UNIT 5
CREDIT MANAGEMENT
Every country has to undergo from the continuous process of development. Banks play a vital role in this process. The Indian banking system has progressed as a powerful mechanism of planning for economic growth. Banks channelize savings to investments and consumption. Through that, the investment requirements of savers are reconciled with the credit needs of investors and consumers.
Out of all principal roles of the banks, lending is the most important role in which banks provide working capital to commerce and industry. Importance of credit is not only because of its social obligation to cater the credit needs of different sections of the community but also because lending is the most profitable activity, as the interest rates realized on business loans have always been well above those realized on investments. Credit being the principal source of income for banks and usually represents one of the principal assets of the banks so its proper management becomes all the more necessary. The extension of credit on sound basis is therefore very essential to the growth and prosperity of a bank. With the increasing role of commercial banking in capital formation, employment generation and production facilitation, the credit operations of commercial banks are expected to be in harmony with the requirements of the economic system.
Till today, banks are the major suppliers of working capital to the trade and industry and they have privilege of having massive lending facilities produced by the banks. Hence, the management of bank credit operations is required to be more creative than the traditional approach followed by it earlier.
Lending activities of banks have surround effect on the economy. For overall development of economy, all the sectors of economy should be grown and developed equally. Credit management serves the concept of credit deployment that bank should observe that overall bank credit should be deployed in such a way that every segment of an economy and system of nation get benefited. This is the one aspect of credit management. On the other hand, if lending activity becomes fail, it adversely affects the whole economy. In last decade, banks have realized that an increase in retail credit increased the credit riskalso.Successofbankliesonprofitabilityandliquidityandthatcome majority from successful lending activity. So an examination of some of the important aspects of credit management of Indian banks would provide an insight into the credit/ lending activity of commercial bank.
The word “credit‟ has been derived from the Latin word “credo‟ which means “I believe‟ or “I trust‟, which signifies a trust or confidence reposed in another person. The term credit means, reposing trust or confidence in somebody. In economics, it is interpreted to mean, in the same sense, trusting in the solvency of a person or making a payment to a person to receive it back after some time or lending of money and receiving of deposits etc.
In other words, the meaning of credit can be explained as,
A contractual agreement in which, a borrower receives something of value now and agrees to repay the lender at some later date.
The borrowing capacity provided to an individual by the banking system, in the form of credit or a loan. The total bank credit the individual has is the sum of the borrowing capacity each lender bank provides to the individual.
1. Prof. Kinley:
“By credit, we mean the power which one person has to induce another to put economic goods at his deposal for a time on promise or future payment. Credit is thus an attribute of power of the borrower.”
2. Prof. Gide:
“It is an exchange which is complete after the expiry of a certain period of time”.
3. Prof. Cole:
“Credit is purchasing power not derived from income but created by financial institutions either as on offset to idle income held by depositors in the bank or as a net addition to the total amount or purchasing power.”
4. Prof. Thomas:
“The term credit is now applied to that belief in a man’s probability and solvency which will permit of his being entrusted with something of value belonging to another whether that something consists, of money, goods, services or even credit itself as and when one may entrust the use of his good name and reputation.”
On the basis of above definitions it can be said that credit is the exchange function in which, creditor gives some goods or money to the debtor with a belief that after sometime he will return it. In other words“Trust‟ is the “Credit‟.
5. Vasant Desai:
“To give or allow the use of temporarily on the condition that some or its equivalent will be returned.”
Some characteristics of credit are of prime importance while extending credit to an individual or to a business enterprise.
1. Confidence:
Confidence is very important for granting or extending any credit. The person or authority must have confidence on debtor.
2. Capacity:
Capacity of the borrower to repay the debt is also very crucial thing to be considered. Before granting or extending any advance, creditor should evaluate the borrower’s capacity.
3. Security:
Banks are the main source of credit. Before extending credit, bank ensures properly about the debtor’s security. The availability of credit depends upon property or assets possessed by the borrower.
4. Goodwill:
If the borrower has good reputation of repaying outstanding in time, borrower may be able to obtain credit without any difficulty.
5. Size of credit:
Generally small amount of credit is easily available than the larger one. Again it also depends on above factors.
6. Period of credit:
Normally, long term credit cannot easily be obtained because more risk elements are involved in its security and repayments.
Credit plays an important role in the gross earnings and net profit of commercial banks and promotes the economic development of the country. The basic function of credit provided by banks is to enable an individual and business enterprise to purchase goods or services ahead of their ability. Today, people use a bank loan for personal reasons of every kind and business venture too. The great benefit of credit with a bank is probably very low interest rates. Majority people feel comfortable lending with bank because of familiarity.
1. Exchange of ownership:
Credit system enables a debtor to use something which does not own completely. This way, debtor is provided with control as distinct from ownership of certain goods and services.
2. Employment encouragement:
With the help of bank credit, people can be encouraged to do some creative business work which helps increasing the volume of employment.
3. Increase consumption:
Credit increases the consumption of all types of goods. By that, large scale production may stimulate which leads to decrease cost of production which in turn also lowers the price of product which in result rising standard of living.
4. Saving encouragement:
Credit gives encouragement to the saving habit of the people because of the attraction of interest and dividend.
5. Capital formation:
Credit helps in capital formation by way that it makes available huge funds from able people to unable people to use some things. Credit makes possible the balanced development of different regions.
6. Development of entrepreneurs:
Credit helps in developing large scale enterprises and corporate business. It has also helped the different entrepreneurs to fight with difficult periods of financial crisis. Credit also helps the ordinary consumers to meet requirements even in the inability of payment. One can borrow money and grow business at a greater return on investment than the interest rates of loan.
7. Easy payment:
With the help of various credit instruments people can pay without much difficulty and botheration. Even the/ international payments have been facilitated very much.
8. Elasticity of monetary system:
Credit system provides elasticity to the monetary system of a country because it can be expanded without much difficulty. More currency can be issued providing for proportionate metallic reserves.
9. Priority sector development:
Credit helps in developing many priority sectors including agriculture. This has greatly helped in rising agriculture productivity and income of the farmers. Banks in developing countries are providing credit for development of SSI in rural areas and other priority sectors too.
Credit is a mixed consent. It involves certain advantages and some dangers also at the same time. Credit is useful as well as harmful to the user even. So it should be used very cautiously otherwise it may spoil all industries and enterprises. Credit, if not properly regulated and controlled it has its inherent dangers.
1. Encouragement of expenditure:
Credit encourages wasteful expenses by the individuals as well as commercial institutions. As people irresponsibly think that the money is not their own. Easy availability leads to over trading over exposure that ultimately leads to bad debts.
2. Encourage weakness:
Credit encourages big entrepreneurs to continue to hide their weakness. Their own shortcomings are met by the borrowed capital. Even the loosing concerns continue with the help of borrowed capital in the hope to survive. In this condition, if business fails, it not only leads the borrowers in dangers but also thousands of those people who advanced credit to such people.
3. Economic crisis:
In several occasions credit is directly responsible for economic crisis. It leads to recession and depression in an economy as boom of credit facilities has its own evil effect on the economy. Financially weak concern having credit facility takes the economy to weaker effects.
4. Dangers beyond limit:
Credit in a country expanded beyond certain limits which results in over investment. Over issue credit takes beyond safe limits that result in over investment, over production and rise of prices. This danger has been emphasized by Prof. Thomas in his “Elements of Economics‟, in his words: “There is no automatic limit to the expansion of a credit system as there is to an expansion of a metallic circulation through the intervention of human element. Uncertainty and variableness is the chief source of danger in a credit organization”.
5. Evil of monopoly:
Credit system has also resulted in the creation of monopolies; monopolistic exploitation is due to money placed at the disposal of individuals or companies that leads to monopolist exploitation. The different organizations have growth with the emergence of credit and have worked to the damage of both the consumers and the workers.
6. Encourage inefficient:
Credit gives encouragement to certain inefficient and worthless producers. Inefficient business concerns availing the credit and not using efficiently, accumulate money in their hands. People come into the market with the feeling that they have nothing to do but just to play only with other’s money.
So, by this it can be said that the government or the central banking authorities must keep the credit within limit so that no evil is allowed to crop up in the economy.
Credit Management refers to Accounts Receivable Management or Trade Receivables Management or Debtors Management. Accounts receivable represent the amount due from customers (book debts) or debtors as a result of selling goods on credit. “The term debtors is defined as ‘debt’ owned to the firm by customers arising from sale of goods or services in the ordinary course of business.” The three characteristics of receivables the element of risk, economic value and futurity explain the basis and the need for efficient management of receivables. The element of risk should be carefully analyzed. Cash sales are totally riskless but not the credit sales, as the same has yet to be received. To the buyer the economic value in goods and services process immediately at the time of sale, while the seller expects an equivalent value to be received later on. The cash payment for goods and services received by the buyer will be made by him in a future period. The customer from whom receivables or book debts have to be collected in future are called Trade debtor and represent the firm’s claim on assets.
Receivables management, also termed as credit management, deals with the formulation of credit policy, in terms of liberal or restrictive, concerning credit standard and credit period, the discount offered for early payment and the collection policy and procedures undertaken. It does so in such a way that taken together these policy variables determines an optimal level of investment in receivables where the return on that investment is maximum to the firm. The credit period extended by business firm usually ranges from 15 to 60 days. When goods are sold on credit, finished goods get converted into accounts receivable (trade debtors) in the books of the seller. In the books of the buyer, the obligation arising from credit purchase is represented as accounts payable (trade creditors). “Accounts receivable is the total of all credit extended by a firm to its customer.”
A firm’s investment in account receivable depends upon how much it sells on credit and how long it takes to collect receivable. Accounts receivable (or sundry debtors) constitute the 3rd most important assets category for business firm after plant and equipment and inventories and also constitute the 2nd most important current assets category for business firm after inventories.
Poor management of accounts receivables are neglect of various overdue account, sharp rise in the bad debt expense, and the collection of debts expense and taking the discount by customers even though they pay after the discount date and even after the net date. Since accounts receivable represent a sizable investment on the part of most firms in the case of public enterprises in India it forms 16 to 20 per cent of current assets. Efficient management of these accounts can provide considerable saving to the firm.
Factors involving in Receivable management:
- The terms of credit granted to customers deemed creditworthy.
- The policies and practices of the firm in determining which customers are to be granted credit.
- The paying practices of credit customers.
- The vigor of the sellers, collection policies and practice.
- The volume of credit sales.
The basic goal of credit management is to maximize the value of the firm by achieving a tradeoff between the liquidity (risk and profitability). The purpose of credit management is not to maximize sales, nor to minimize the risk of bad debt. If the objective were to maximize sales, then the firm would sell on credit to all. On the contrary, if minimization of bad debt risk were the aim, then the firm would not sell on credit to anyone. In fact, the firm should manage its credit in such a way that sales are expanded to an extent to which risk remains within an acceptable limit. Thus to achieve the goal of maximizing the value, the firm should manage its trade credit.
The efficient and effective credit management does help to expand sales and can prove to be an effective tool of marketing. It helps to retain old customers and win new customers. Well administrated credit means profitable credit accounts. The objectives of receivable management is to promote sales and profits until that point is reached where thereturn on investment is further funding of receivables is less than the cost of funds raised to finance that additional credit.
Granting of credit and its management involve costs. To maximize the value of the firm, these costs must be controlled. These thus include the credit administration expanses, b/d losses and opportunity costs of the funds tied up in receivable. The aim of credit management should be to regulate and control these costs, not to eliminate them altogether. The cost can be reduced to zero, if no credit is granted but the profit foregone on the expected volume of sales arising due to the extension of credit.
Debtors involve funds, which have an opportunity cost. Therefore, the investment in receivables or debtors should be optimized. Extending liberal credit pushes sales and thus results in higher profitability but the increasing investment in debtor’s results in increasing cost. Thus a tradeoff should be sought between cost and benefits to bring investment in debtors at an optimum level. Of course, the level of debtors, to a great extent is influenced by external factors such as industry norms, level of business activity, seasonal factors and the degree of completion. But there are a lot of internal factors include credit terms, standards, limits and collection procedures. The internal factors should be well administered to optimize the investment in debtors.
1. Terms of Sale
These are the payments terms that seller and the buyer have agreed on. Terms such as cost, amount, delivery, payment method, and when the payment is expected or due. These are also the essential components of any invoice.
In short, it’s the expectations between the buyer and seller so that there won’t be any potential misunderstandings nor disagreements because both parties clearly know what is expected and they are satisfied with the requirements.
Terms of sale are particularly important in international trade since it covers when shipping occurs, who is responsible for international duties and taxes, and any other factors that have been established by the international chamber of commerce regulations.
2. Payment in Advance
Payment in advance, PIA for short, is simply a payment that is made ahead of schedule. It’s not uncommon for business owners to require advance payments for their products or services. For example, a freelance graphic designer may need a 50% down payment before starting a project. Advances protect sellers against non-payments and to cover any out-of-pocket expenses.
3. Immediate Payment
This term, which is associated with “Cash on Delivery” (COD) or “Payable on Receipt,” means that a payment is due at the same time as a product or service is delivered. If the client doesn’t make the payment immediately — whether by credit card, e-check, wire transfer, or online service payment — the seller has the right to repossess the goods of intellectual property.
While this term is beneficial for the business owner since it speeds-up the payment process, it’s unpopular among some clients and customers since they’re afraid that they won’t have the cash to cover the bill.
4. Net 7, 10, 30, 60, 90
These imply that the net payment is due in either 7, 10, 30, 60, or 90 days after the invoice date. For example, if the invoice was dated June 10 and you used one of the most used payment terms, Net 30, then the payment would be expected before July 9.
Because this term can be confusing to both accounts payable teams and clients alike, it’s suggested that you use a term that is clearer, such as, “Days” instead of “Net.” Furthermore, to keep your cash flow positive, use shorter terms like, “Please make payment within 10 days.”
5. 2/10 Net 30
A term such as “Net 30” requires the client or customer to make a payment within 30 days. However, if they make a payment within ten days, they’ll receive a 2% discount. Of course, you can change these terms as you like. For example, you could sweeten the incentive by offering a 5% discount if the invoice is paid within a week.
To receive a greater response, however, rephrase this term so that it doesn’t confuse the client. A simple phrase like, “Please pay within 10 days and save 2 percent” will make the offer perfectly clear and concise.
6. Line of Credit Pay
This payment option gives the client the opportunity to settle their bills over a period of time — typically on a monthly or quarterly basis. In other words, it’s allowing the customer to purchase a product or service on credit. This is more commonly used among larger companies and not small-to-medium sized businesses because of the risk involved, as well as its ability to decrease your cash flow.
7. Quotes & Estimates
This is simply the purposed price for goods or services. This ballpark figure is commonly used when a client is comparing prices. While this isn’t the final amount that the seller going to bill the client, it should still include invoicing essentials like the price of products or service, an itemized breakdown of how the price determine, and a time schedule of when the final goods or services will be delivered. Most invoicing platforms allow businesses to painlessly convert their quote or estimate into an invoice.
8. Recurring Invoice
Recurring invoices are for ongoing services, such as landscaping or web hosting, and are typically for the same amount each month, like for a membership or subscription. Recurring invoices guarantee cash flow for business, makes forecasting a breeze, and saves time from having to invoice clients each month. This monthly payment erases some of the uncertainty and makes life easier.
9. Interest Invoice
What are the consequences when a client doesn’t pay the invoice on-time? One of the most common solutions is to charge interest or fees on the invoice. Remember, when calculating the interest on late payment, only charge for the number of days that the payment is past due.
For example, if you charge a 6% interest rate and the invoice for Rs.1,500 is 20 days late then you divide 20 by 365. Then multiply that result by .06 and finally multiply that figure by 1,500. The interest charge would come out to Rs.4.93 for the 20-day period.
With that in mind, an interest invoice is not only a reminder of a past due payment, it’s an invoice that contains the relevant interest charges and a payment date to settle the payment.
Resend these invoices every month and adjust the calculation so that will reflect the additional days past due.
10. Invoice Factoring
What if a client hasn’t paid for the invoice and seller is in desperate need of cash? Seller could consider invoice factoring.
This is where seller hands over customer’s invoice to an invoice factoring company. Seller will receive an 85% advance upfront in as little as one day. Keep in mind that these companies will charge a fee, so make sure reading the fine print.
A company like BlueVine charges a fare 0.5 % fee per week and will even allow clients to continue to make payments under seller’s business name.
Conclusion
When thinking about your terms of payment, remember to always be polite, keep the terms short and clear, offer incentives for early payments, interest rates for late payments, and offer a variety of payment process options.
Remember, when you have clear, specific, and consistent payment terms you can increase the chances of getting your invoice paid-on-time – which is what your goal is in the first place and is always great for your cash flow.
The first stage of credit sales is to decide policy in which most important variable is whether credit sales should be made or not and if yes to what extent i.e. what percentage of sales should be done on cash and what percentage on credit. The discussion with cement companies marketing and finance department clearly suggest that the credit policy is more dependent upon market forces and less on company specially in periods when there is excessive competition which has happened a number of times in the history of cement industry after decontrol and manufactures have been forced to provide credit if they wanted full utilization of capacity. If in the market there is practice of providing credit, those companies who do not fall in line have lower sales and so lower utilization of instilled capacity. The management has to weigh whether it should avoid risk of realization and problem of arranging funds for larger sales on credit or decide for reduced capacity utilization thereby resulting in higher cost per ton of cement produced.
Actually, the policy should be based on cost benefit analysis of these factors but often policy is decided without detailed calculations. In actual practice when one waits to push sales the marketing department pressurizes the management to provide liberal credit to buyers to realize sales targets.
The second virtual point of credit policy is to whom to give credit and whom it should be denied. Whether it should be given to everyone or on selective basis? As per standards one can work out the impact of credit sales on profits by following formulae:
∆P = ∆S (1-V) – K * ∆I – B, ∆S
In the above formula
∆P = Change in profit
∆S = Change in sales
V = Ratio of variable cost to sales
K = Cost of capital i.e. interest cost of credit
∆I = Increase in receivables investment
B = Bad debts ratio on additional sales
The change in profits (∆P) is dependent upon ratio of variable cost and fixed cost and change in sales. The figure is worked out by deducting variable cost from sales i.e. sales minus variable cost is change in profits.
The above formula appears to be very simple but for policy purposes it requires that policy maker should be able to estimate precisely the impact of credit on sales value, the variable cost and bad debts besides the cost of capital. In practice besides the cost of capital, it is very difficult to measure extent of increase in sales as a result of credit and it is only broad estimate of sales department. Similarly, it is very difficult if not impossible to workout likely bad debts. The variable cost can be worked out with great precision if proper costing system is maintained. Because of difficulties in quantifying various variables in the formulae often credit policy is decided without working details on prevailing market conditions and the need of the company to push sales at a point of time. It has been by various companies that no details are worked.
The credit period is the time length for which seller agrees to provide credit to the buyers. It varies according to the practice of trade and varies between 15 to 60 days. In some cases, for an early payment pre-agreed discount is given to induce buyer make an early payment. For late payment in the agreement there is provision for interest payment by buyer. If credit is given for longer period it induces to push up sales but this is true only when one provides longer period credit than competitors. The customer-distributor, dealer, consumers is attracted to a firm who provides longer period credit. The impact of credit on profits and sales can be worked out from the following formula:
∆P= ∆S (1-V)*K*∆1-b, ∆S
The various components are as under:
∆ P= Change in profit
∆ S= Change in sales
∆ 1= Change in investments receivables V= Ratio of variable cost to sales
K= Cost of giving credit
b= bad debits ratio to increased credit
The discussion with the industry suggests that they rarely take decision on period of credit based on formula. It is market conditions and practices in the trade, which decides the period of credit and hardly any calculations of cost are done. In practice it is marketing department whose advice plays an important and deciding role. In the period when sales have to be pushed up more credit is provided and there is no uniform policy overtime. During rainy season (July-Sep.) when demand is generally slack more liberal credit is granted than rest of the year. Further, when stocks accumulate due to sluggish sales, producers accept the terms of their customers and traders about the period of credit but when market conditions are tight, the seller becomes stricter in providing credit.
Credit policy refers to those decision variables that influence the amount of trade credit i.e. the investment in receivables. The firm’s investment in receivable are affected by general economic conditions, industry norms, pace of technological change, competition etc. Though the firm has no control on these factors, yet they have a great impact on it and it can certainly influence the level of trade credit through its credit policy within their constraints imposed externally. The purpose of any commercial enterprise is the earning of profit. Credit itself is utilized to increase sales, but sales must return a profit. Further, whenever some external factors change, the firm can accordingly adopt its credit policy. R.J. Chambers says, “The responsibility to administer credit and collection policies may be assigned to a financial executive or marketing executive or both of them jointly depending upon the original structure and the objectives of the firm.”
Different types of credit policy are:
1. Loose or Expansive Credit Policy– Firms following this policy tend to sell on credit to customers very liberally. Credits are granted even to those whose credit worthiness is not proved, not known and are doubtful.
Advantages of Loose or Expansive Credit Policy:
(i) Increase in Sales (higher sales),
(ii) Increase in profit (higher profit),
Disadvantages of Loose or Expansive Credit Policy:
(i) Heavy bad/debts.
(ii) Problem of liquidity
(iii) Increase in cost of credit management.
2. Tight or Restrictive Credit Policy– Firms following this policy are very selective in extending credit. They sell on credit, only to those customers who had proved credit worthiness.
Advantages of Tight of Restrictive Credit Policy:
(i) Minimize cost.
(ii) Minimize chances of bad debts.
(iii) Higher sales in long run.
(iv) Higher profit in long run.
(v) Do not pose the serious problem of liquidity.
Disadvantages of Tight or Restrictive Credit Policy:
(i) Restrict Sales.
(ii) Restrict Profit Margin. Benefits of Credit Extension:
(i) Increases the sales of the firm.
(ii) Makes the credit policy liberal.
(iii) Increase the profits of the firm
(iv) The market value of the firms share would rise.
Cost of Credit Extension:
(i) Bad debt losses
(ii) Production and selling cost.
(iii) Administrative expenses.
(iv) Cash discounts and opportunity cost.
Cost Benefit Trade off Profitability
(i) Bad debt losses
(ii) Production and selling cost.
(iii) Administrative expenses.
(iv) Cash discounts and opportunity cost.
Aspects of Credit Policy:
(i) Credit terms
(a) Credit Period
(b) Cash Discounts
(ii) Credit Standard
(iii) Collection policy or collection efforts.
(i) Credit terms – The stipulations under which the firm sells on credit to its customers are called credit terms.
(a) Credit Period – The time duration for which credit is extended to the customers is referred to as credit period. It is the length of time for customers under which they are allowed to pay for their purchases. It is generally varies between 15-60 days. When a firm does not extend any credit the credit period would obviously be zero. It is generally stated in terms of a net date, for example, if firm allows 30 days of credit with no discount to induce early payments credit then its credit terms are stated at ‘net 30’. Usually the credit period of the firm is governed by industry norms, but firms can extend credit for longer duration to stimulate sales. If the firm’s bad debts build up, it may tighten up its credit policy as against the industry norms. According to Martin H. Seidhen, “Credit period is the duration of time for which trade credit is extended. During this period the overdue amount must be paid by the customer. The length of credit period directly affects the volume of investment in receivables and indirectly the net worth of the company. A long credit period may blast sales but it also increase investment in receivables and lowers the quality of trade credit.”
(b) Cash Discounts – It is another aspect of credit terms. Many firms offer to grant cash discount to their customers in order to induce them to pay their bill early. The cash discount terms indicate the rate of discount and the period for which discount has been offered. If a customer does not avail this offer, he is expected to make the payment by the net date. In the words of Martin H. Seiden “Cash Discount prevents debtors from using trade credit as a source of Working Capital.”
Liberalizing the cash discount policy may mean that the discount percentage is increased and or the discount period is lengthened. Such an action tends to enhance sales (because the discount is regarded as price reduction), reduce the average collection period (as customers pay promptly). Cash Discount is a premium on payment of debts before due date and not a compensation for the so - called prompt payment.
(ii) Credit Standard - The credit standard followed by the firm has an impact of sales and receivables. The sales and receivables level are likely to be high, if the credit standard of the firm are relatively low. In contrast, if the firm has relatively low credit standard, the sales and receivables level are expected to be relatively high. The firm’s credit standard are influenced by three “C” of credit. (a) Character – the willingness of the customers to pay, (b) Capacity – the ability of the customers to pay, and (c) Condition – the prevailing economic conditions.
Normally a firm should lower its credit standards to the extent profitability of increased sales exceed the associated costs. The cost arising due to credit standard realization are administrative cost of supervising additional accounts and servicing increased volume of receivables, bad debt losses, production and selling cost and cost resulting from the slower average collection period.
The extent to which credit standard can be liberalized should depend upon the matching between the profits arising due to increased sales and cost to be incurred on the increased sales.
(iii) Collection policy- This policy is needed because all customers do not pay the firm’s bill in time. There are certain customers who are slow payers and some are non-payers. Therefore the collection policy should aim at accelerating collections from slow payers and non-payers and reducing bad debt losses. According to R.K. Mishra, “A collection policy should always emphasize promptness, regularity and systematization in collection efforts. It will have a psychological effect upon the customers, in that, it will make them realize the attitude of the seller towards the obligations granted.”
The collection programme of the firm aimed at timely collection of receivables, any consist of many things like monitoring the state of receivable, dispatch of letter to customers whose due date is approaching, telegraphic and telephone advice to customers around the due date, threat of legal action to overdue accounts, legal action against overdue accounts.
The firm has to be very cautious in taking the steps in order to collect from the slow paying customers. If the firm is strict in its collection policy with the permanent customers, who are temporarily slow payers due to their economic conditions, they will get offended and may shift to competitors and the firm may loose its permanent business. In following an optimal collection policy the firm should compare the cost and benefits. The optimal credit policy will maximize the profit and will consistent with the objective of maximizing the value of the firm.
Before granting credit to a prospective customers the financial executive must judge, how creditworthy is the customer. In judging the creditworthiness of a customer, often financial executive keep in mind the four basic criteria as
(i) Capital –refers to the financial resources of a company as indicated primarily by the financial statement of the firm.
(ii) Capacity – refers to the ability of the customers to pay on time.
(iii) Character – refers to the reputation of the customer for honest and fair dealings.
(iv) Collateral – represents the security offered by the customer in the form of mortgages.
Credit evaluation involves a large number of activities ranging from credit investigation to contact with customers, appraisal review, follow up, inspection and recovery. These activities required decision-making skills which can partly be developed through experience but partly it has to be learned externally. This is particularly true in area of pre-credit appraisal and post-credit follow up.
It is an important element of credit management. It helps in establishing credit terms. In assessing credit risk, two types of error occur –
(i) A good customer is misclassified as a poor credit risk.
(ii) A bad customer is misclassified as a good credit risk.
Both the errors are costly. Type (i) leads to loss of profit on sales to good customer who are denied credit. Type (ii) leads in bad debt losses on credit sales made to risky customer. While misclassification errors cannot be eliminated wholly, a firm can mitigate their occurrence by doing proper credit evaluation.
Three broad approaches used for credit evaluation are:
- Traditional Credit Analysis - This approach to credit analysis calls for assuming a prospective customer in terms of 5 of credit: (i) Character, (ii) Capacity, (iii) Capital, (iv) Collateral, and (v) Conditions.
To get the information on the 5 firm may rely on the following.
- Financial statements
- Bank references
- Trade references
- Credit agencies
- Experience of the firm
- Prices and yields on securities
B. Sequential Credit Analysis – This method is more efficient method than above method. In this analysis, investigation is carried further if the benefits of such analysis outweigh its cost.
C. Numerical Credit Scoring – This system involves the following steps.
- Identifying factors relevant for credit evaluation.
- Assign weights to these factors that reflect their relative importance.
- Rate the customer on various factors, using a suitable rating scale (usually a 5 pt. Scale or a 7pt. Scale is used).
- For each factor, multiply the factor rating with the factor weight to get the factor score.
- Add all the factors score to get the overall customer rating index.
- Based on the rating index, classify the rating index.
D. Discriminant Analysis - The credit index described above is somewhat ad hoc in nature and is based on weights which are subjective in nature. The nature of discriminate analysis may be employed to construct a better risk index.
Under this analysis the customers are divided into two categories:
1. Who pay the dues (X)
2. Who have defaulted (O)
The straight line seems to separate the x’s from o’s, not completely but does a fairly good job of segregating the two groups.
The equation of this straight line is
Z = 1 Current Ratio + 0.1 return on equity
A customer with a Z score less than 3 is deemed credit worthy and a customer with a Z score less than 3 is considered not credit worthy i.e. the higher the Z score the stronger the credit rating.
E. Risk Classification Scheme - On the basis of information and analysis in the credit investigation process, customers may be classified into various risk categories.
Risk Categories Description
1. Customers with no risk of default -----
2. Customer with negligible risk of default (< 2%)
3. Customer with less risk of default (2% to 5%)
4. Customer with some risk of default (5% to 10%)
5. Customer with significant risk of default (> 10%)
Credit Granting Decision - After assessing the credit worthiness of a customer, next step is to take credit granting decision.
There are two possibilities:
(i) No repetition of order.
Profit = P (Rev-Cost) – (1-P) Cost
Where P is the probability that the customer pays his dues, (1-P) is the probability that the customer defaults, Rev is revenue for sale and cost is the cost of goods sold.
The expected profit for the refuse credit is O. Obviously, if the expected profit of the course of action offer credit is positive, it is desirable to extend credit otherwise not.
(ii) Repeat Order - In this case, this would only be accepted only if the customer does not default on the first order. Under this, once the customer pays for the first order, the probability that he would default on the second order is less than the probability of his defaulting on the first order. The expected profit of offering credit in this case.
Expected profit on initial order + Probability of payment and repeat order x expected profit on repeat order.
[P1 (Rev1 – Cost1)-(1-P1) Cost1] + P1 x [P2(Rev2-Cost2)-(1-P2) Cost2]
The optimal credit policy, and hence the optimal level of accounts receivable, depends upon the firm’s own unique operating conditions. Thus a firm with excess capacity and low variable production cost should extend credit more liberally and carry a higher level of accounts receivable than a firm operating a full capacity on a slim profit margin. When a sale is made, the following events occur:
- Inventories are reduced by the cost of goods sold.
- Accounts receivable are increased by the sales price, and
- The difference is recorded as a profit, if the sale is for cash.
Generally two methods have been commonly suggested for monitoring accounts receivable.
(1)Traditional Approach
(a)Average collection period
(b)Aging Schedule
(2)Collection Margin approach or Payment Pattern Approach
(a) Average Collection Period (AC): It is also called Day Sales Outstanding (DSOI) at a given time ‘t’ may define as the ratio of receivable outstanding at that time to average daily sales figure.
ACP = Accounts receivable at time “t”
Average daily sales
According to this method accounts receivable are deemed to be in control if the ACP is equal to or less than a certain norm. If the value of ACP exceeds the specified norm, collections are considered to be slow.
If the company had made cash sales as well as credit sales, we would have concentrated on credit sales only, and calculate average daily credit sales.
The widely used index of the efficiency of credit and collections is the collection period of number of days sales outstanding in receivable. The receivable turnover is simply ACP/360 days.
Thus if receivable turnover is six times a year, the collection period is necessarily 60 days.
(b) Aging Schedule – An aging schedule breaks down a firm’s receivable by age of account. The purpose of classifying receivables by age group is to gain a closer control over the quality of individual accounts. It requires going back to the receivables’ ledger where the dates of each customer’s purchases and payments are available.
To evaluate the receivable for control purpose, it may be considered desirable to compare this information with earlier age classification in that very firm and also to compare this information with the experience of other firms of same nature. Financial executives get such schedule prepared at periodic intervals for control purpose.
So we can say Aging Schedule classifies outstanding accounts receivable at a given point of time into different age brackers. The actual aging schedule of the firm is compared with some standard aging schedule to determine whether accounts receivable are in control. A problem is indicated if the actual aging schedule shows a greater proportion of receivable, compared with the standard aging schedule, in the higher age group.
An inter firm comparison of aging schedule of debtors is possible provided data relating to monthly sales and collection experience of competitive firm are available. This tool, therefore, cannot be used by an external analyst who has got no approach to the details of receivable.
The above both approaches have some deficiencies. Both methods are influenced by pattern of sales and payment behaviour of customer. The aging schedule is distorted when the payment relating to sales in any month is unusual, even though payments relating to sales in other months are normal.
II. Payment Pattern Approach - This pattern is developed to measure any changes that might be occurring in customer’s payment behaviour.
It is defined in terms of proportion or percentage. For analyzing the payment pattern of several months, it is necessary to prepare a conversion matrix which shows the credit sales in each month and the pattern of collection associated with it.
Payment pattern approach is not dependent on sales level. It focuses on the key issue, the payment behaviour. It enables one to analyze month by month pattern as against the combined sales and payment patterns.
From the collection pattern, one can judge whether the collection is improving, stable, or deteriorating. A secondary analysis is that it provides a historical record of collection percentage that can be useful in projecting monthly receipts for each budgeting period.
Some of the important techniques for controlling accounts receivable are ratio analysis, discriminate analysis, decision tree approach, and electronic data processing. Information system with regard to receivables turnover, age of each account, progress of collection size of bad debt losses, and number of delinquent accounts is also used as one of the
Control measures.
Ratio analysis is widely used in the control of accounts receivable. Some of the important ratios used for this purpose are discussed below:
(1) Average collection Period (Receivables x 365/Annual Credit Sales)
The average collection period indicates the average time it takes to convert receivables into cash. Too low an average collection period may reflect an excessively restrictive credit policy and suggest the need for relaxing credit standards for an acceptable account. On the other hand too high an average collection period may indicate an excessively liberal credit policy leading to a large number of receivables being past due and some being not collectable.
(2) Receivables Turnover (Annual Credit Sales/Receivables)
This ratio also indicates the slowness of receivables. Both the average collection period ratio and receivables ratio must be analyzed in relation to the billing terms given on the sales. If the turnover rates are not satisfactory when compared with prior experience, average industry turnover and turnover ratios of comparable companies in the same industry, an analysis should be made to determine whether there is any laxity in the credit policy or whether the problem is in collection policy.
(3) Receivables to Sales (Receivables/Annual Credit Sales x 100)
Receivables can be expected to fluctuate in direct relation to the volume of sales, provided that sales terms and collection practices do not change. The tendency towards more lenient credit extension as would be suggested by slackening of collections and increase in the number of slow paying accounts needs to be detected by carefully watching the relationship of receivables to sales. When credit sales figures for a period are not available, total sales figures may be used. The receivables figures in the calculation ordinarily represent year-end receivables. In the case of firms with seasonal sales, year-end receivables figures may be deceptive. Therefore, an average of the monthly closing balances figures may be more reliable.
(4) Receivables as percentage of Current Assets (Receivables/Total Current Assets Investment)
The ratio explains the amount of receivables per rupee of current asset investment and its size in current assets. Comparison of the ratio over a period offers an index of a firm’s changing policies with regard to the level of receivables in the working capital.
Some other ratios are:
1. Size of receivable = receivable/total current assets
2. Size of debtors = debtors/total current assets
