Credit Management

10 October 2016

Controlling the accounts receivables process demands the development of policies that are compatible with an enterprises profits, liquidity and market share. Since the accounts receivables policy has a broad impact, it must be managed carefully and assessed frequently. Accounts receivables policy development is subject to internal and external business constraints and requires careful evaluation of the policies potential impact on sales volume, cash management objectives and procedures, direct and indirect cost of receivables management and customer relations.

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Once an account receivables policy is implemented, it should be reassessed at least annually, since policy changes could be required to adjust for changing internal and external conditions, such as changing business objectives, varying competitive industry standards, fluctuating interest and foreign exchange rates, inflation, rapidly increasing credit volume, technological advances and globe trade pattern trends. Receivable is a permanent investment and is an ever-rolling account. The finance manager has to determine the level of this account suitable so that there will be an easy flow of working capital.

The management should see that debtors turn fast. If the debtors’ turnover velocity is high then the firm can minimize borrowings for working capital. Accounts receivable management is a decision making process, which takes into account the creation of debtors, and minimizing the cost of borrowings of working capital due to locking of funds in account receivables. Impact of receivables management on business Financial Impact: • Improved return on receivables. • Increased cash flow. • Generates investment opportunities. • Increase collection of effectiveness. • Reduce receivable delinquencies. Reduced operation costs. • Reduce administration costs. • Early intervention turns marginal accounts into profitable accounts. • Customized receivables service based on invoice amount. • Productivity gain. Strategic Impact (Long Term) • Focus on core business. • Better use of internal revenue. • Best in class capabilities utilized. Tactical Impact (Short Term) • Reducing/controlling operating cost. • Reallocation of capital funds. • Tapping into new resources. Receivables management flow chart Order processing Order confirmation Billing and dispatch Consolidation of sales data

An enterprises credit policy is a major, controllable element that has a significant influence on sales demand and profits. The many factors that comprise credit policy should be analyzed before the decision is made whether or not to offer credit or to make changes to current policy. Foctors that could constrain or influence credit policy include: ability to finance the credit policy. Costs of financing receivables by means of internal or external credit facilities should be estimated to determine which approach is feasible for the enterprise.

The development of the enterprises credit policy requires that specific decisions be made regarding several variables that establish the terms of sale and the acceptable level of credit risk. The variables are: • Credit standards • Credit period • Credit terms • Cash discount and surcharges • Credit limits • Credit instruments • Payment methods When implementing or varying the credit policy by changing any one, or all, of the above variables, management must assess the impact on net income, calculate the probability of achieving the planned results, and determine the additional level of risk assumed.

In particular, any relaxation of credit policy should be considered only after very careful evaluation of the impact of the change by top management, because it is extremely difficult to revert to more stringent policies without experiencing adverse effects on customer relations and sales. `Credit Standards A firm has a wide range of choice in choosing the credit standards. A firm has to decide what standard should be applied in accepting or rejecting an account for credit granting. At one end of the spectrum it may decide not to extend credit to any customer, however strong his credit rating may be.

At other end it may decide to grant credit to all customers irrespective of their credit rating. Between these two extreme positions lie several possibilities, often the more practical ones. This gives ample scope for the Credit manager/ Finance manager to play a critical role. In general liberal credit standards tend to push sales up by attracting more customers. This is, however accompanied by a higher incidence of bad debt loss, a large investment in receivables and a higher cost of collection. Stiff credit standards have the opposite effect.

They tend to depress sales, reduce the incidence of bad debt losses, decrease the investment in receivables and lower the collection cost. Credit Period The credit period is the length of time credit is granted (for example, from invoice date to due date), and is normally established according to an industry standard. The credit period has direct impact on the cost of financing receivables and on collection risk. An enterprise may elect to deviate from the industry standards for one or more reasons: to obtain a competitive advantage, to reflect the enterprises classification of customer quality, or to longer-term economic or business changes.

The date when payment is deemed to be received should be defined. It may be based on the envelope postmark date, the remittance processing date, or the date funds are received. Customers should be clearly advised of the payment receipt date. Credit Terms Credit terms are normally specified on the contractual documents, or on the customer invoice or statement. Frequently used payment terms include the following: cash before delivery (CBD) or Cash on delivery (COD) may be required when the buyer has been classified as a poor credit risk.

In case of an unknown or one-time buyer, credit cheque may be required when the order is placed, or before the goods or services are delivered. Cash terms permit the buyer a payment period of about 5 to 10 days and maybe used for high turnover or perishable goods. Invoice terms often a net due date and a discount due date that maybe calculated from various starting dates such as the invoice, delivery or client acceptance dates. The term maybe quoted, for example, as 2/10, net 30 meaning a payment discount of 2% is given if the invoice is paid within 10 days.

Full payment is required after 10 days but within 30 days. Periodic statements are normally issued monthly. The statement terms may be similar to invoice terms and include discounts and interest charges for late payment. All invoice transactions are listed up to a cut-off date and payment is due by a specified date in the following period. Credit discounts and surcharges Cash discount policies may be established for a number of reasons: to conform to the industry norm, to stimulate sales, or to expedite receipt of cash.

To be an effective collection tool, the discount rate must be established at a rate of interest higher than that at which the customer is able to borrow. Consideration should be given to the implications of customers taking a discount to which they are not entitled. A surcharge, or late payment charge, can be used to encourage prompt payment and to equalize treatment for customers who pay on time versus those who delay payment. Credit Limit Credit limit categories should be established to codify the total credit that may be granted to customers in each credit quality classification.

To ensure that credit limits remain appropriate, given business or other major changes, they should be regularly reviewed. Periodic credit worthiness reassessment can be simplified by automatically reassigning customers to a higher credit limit level after a specified period of satisfactory payment experience. Credit factors, assigned by the credit grantor and weighted by relative importance, can be used to calculate a single numerical value that could be used to assign distinctive credit limits and payment periods to different customers.

The credit score must always be tempered by informed management judgment because the accept-reject decision implicitly includes economic trade-offs: to minimize rejection of an acceptable credit customer (with loss of future business) versus to accept a poor credit risk (and resulting debt losses). Credit Instruments Credit instruments are written payment contracts agreed to by the enterprise and its customers. Instruments range from simple invoices to formal credit arrangements that are selected to reduce credit risk. When selecting an instrument to be used, the enterprise should consider industry standards, market norms and buyer risks.

The enterprise may choose different instruments at different times depending on the product or services sold, the customers geographical location, or customer quality classification. The ability to use different instruments provides flexibility when dealing with significant or sensitive customers and orders. Compliance with relevant consumer protection legislation may require detailed disclosure to the buyer of credit instrument terms. The following are the 4 major credit instrument: 1. Open Account 2. Promissory notes 3. Conditional sales contracts 4. ocumentary credits Payment Methods The management of the enterprise selling the goods or services should advice its customers of acceptable payment methods, including advance payments, cash, cheque, credit card or electronic fund transfer. The implications associated with each method should be assessed carefully before determining which payment vehicles to allow. For example, electronic funds transfer (EFT) speeds cash flow and reduces collection risk because funds are immediately withdrawn from the customers account and credited to the seller account.

However, there are initial development and on-going operational costs, and some enterprises may not find this process cost effective. Factors to consider when determining possible payment methods are: provisions of the Federal Currency Act concerning legal tender; standard trade practices; cost of processing; cash flow implications and impact on collection risk. Currency hedging may be a major factor for industries involved in foreign transactions, and the policy related to hedging should be in writing. CREDIT ANALYSIS Besides establishing credit standards, a firm should develop procedures for valuating credit applicants.

The second aspect of credit policies of the firm is credit analysis and investigation. Two basic steps are involved in the credit investigation process. a) Obtaining credit information. b) Analysis of credit information. It is on the basis of credit analysis that the decisions to grant credit to a customer as well as the quantum of credit would be taken Obtaining credit information The first step in credit analysis is obtaining credit information on which to base the evolution of the customer the sources of information, broadly peaking are: • Internal •

External Internal Usually firms require their customer to fill various forms and documents giving the details of the financial operations. They are also required to furnish trade references with which firms can have contacts to judge the suitability of the customer for credit. This type of information is obtained from internal sources of credit information another internal sources of credit information is derived from the records of the firm’s contemplating an extension of credit facility . t is likely that a particular customer or applicant may have enjoyed credit facility in the past in the case that firm would have information on the behavior of the applicants in terms of the historical payment pattern this type of information may not be adequate and may therefore have to be supplemented by information from other sources. External The availability of the information from the external sources to assess the credit worthiness of the customers depends on the development of the institutional facilities and industry practices. n India, the external sources of credit information have not as developed as in the industrially advanced countries of the world. Depending upon the availability of the following external sources may be employed to collect the information. Financial Statements The external sources of credit information is the published financial statement that is the balance sheet and the profit and loss account. The financial statement contains very useful information they throw light on an applicants financial viability, liquidity profitability and debt capacity.

Although the financial statement do not directly reveal the past payment period of the applicant they are very helpful in assessing the overall financial position of a firm which is significantly determines its credit standings. Bank References Another useful source of credit information are the banks of the firm, which is contemplating the extension of credit the modus operadi here, is that the firm’s banker collects the necessary information from the applicant’s bank. Alternatively, the applicant may be required to ask his banker to provide necessary information either directly to the firm or to its bank.

Trade References These refer to the collection of information from firms with whom the applicant has dealings and who on their experience would vouch for the applicant. Credit Bureau Reports Finally, specialists credit bureau from organizations specializing in supplying credit information can also be utilized. Analysis of Credit Information Once the information has been collected from different sources, it should be analysed to determine the credit worthiness of the applicant. Although there are no established procedures to analyse the information, the firm should device one to suit its needs.

The analysis should cover two aspects: a) Quantitative b) Qualitative Quantitative The assessment of the quantitative aspect is based on the factual information available from the financial statements, the past records of the firm, and so on. The first step involved in this type of assessment is to prepare an ageing schedule of the accounts payable of the applicant as well as calculate the average age of the accounts payable. This exercise will give an insight into the past payment pattern of the customer.

Another step in analyzing the credit information is through a ratio analysis of the liquidity, profitability and debt capacity of the applicant. These ratios should be compared with the industry average; moreover, rend analysis over a period of time would reveal the financial strength of the customer. Qualitative The qualitative assessment should be supplemented by a qualitative/subjective interpretation of the applicant credit worthiness. The subjective judgment would cover aspects relating to the quality of management.

Here, the reference from other suppliers, bank references and specialist bureau reports would form the basis for the conclusions to be drawn. In the ultimate analysis, therefore, the decision whether to extend credit to the applicant and what amount to extend will depend upon the subjective interpretation of this credit standing. COSTS The major categories of costs associated with the extension of credit on accounts receivable are: 1) Collection cost 2) Capital cost 3) Delinquency cost 4) Default cost Collection Cost

Collection costs are administrative costs incurred in collecting the receivables from the customers to whom credit sales have been made. Included in the category of costs are (i) additional expenses on the creation and maintenance of a credit department with staff, accounting records, stationary, postage and other related items; (ii) expenses involved in acquiring credit information either through outside specialist agencies or by the staff of the firm itself. These expenses would not be incurred if they do not sell on credit.

Capital Cost The increased level of accounts receivable is an investment in assets, they have to be financed thereby involving a cost. There is a time lag between the sale of goods to, and payment by, the customers. Meanwhile, the firm has to pay employees and suppliers of raw materials, thereby implying that the firm should arrange for additional capital to support credit sales, which alternatively could be profitability employed elsewhere, is, therefore, a part of the cost of extending credit or receivables. Delinquency cost

This cost arises out of the failure of the customers to meet their obligations when payment on credit sales becomes due after the expiry of the credit period. Such costs are called delinquency cost. The important components of this cast are: 1) Blocking up of funds for an extended period. 2) Cost associated with steps that have to be initiated to collect the over dues, such as, reminders and other collection efforts, legal charges, where necessary, and so on. Default Cost Finally, the firm may not be able to recover the over dues because of the inability of the customers.

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