Chapter 7 Credit Management

Credit management is a term used to identify accounting functions usually conducted under the umbrella of Accounts Receivables. Essentially, this collection of processes involves qualifying the extension of credit to a customer, monitors the reception and logging of payments on outstanding invoices, the initiation of collection procedures, and the resolution of disputes or queries regarding charges on a customer invoice. When functioning efficiently, credit management serves as an excellent way for the business to remain financially stable.

The process of credit management begins with accurately assessing the credit-worthiness of the customer base. This is particularly important if the company chooses to extend some type of credit line or revolving credit to certain customers. Proper credit management calls for setting specific criteria that a customer must meet before receiving this type of creditarrangement. As part of the evaluation process, credit management also calls for determining the total credit line that will be extended to a given customer.

Several factors are used as part of the credit management process to evaluate and qualify a customer for the receipt of some form of commercial credit. This includes gathering data on the potential customer’s current financial condition, including the current credit score. The current ratio between income and outstanding financial obligations will also be taken into consideration. Competent credit management seeks to not only protect the vendor from possible losses, but also protect the customer from creating more debt obligations that cannot be settled in a timely manner.

After establishing the credit limit for a customer, credit management focuses on providing the client with accurate and timely statements or invoices. The invoices must be delivered to the customer in a reasonable amount of time before the due date, thus providing the customer with a reasonable period to comply with the purchase terms. The period between delivery of the invoice and the due date should also allow enough time for the customer to review the invoice and contact the vendor if there are any questions or concerns about a line item on the invoice. This allows all parties concerned time to review the question and come to some type of resolution.

When the process of credit management functions efficiently, everyone involved benefits from the effort. The vendor has a reasonable amount of assurance that invoices issued to a client will be paid within terms, or that regular minimum payments will be received on creditaccount balances. Customers have the opportunity to build a strong rapport with the vendor and thus create a solid credit reference.

Managing Credit

Credit is an indispensable catalyst in financing the movement of commerce. Its roots go fairly deep in time and are definitely as old as the concept of trade itself. As early as 1300 BC the Babylonians were lending on the basis of getting a charge on security or collateral. Credit touches us in various ways. To some it could be a mere caress or a tickle, to others it could be a brush, to some a graze and for others a crash or a collision. Credit helps in production, distribution, selling, consumption and expansion. It helps smoothen the rough curve of seasonality of a seasonal business. It increases the immediate buying power of a consumer. But where there is good there may also be bad and ugly. Credit could mean a collapse due to Overbuying, Overexpansion or Overselling.

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Probably the single most important factor is the maintenance of proper cash flow in operating a successful franchise. Cash flow problems can be avoided by making sure that you administer and manage credit with financial prudence and get paid promptly for goods or services rendered. Accounts Receivables, which can be broadly defined as uncollected sales, are one of the largest assets of a business, amounting to approximately 15% to 20% of the total assets of a typical manufacturing business. An uncontrolled growth in sales could result in an uncontrolled management of account receivables. It just goes to corroborate the fact that no matter how big or small is the size of business operation, companies are focusing increasingly on managing and collecting their receivables efficiently and effectively, thus maximizing their cash inflows.

Credit is temporary capital and the objective of credit is to lend with the purpose of increasing profits and sales. A sound credit policy in business is the blue print to managing by measurement and benchmarks. The question then arises is 'What is a Credit Policy and how does one write a Credit Policy for their specific nature of business operations?

Writing an effective Credit Policy begins with an understanding of the financial exposure that you or your business can endure and the amount of your working capital that you would be willing to risk, or call it 'invest' in your customers.

Revolutionary developments in the computer and communications fields have forced companies to increase speed and become relevant. Markets are becoming global and economic activity across nations is becoming increasingly integrated. Competition can come from the face of a computer screen with the competitor sitting in a different time zone. About the only thing in business that is a constant, is change. As the world transforms at an unprecedented pace so have to the components that propel its engines. Thus a credit policy that is written without an understanding of the market and ample room for change in it and the one that is not frequently revisited could become obsolete in matter of days. With the information-age revolution, knowledge-based activities are becoming increasingly important for existence. Hence, enhancing skill-sets and knowledge is an intangible component of a credit policy.

I am of the firm belief that 'what gets measured gets managed'. Therefore as a matter of policy one should manage by measuring results. Every time a deal goes bad, review the things that were done incorrectly in either setting up of the account, monitoring or collecting it. Measure Days Sales Outstanding (DSO), aging receivables, and bad debts as a percentage of sales. Keep a tab on your liquidity by reviewing liquidity ratios like the current or working capital ratio. Also keep a pulse on your inventory turnover. This will tell you if your efficiency is increasing, decreasing or the same over different time periods. Profits are a combined function of liquidity and efficiency. You can use the same logic when assessing your customer.

Using quality information can help scores in managing risk. Collecting relevant information requires a well thought-out Credit Application. It should seek permission from your customers to conduct credit investigation from credit bureaus, trade and bank references for the purpose of granting credit. A Credit Application is a document that not only collects information but is also an 'Application for a Loan ' that the applicant fills. Make sure that your Credit Application reflects the sentiments that you are serious about the amount that you will be extending in the form of cash or kind.

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As a guideline you can write your policy in the following sections. The contents of each section can be written to best fit the nature of your franchise:

1. The set-up of credit function.2. Objectives of the credit function 3. Terms and conditions of sale4. Sales responsibilities with credit issues5. Billing procedures6. Obtaining Information on new customers7. Procedures for opening new accounts8. Process of assessing the information to arrive at line of credit and credit terms that will be offered 9. Monitoring your investment in your customers10. Profiling your customers to do strengths, weakness, opportunity and threat analysis.11. The feedback loop for reporting12. Allocating resources and responsibilities13. Defining past-due and bad debts14. Targets, benchmarks and deadlines for the credit function15. Procedure of collecting from delinquent customers.16. Analyzing the changing needs of your markets/customers.

Entering the marketplace by investing in a franchise can be one of the best ways that an entrepreneur can launch a successful business. Franchising in Canada continues to grow at a significant rate. Franchise sales in Canada in 1987 were estimated at $61 billion; and now it is close to 90 billion. The retail trade alone represents almost two-thirds of that number. It is expected that sales will increase 10 to 15 percent annually over the next few years. The person who operates a franchise gets the better of both the worlds - the satisfaction of operating an independent business, combined with the leverage of working for a large organization.

Ultimately, Credit Management is an art and not a science. It is definitely an 'indefinite'. It gets its design from a variety of inputs like the creativity, experience philosophies and attitudes of the individuals administering it. Sometimes a decision based on your 'gut' feeling against all odds could prove to be the best one. But as a credit adage goes "get the calculations right in a calculated risk" and remember that 'A sale is not complete till the money is collected.' Good luck with your franchise.

Setting Credit Limits

Like most elements in credit management, setting ‘credit limits’ is an art and not a science of granting credit. There are seasoned credit professionals that have used and relied merely upon their gut feeling to grant credit limits. However, it is always better to take a ‘calculated’ risk than base your decision purely on gut feeling!

Credit Limits. Are threshold that a company (creditor) will allow its customers to owe at any one time without having to go back and review their credit file. Credit Limit is the maximum amount that a firm is willing to risk in an account.

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Credit Limits helps the creditor in the following ways:1. It frees up valuable time for other credit management tasks2. It speeds up the sales process3. It reduces risk and improves collection activity and efforts.4. It is an account monitoring tool

Credit limits have also known to upset customers. Thus, the decision to communicate credit limits to your customers rests upon you. It has its advantages and disadvantages.

One important approach that credit management should take with customers who are near their limits; asking for more or with overdue amounts is that of a counselor. This is the time to collect more information on your customer or cajole them into paying overdue amounts. Credit Limits need not be Sales Limits and should be used as a guide to enhancing profitable sales. They can be flexible and revised often.

The first thing that the company needs to consider is its own exposure. What is the kind of exposure that a company can take with its customer base? Will it be a Liberal or a ‘Conservative’?

Important factors influencing these elements will be· The strength or weakness of ‘Product or Service’ that is being sold;· The degree of ‘Competition’ or ‘Opportunities’ in the marketplace; the nature of the industry

that you are in or deal with- Is the industry growing or going? Your role as a supplier, especially if you are the key supplier to your customer.

· Whether you are a ‘Secured’ or ‘Unsecured’ creditor. If there is any lien rights that you can exercise.

· The financial strength of your customer; the information that you have or can obtain from your customer or other sources. The number of years that the customer has successfully run that particular business and the reputation carried in the marketplace, both of the business and its management. The customer’s businesses plan or blueprint to operating the business in the future.

· The overall ‘Margin’ that the product or service contributes to the bottom line;· The confidence that you have in your in-house ‘Collection’ process;· The length of your terms to your customer because risk is directly proportional to the length of

your terms

Methods of Setting Credit Limits

As indicated earlier setting credit limits is not a science. Although, by incorporating the process into their scoring models some companies have made it into a near science. The starting point to setting most credit limits is the needs and requirements of the customer. What is the customer asking for and subsequently what will be the requirement periodically? If the customer is creditworthy then would you

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as a customer want to set the a credit limit for the customer higher than what is being sought in order to save time in the future i.e. if credit limits are to be increased later due to increased sales volume?

The following are some common techniques applied in setting Credit Limits:

Trade References: After obtaining the trade references you can compare the amounts of the High Credits awarded to your customer.(applicant) You can choose the ‘Highest’ from the ‘High Credits’ or take an ‘Average’ or pick the ‘Lowest’.

Bank References: In doing a bank reference on your applicant find out the amount of line of Credit that was established by the applicant with the bank. If this line is unsecured then perhaps it can give you a little more comfort in setting a relatively higher credit limit for the applicant. The use of this information is rather sketchy since the banks generally are secured creditors with stiff remedies upon default.

Agency Credit Reports: Credit Agencies generally give two pieces of information that are quite popular among credit professionals that aid in the setting of credit limits.

1. Payment Performance: This section lists the paying habits of the applicant. The information is collected from different suppliers to the applicant. You can treat this section almost like doing a trade reference. It will give you High Credits and the customer’s (applicant) payment habit in different dollar ranges. It is quite possible that the customer might be a good paymaster in the dollar range that is being sought from you as a credit limit. Thus, increasing your confidence level.

2. The Rating: Based on certain credit and financial information obtained on the customer (your applicant), the Agencies assign ratings. These ratings can assist you in setting your own credit limits. You can map your own limit amounts against individual ratings that a credit agency assigns.

Financial Statements: Financial statements are also used in assigning Credit Limits to customers. Mainly ratios or factors like net worth and working capital are taken and trended or compared to Industry norms or standards. If a customer shows liquidity and efficiency as per industry norms then a more confident approach can be taken in setting the credit limits. One has to also consider if short-term liquidity is important or meaningful to the nature of your credit or is long-term liquidity more consequential.

Past Performance:: Credit Limit in this case is based on the past history of the customer as per the information contained in your books. The two elements that you would consider and weigh would be the past:

· Payment performance· Purchase Pattern

Need Based: In this case Credit Limits are set based on the needs of the customer. It could be set to accommodate the first Requested Credit Limit or the Size of the first Order: It should not be done in isolation but by a combination of the other methods that are discussed in this article.

In a survey that was conducted by the Conference Board one of the most popular techniques used for setting credit limits was by using the information and ratings given by credit agencies.

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The trade credit insurer issues a credit limit for every buyer with whom the policyholder trades. The level of the limit is set at the maximum amount that can be owed by the buyer at any time. Limits are granted at a lower level, if the underlying information justifies this. The granted credit limit is the maximum insured credit line for a specific buyer and the policyholders can trade on an insured basis within the approved credit limit throughout the policy period without further reference to the insurer. If a discretionary limit has been agreed, exposures up to that amount do not have to be agreed by the insurance company but are covered based on the payment experience of the policy holder.The insurance company has the right to reduce or cancel a granted limit at any time, usually as a result of negative information. This allows the exposure to be brought down in a timely manner, as negative news (such as deterioration in payment behavior) is known immediately. A new limit will apply to all deliveries that are made by the policyholder to the buyer after the date of the trade credit insurer’s decision to reduce or cancel a limit.

If a buyer is late in paying his bill, an established collection procedure is called for. Most companies have internal guidelines on how to deal with late payers. However, sometimes these efforts do not have the desired effect. In these instances it can be helpful to employ a professional collection agent. Recovery approaches include telephone calls, written demands, and visits to the buyer’s premises. Most trade credit insurance companies either offer debt collection services, or have partnered with specialised collections firms.

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