Credit Management – Granting Credit, Monitoring and Collecting

1 Why offer credit?

A business should offer credit only if it increases profits and that can only be because it makes the business more competitive and more attractive to customers. If all competitors are offering credit then not to do so is likely to be a disadvantage. Even if the company is a monopolist then offering credit could induce a customer to buy goods as it makes it easier for the customer to pay and might be closer to expected trading norms.

However, remember that offering credit is expensive as:

• The company has to do without receiving cash for the credit period and this will require funding in some way, for example, by having a larger overdraft on which interest will be payable.
  

• The customer might never pay, for example, if the customer becomes bankrupt.
  

• Often discounts will be offered to encourage prompt payment.
  

• If credit is offered to retain customers by allowing payment by credit cards, the credit card company will take a commission (say 1 - 2% depending on the type of card)
  

The company may be able to increase its selling prices to cover these costs, but competitive pressures will mean that price increases are often constrained.

2 Credit granting

The decision to offer credit at all, the period of credit, the establishment of credit limits and the monitoring of receipts from credit sales requires a credit policy to be set at a management level. Remember, credit sales means that valuable goods are leaving the company without cash being received then in exchange and good policies, frequently reviewed are essential.

A credit policy will involve:

• The decision by the business to offer credit at all. As stated above, this should be justified if it leads to a profit increase.
  

• The period of credit to be offered (and this could be different for different customers depending on their importance, bargaining power and financial resources).
  

• Establishing credit limits for each customer.
  

• Deciding on discount terms (if any)
  

• Policies and mechanisms for following up payments not received when due.
  

• Policies on removing or reducing credit facilities from 'bad payers' or companies which look in trouble.
  

• Establishing policies on bad debt recovery.
  

The credit-worthiness of customers can be assessed by:

• Examining their financial statements. These will show trading history, profitability, liquidity and the size of the company. All of these factors will influence the credit limit and for how long it might be safe to offer credit for. If the company has just started to trade financial statements will not be available and if so budgets might be the only financial information that can be supplied.
  

• Trade references. A trade reference is a letter from another supplier stating that the customer has a good credit history with them. This is open to some abuse eg references might be supplied only from the few suppliers who are paid promptly. Also, companies might be reluctant to criticise other companies for fear of causing trouble.
  

• Bank references. Banks have considerable information about their customers and their cash flows, however, banks are cautious about either praising or criticising their customers and replies to queries are often rather bland.
  

• Credit reference agencies. These are commercial organisations which collect information about companies to allow assessment of their credit-worthiness. For example, they will search court judgement records to see if the company has been taken to court about debt disputes. For individuals they will have information about defaults on credit card payments etc. The result of their investigations will be a credit rating for the potential credit customer.
  

• Companies House (Company Registrar) information. Typically shows financial information owners and directors. Credit reference agencies can then be used to investigate the owners and directors who stand behind the company.
  

• Court judgement information. Instead of getting a credit reference agency to look for payment defaults, companies can search judgement records themselves.
  

• Consideration of the type of business. Different businesses are exposed to different risks. For example, building companies tend to be greatly affected by economic confidence whereas a company that is renting out many properties on long leases is likely to have more predictable income. New businesses with inexperienced management are likely to be riskier than established businesses.
  

Typically, with a new application from a customer for credit, the initial credit limit will be relatively low. If the customer establishes a good, reliable payment behaviour then the credit limit can be raised and this process can be repeated as trust grows.

Once the decision has been made at a high level to offer credit, most of the other activities credit sale transactions are carried out by the company's credit control department.

2.1 A credit policy and customer assessment

• Set the overall receivables budget, standard credit period, limits, approval authority and review/stop-credit triggers. Balance sales growth against finance cost, default risk and collection workload.

• Assess the customer’s payment character/history, capacity and cash flow, financial strength/capital, security and business conditions. Strong security does not substitute for ability to pay.

• Use internal payment records, aged balances, disputes, previous bad debts, sales-staff reports and the application itself. Record the evidence and reasons for approval or refusal.

2.2 Credit scoring and decisions

A credit score combines weighted indicators under a consistent policy. Example: payment record 20 points, liquidity 30 and trading history 25 gives 75; policy requires 70 for a standard limit. Check the underlying information and any mandatory rejection conditions before approval.

Scoring supports judgement; it does not guarantee payment. A good customer with a temporary cash problem might receive a smaller limit or staged payments. Repeated overdue debts, worsening finances or unresolved disputes can justify refusing more credit. Review limits when circumstances change.

2.3 Using financial statements to assess credit

Read recent statements and notes for profitability, liquidity, debt and cash-flow trends. Compare ratios over time and with similar businesses. Example: annual credit sales $500,000, operating profit $50,000, interest $10,000, capital employed $250,000, current assets $120,000 (inventory $40,000), current liabilities $80,000, receivables $60,000, debt $100,000 and equity $150,000.

• Check definitions and accounting policies before comparison. Year-end balances, old information, seasonality and window dressing can mislead. Ratios identify warning signs, but cannot replace cash forecasts, payment history and a reasoned credit decision.

3 Discounts

Many businesses offer discounts for prompt payment (settlement discounts). This was discussed in the earlier chapter on working capital because receiving cash more quickly from customers eases working capital problems.

The principle is easy: offer a 2.5% (say) discount for payment within 30 days (say). However, it is important to always appreciate how expensive the modest-looking discount actually is.

There are two types of calculation: approximate and accurate.

4 Monitoring receivables

It is very important that receivables are closely monitored to see that amounts are received when due and that discounts are not incorrectly calculated and or taken when not due. In general, the older a debt becomes the less chance there is of it ever being paid. You have to consider that the customer is not paying on time because the customer is having financial problems.

Usually at the end of every month statements are sent to each customer. These act as reminders and also allow customers to compare their version of the account on their payables ledger with the supplier's version on their receivables account. Disputed items should be sorted out as soon as possible because customers sometimes claim they won't pay anything until disputes are settled.

Looking at the days of credit taken by customers is an easy and useful calculation. In particular, it is worrying if a customer begins to take more and more days of credit and it is especially worrying if customers move from paying quickly enough to receive settlement discounts to paying more slowly so that the discount is lost. We know from calculations set earlier that this is a very expensive way of borrowing (effectively the debtor is borrowing from the seller by not paying on time).

To show you again how this calculation is done consider the following:

Annual sales = $1.4m

Receivables = $190,000

= 190,000 x 365/1,400,000 = 49.5 days.

This period is not necessarily either good or bad: it depends on what period of credit has been agreed with the customer and also whether the period has changed. For example, if last year 28 days of credit were taken and it has now risen to near 50, then we need to ask why the company has done that. Perhaps they are having difficulty paying more quickly and are suffering liquidity problems. The situation needs careful monitoring.

In addition, aged receivables analysis should be produced showing the age of unpaid invoices for each customer. Typically these are set out like:

Customers ABC Ltd, DAB Ltd and EAT Ltd look normal and cause no worries.

CAB Ltd seems to have a problem with an old invoice for $500. Perhaps that needs to be investigated.

BBC Ltd will probably give cause for concern as the company has been owing a large amount for over three months.

The credit controller will often ring customers asking to speak to their payables department to discuss outstanding amounts and to try to reach an agreement as to when amounts will be paid. If that fails a meeting is likely to be requested.

At some point the credit controller might say that no more goods should be sent until payment has been received and might lower credit limits for future dealings. Some care is needed here, however, as there is play-off between encouraging faster payment and perhaps losing a valuable customer, so jeopardising future sales, if pressure is applied inappropriately.

If payments are still not received the company might resort to:

• Arbitration: parties may agree to submit a dispute to an independent arbitrator for a binding decision. Its cost and speed depend on the case.

• Formal legal action: in England and Wales, a debt may be pursued through a court money claim; small claims is a procedural track, not a separate court. A judgment does not itself guarantee payment.

• A collection agency can seek payment or buy a debt, but cannot simply seize the customer’s goods. Enforcement powers require the appropriate legal authority.

4.1 Maintaining records and preparing an aged analysis

Keep customer contact details, approved limit and terms; invoice/credit-note references, dates and due dates; receipts and their allocation; and the remaining balance. Age balances using the specified basis (invoice date or overdue date), consistently.

Example: at 31 March, use days overdue. All due dates are given; allocate a $200 receipt against invoice A.

• Reconcile the aged total to the ledger and investigate old/disputed items. Monitor bad debts as a proportion of credit sales: $10,000 written off on $500,000 credit sales = 2%, then compare periods and investigate deterioration.

4.2 Ongoing external credit checks

• Update external credit reports, filed accounts and trade/bank references where available. Watch industry conditions, public insolvency information and adverse business news.

• Review regularly and when late payment, returned payments, ownership changes or deteriorating accounts trigger concern. Confirm the reliability and date of the information before changing a limit.

4.3 Choosing collection action and writing off a debt

• Match recovery action to the case: resolve a genuine dispute, agree instalments for a viable customer with temporary problems, or stop further credit and escalate persistent default. Compare collection-agency/legal costs and likely recovery, including the customer relationship.

• Write off a balance only with authorised approval and evidence that recovery is no longer reasonably expected, such as confirmed insolvency with no likely distribution or exhausted proportionate recovery action. Update the customer ledger and records and prevent inappropriate further credit.

• A write-off records a loss; it does not by itself waive the legal debt. Any subsequent receipt must be recorded. Tax relief has separate conditions; this syllabus does not require write-off journal entries.

5 Debt factoring

A factor can provide receivables-ledger administration, collection and an advance against invoices. It may help assess customers and set credit limits. The seller must compare fees and interest with the cash released, administration savings and any transferred bad-debt risk, while considering the effect of collection methods on customer relationships.

Factors can offer a 'with recourse' or 'without recourse' service. 'With recourse' means that if the customer goes into liquidation so that the debt will not be paid to the factor then the factor can ask the seller to pay back any monies advanced to them.

'Without recourse' means that the factor bears the cost of the bad debt and suppliers can keep all monies advanced to them. The factor is then offering:

• Receivables ledger management
  

• Advance of cash before payment by the customer
  

• Credit insurance
  

This service is obviously more expensive than with recourse arrangements. Because the factor is at risk from incurring bad debts they will have more involvement with customer approval and credit limit setting.

Invoice discounting provides finance against invoices while the seller usually retains ledger administration and collection; it is often confidential. The arrangement is usually with recourse, so the seller keeps customer default risk. Any non-recourse protection depends on the actual contract and its exclusions. Factoring can additionally provide collection and, under a non-recourse agreement, cover specified default risks.

5.1 Costing factoring and invoice discounting

Factoring example: annual credit sales $1.2m, 60-day collection period (360-day year), receivables $200,000. The factor advances 80% ($160,000), charges 12% interest on that advance and a 2% annual sales fee. Assume the advance replaces an equal overdraft at 10%, saves $12,000 administration and, under this non-recourse contract, $12,000 expected bad debts. Collection time is unchanged.

• The factor costs $3,200 more per year under these assumptions. Assess whether liquidity, risk transfer and services justify it. With recourse, do not assume bad debts are avoided. Avoid counting both financing released and its interest saving as annual profits.

5.2 Invoice discounting: effective annual cost

If invoices of $1m payable in six months generate $970,000 now, the finance charge is $30,000. Six-month cost = 30,000/970,000 = 3.0928%. Effective annual cost = (1 + 30,000/970,000)² − 1 = 6.28%. Use the cash actually received as the base; simple doubling gives a different result.

For an interest-and-fee facility, separately calculate interest on the amount advanced for the days used, add fees on their stated base and compare equivalent annual costs and services.

5.3 Assessing a change in credit policy

Example (360-day year): credit sales rise from $1m to $1.1m; contribution margin is 20%, credit period rises from 30 to 45 days, bad debts rise from 1% to 2% of sales and financing costs 10%. Assume the receivables investment is measured at variable cost (80% of sales); no other costs change.

• A positive $3,667 supports the proposal financially under these estimates. Also check cash capacity and default risk. Include incremental settlement discounts, administration or other relevant costs if the proposal changes them.

6 Chapter 14 questions

Question 1

What are five sources of information that can be used to decide on the credit- worthiness of a new customer?

Question 2

What does 'non-recourse' or 'without recourse' mean in the context of debt factoring and invoice discounting?

Question 3

Annual sales = $14m

Receivables = $2.1m

How many days' credit is the customer taking?

Question 4

What does a debt factor do?