Basic Credit Management
Basic Credit Management
Companies sell goods or services either for cash or on credit. Sale on credit is used as a way of generating increase in sales volumes by the provision of goods or services with delayed payment. In the books of the seller credit sales are recorded as accounts receivable while in the books of the buyer, it is recorded as accounts payable. This form of credit is an important form of short-term financing; once the terms of sale are agreed, the volume of credit increases with the level of activity and has no explicit cost (i.e. no interest charge).
The costs associated with delayed payment are the cost of seeking alternative sources of cash due to the delay in receipt of cash from the sale, and the probability that payment will not be made The credit policy of a company must therefore be a trade-off between the benefits of increased sales income and the costs of granting the credit.
The objective of credit management can be described as: “Not to minimize credit loss but to maximize profits”. At the point of agreeing a sale on credit, the seller assumes that he will collect full payment on the due date; this assumption is flawed if no steps have been put in place to try and minimize the granting of a bad debt. It is important that these steps are instituted and followed before the credit is granted.
To facilitate basic management of credit, the following procedures must be instituted for the extension and collection of credit:
Establish terms of sale
In this process, The Company defines how it intends to sell its goods or services. If sale will be made on credit, the terms of sale defined include, the due date of payment (i.e. the length of the period of credit), the discount available and the discount period. In making these decisions, factors such as the industry standards, cost of funds, nature of product and competition should be considered.
Decide the form of contract
All sales must be evidenced by a form of contract which documents the nature of the transaction. The type of credit instrument should be specified. The simple form of credit sale contract exists whereby the sale is recorded and evidenced with a receipt (commonly known as sale on ‘open account’). Another form contract, evidencing credit sales is the letters of credit.
Assess customer’s credit worthiness
In performing a credit analysis to assess the customer’s credit worthiness, the minimum requirements that should be determined are the following:
1. Availability and adequacy of assets to as Collateral (i.e. physical security against the obligation)
2. Capacity to repay; assessment of the ‘health’ of the business (Financial Statement analysis and review). This involves the preparation and interpretation of ratios, and performing other comparisons in order to determine the ability to repay out of operating cash flows.
3. Determination of the credibility of the Character of the management of the business in order to establish the good intention to make payment when due.
4. Sufficiency of the customers financial Capital (reserves)
5. General environmental Condition in which the business is operating (economic, political, industry trend)
Sources of information to assist in assessing creditworthiness include Financial Statements, Industry ratings and reports, External References e.g. from bankers, suppliers, customers
Set credit limits
The maximum amount of credit that can be granted must be determined so as to ensure that issues such as the cash flow and cost of funds of the business are optimized.
Establish a credit collection policy
The company has the problem of collecting the proceeds of the credit sale. To facilitate this process, a collection policy should be established. The company must be able to monitor outstanding payments to ensure that payments are made as agreed. Procedures and responsibilities must be set and communicated to the appointed staff in the credit department.
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