accurate forecasting of short-term financing needs is critical because it ensures that firms have adequate financing in place to meet increased sales demands and other short-term obligations, preventing liquidity issues.

Question 19

What is the formula to estimate the annual effective rate of return or cost (k) associated with short-term financing?

Answer 19

The formula is:

k = ((1 + (n-day financing cost / Purchase price))^(365/n)) - 1

Question 20

What is trade credit, and why is it a common source of short-term financing?

Answer 20

Trade credit is a short-term financing method where firms delay payments to their suppliers.

It is common because it automatically increases with sales, is usually inexpensive, does not require restrictive covenants, and is flexible.

Question 21

What are the potential costs associated with trade credit?

Answer 21

While trade credit is generally inexpensive, it can become costly if the firm forgoes discounts offered for early payments, as demonstrated by the effective annual cost calculation.

Question 22

What is the effective annual cost of forgoing a discount on trade credit?

Answer 22

The effective annual cost is calculated using the formula:

k = ((1 + (n-day financing cost / Purchase price))^(365/n)) - 1

For example, if the n-day financing cost is $24, and the purchase price is $1,176, the effective annual cost would be approximately 27.86%.

Question 23

What lesson is learned from the trade credit and financing example?

Answer 23

The lesson is that having access to credit is vital for firms to manage their cash flow efficiently and take advantage of discounts. It also highlights the importance of maintaining a strong balance sheet to finance sales when other sources of finance are unavailable.

Question 24

What are the typical short-term loan arrangements available through financial institutions?

Answer 24

Short-term loan arrangements include variable rate or prime-based loans linked to the firm’s current account (chequing account).

These loans enable businesses to borrow up to a predetermined amount to finance temporary cash deficits, with the ability to make “interest only” payments.

Question 25

What is an operating loan, and how is it typically secured?

Answer 25

An operating loan is a line of credit secured by accounts receivable and inventory, typically allowing firms to borrow up to 70-75% of their good accounts receivable under 90 days and up to 50% of their inventory value.

Question 26

What are the advantages of operating loans for firms?

Answer 26

Operating loans offer flexibility, low costs, and the opportunity to develop solid banking relationships.

They are crucial for managing short-term financing needs without arranging unnecessary borrowing capacity.

Question 27

How do you calculate the effective annual cost of a bank loan with a variable interest rate?

Answer 27

The effective annual cost k can be calculated using the formula:

k = (1 + (Quoted rate / m))^m - 1

Where m is the number of compounding periods per year.

For example, with a quoted rate of 3.85% compounded monthly:

k = (1 + (0.0385 / 12))^12 - 1 = 3.92%

Question 28

How do you calculate the effective annual cost of an operating line of credit?

Answer 28

The effective annual cost k can be calculated by estimating the total costs, including interest and commitment fees, and then dividing by the average net financing for the year:

Average net financing = (7/12 * $600,000) + (5/12 * $400,000) = $516,667

k = (1 + (Total Costs / Average Net Financing)) - 1

For example, with total costs of $42,833.54:

k = (1 + (42,833.54 / 516,667)) - 1 = 8.29%

Question 29

What is a factor arrangement, and how does it work?

Answer 29

A factor arrangement involves an independent company (the factor) that acts as an outside credit department for its clients, handling credit checks, collections, and sometimes purchasing a firm’s receivables at a discount.

The factor typically charges fees for these services, which can include a commission and interest on any advances provided.

Question 30

What are money market instruments, and which types are commonly used?

Answer 30

Money market instruments are short-term debt instruments used by firms to obtain short-term financing.

The two major types are Commercial Paper (CP) and Bankers’ Acceptances (BAs), both of which are typically issued at a discount and have common maturity dates of 30, 60, and 90 days.

Question 31

How do you calculate the approximate annual yield for CP and BAs?

Answer 31

Approximate annual yield = (Discount / Market price) * (365 / Days to maturity)

For example:

Approximate annual yield = ($0.10 million / $9.90 million) * (365 / 90) = 0.0410 or 4.10%

Question 32

What is securitization?

Answer 32

Securitization is the process of packaging loans and/or receivables together to create new securities that can be sold to investors, often through an SPV, to avoid showing the loans or receivables on the company’s balance sheet.

Question 33

Why are credit enhancements necessary in securitization?

Answer 33

Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance, or other agreements.

They are often necessary to improve the credit quality of the underlying assets to obtain an investment-grade rating.

Question 34

What are some forms of credit enhancements?

Answer 34

The seller may absorb a percentage of the losses, often referred to as over-collateralization.

A third party, such as a major bank, may absorb a portion of the losses.
Subordinated debt may be issued by the seller to absorb further defaults.

Different classes of securities may be created to allocate prepayment risks.

Question 35

What is prepayment in the context of securitization?

Answer 35

Prepayment is the payment of a debt before its due date.

In securitization, this risk is often allocated to different classes of securities, especially in mortgage SPVs.

Question 36

How does the Canadian market view securitization?

Answer 36

Securitization has been an important part of the Canadian financial landscape for more than two decades, with significant activity in credit card receivables and auto-related loans.

As of March 2019, the market totaled nearly $96 billion.

Question 37

What is the cost of 3/15 net 60 trade credit?

Answer 37

The cost can be calculated using the formula for the effective annual cost, which compares the cost of forgoing the discount to the cost of taking the credit terms.

The specifics would depend on the amount and terms provided.

Question 38

What is the difference between a bank operating line of credit and a traditional loan?

Answer 38

A bank operating line of credit is typically used for short-term financing needs, allowing the firm to draw funds as needed up to a limit, whereas a traditional loan provides a lump sum that is repaid over a fixed schedule.

Question 39

What additional services does a factor provide over a bank?

Answer 39

Factors may offer services like credit checks on customers, handling collections, and providing immediate cash advances on receivables, often at a higher cost compared to traditional bank services.

Question 40

What is the difference between a BA and commercial paper?

Answer 40

Commercial paper is unsecured short-term debt issued by companies with high credit ratings, while Bankers’ Acceptances are short-term debt instruments guaranteed by a bank, making them more secure but often more expensive.

Question 41

Why do securitizations require credit enhancements?

Answer 41

Credit enhancements are required to improve the credit quality of the securitized assets, often necessary to achieve an investment-grade rating, which makes the securities more attractive to investors.