CHAPTER 3

Credit Management
After studying this chapter you should be able to:

■ Describe the terms of payment used widely in

practice.
■ Discuss the important dimensions of a firm's
credit policy.
■ Explain the approaches used for credit analysis.
■ Discuss the methods used for control of
receivables
 Introduction to Credit Management
 While business firms would like to sell on cash, the pressure of competition
and the force of custom persuades them to sell on credit.
 Firms grant credit to facilitate sales. It is valuable to customers as it augments
their resources - it is particularly appealing to those customers who cannot
borrow from other sources or find it very expensive or inconvenient.
 The credit period extended by business firms usually ranges from 15 days 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).
 A firm's investment in accounts receivable depends on how much it sells on
credit and how long it takes to collect receivables.
 Terms of Payment
Terms of payment vary widely in practice.
 At one end, if the seller has financial strength it may extend

liberal credit to the buyer till it converts goods bought into

cash.
 At the other end, the buyer may pay cash in advance to the

seller and finance the entire trade cycle.

 Most commonly, however, some in-between arrangement

is chosen wherein the trade cycle is financed partly by the

seller, partly by the buyer, and partly by some financial
intermediary.
The major terms of payment are discussed below.

 Cash Terms
 Open Account
 Consignment
 Bill of Exchange/Draft
 Letter of credit
Cash Terms:

 When goods are sold on cash terms, the payment is received either
before the goods are shipped (cash in advance) or when the goods are
delivered (cash on delivery).
 Cash in advance is generally insisted upon when goods are made to
order.
 In such a case, the seller would like to finance production and eliminate
marketing risks.
 Cash on delivery is often demanded by the seller if it is in a strong
bargaining position and/or the customer is perceived to be risky.
 Open Account

 Credit sales are generally on open account. This means that

the seller first ships the goods and then sends the invoice
(bill).
 The credit terms (credit period, cash discount for prompt
payment, the period of discount and so on) are stated in
the invoice which is acknowledged by the buyer.
 There is no formal acknowledgement of indebtedness by
the buyer.
 Credit Period: The credit period refers to the length of time the customer is
allowed to pay for its purchases. It is usually mentioned in days from the
date of invoice. If a firm allows 30 days, say, of credit with no discount for
early payment, its credit terms are stated as 'net 30'.

 Cash Discount: Firms generally offer cash discount to induce customers to

make prompt payment. For example, credit terms of 2/10, net 30 mean that
a discount of 2 per cent is offered if the payment is made by the tenth day;
otherwise, the full payment is due by the thirtieth day.

 Billing: To streamline billings, it is a common practice to send a single bill

every month. For example at the end of every month, the customer may be
sent a consolidated bill for the purchases made from the 26th of the
previous month to the 25th of the current month.
Consignment:
 When goods are sent on consignment, they are

merely shipped but not sold to the consignee.

 The consignee acts as the agent of the seller

(consignor).
 The title of the goods is retained by the seller till

they are sold by the consignee to a third party.

 Periodically, sales proceeds are remitted by the

consignee to the seller.

  Seller( Consignor)>>>>> Consignee>>>>> Buyers
Bill of Exchange/Draft:
 Whether goods are shipped on open account or consignment, the seller
does not have strong evidence of the buyer's obligation.
 A draft represents an unconditional order issued by the seller asking
the buyer to pay on demand (demand draft) or at a certain future date
(time draft), the amount specified on it.
 It is typically accompanied by shipping documents that are delivered to
the drawee when he pays or accepts the draft.
 When the drawee accepts a time draft it becomes a trade acceptance.
The seller may hold the acceptance till it matures or get it discounted.
 The draft performs three useful functions:
(i) It serves as a written evidence of a definite obligation,
(ii) It helps in reducing the cost of financing to some extent,
(iii) It represents a negotiable instrument.
 Letter of Credit:
 Commonly used in international trade, the letter of credit is now used

in domestic trade as well.

 A letter of credit, or L/C, is issued by a bank on behalf of its customer

(buyer) to the seller.

 As per this document, the bank agrees to honour drafts drawn on it

for the supplies made to the customer, if the seller fulfils the
conditions laid down in the L/C.
 The L/C serves several useful functions:

(i) It virtually eliminates credit risk, if the bank has a good

standing,
(ii) It reduces uncertainty as the seller knows the conditions that

should be fulfilled to receive payment,

(iii) It offers safety to the buyer who wants to ensure that payment

is made only in conformity with the conditions of the L/C.

 >>>>> Bank/Financial Institution>>> Buyer>>>>Seller
 Harish :
100 (50% Credit and 50% Cash)
Credit Period: 15 days?
30days?
45 days?
60 days?
How much discount ?
5/10 , 3/5
Credit Policy Variables
 The important dimensions of a firm’s credit policy
are:
 Credit standards
 Credit period
 Cash Discount
 Collection effort
 These variables are related and have a bearing on
the level of sales, bad debt loss, discounts taken by
customers, and collection expenses.
Credit Standards
A pivotal question in the credit policy of a firm is: What standard should
be applied in accepting or rejecting an account for credit granting?
 A firm has a wide range of choice in this respect.

 At one end of the spectrum, it may decide not to extend credit to any

customer, however strong his credit rating may be.

At the 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.
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

larger investment in receivables, and a higher cost of collection.

Stiff credit standards have opposite effects.

They tend to depress sales, reduce the incidence of bad debt loss, decrease

the investment in receivables, and lower the collection cost.

 Credit Period
 The credit period refers to the length of time customers are allowed to pay for
their purchases.
 It generally varies from 15 days to 60 days. When a firm does not extend any
credit, the credit period would obviously be zero. If a firm allows 30 days,
say, of credit, with no discount to induce early payments, its credit terms are
stated as 'net 30'.
 Lengthening of the credit period pushes sales up by inducing existing
customers to purchase more and attracting additional customers.
 This is, however, accompanied by a larger investment in debtors and a higher
incidence of bad debt loss.
 Shortening of the credit period would have opposite influences. It tends to
lower sales, decrease investment in debtors, and reduce the incidence of bad
debt loss.
Cash Discount
 Firms generally offer cash discounts to induce customers to make
prompt payments
 The percentage discount and the period during which it is available
are reflected in the credit terms.
 For example, credit terms of 2/10, net 30 mean that a discount of 2
percent is offered if the payment is made by the tenth day; otherwise
the full payment is due by the thirtieth day.
 Liberalising 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
Collection Effort
 The collection programme of the firm, aimed at timely collection of
receivables, may consist of the following:
■ Monitoring the state of receivables
■ Dispatch of letters to customers whose due date is approaching
■ E-mail and telephonic advice to customers around the due date
■ Threat of legal action to overdue accounts
■ Legal action against overdue accounts
 A rigorous collection programme tends to decrease sales, shorten the

average collection period, reduce bad debt percentage, and increase the
collection expense.
 A lax collection programme, on the other hand, would push sales up,

lengthen the average collection period, increase the bad debt percentage,
and perhaps reduce the collection expense.
CREDIT EVALUATION
 Proper assessment of credit risks is important as it helps in establishing credit
limits. In assessing credit risks, two types of errors occur:

Type I error A good customer is misclassified as a poor credit risk.

Type II error A bad customer is misclassified as a good credit risk.

 Both the errors are costly. Type I error leads to loss of profit on sales to good
customers who are denied credit. Type II error results in bad-debt losses on
credit sales made to risky customers.
 While misclassification errors cannot be eliminated wholly, a firm can mitigate
their occurrence by doing proper credit evaluation.
 Two broad approaches are used for credit evaluation, viz., traditional credit
analysis, numerical credit scoring ( Risk Classification Scheme)
 
 
Traditional Credit Analysis
 The traditional approach to credit analysis calls for assessing a prospective
customer in terms of the "five C's of credit“
 Character :The willingness of the customer to honour his obligations. It
reflects integrity, a moral attribute that is considered very important by credit
managers.
 Capacity: The ability of the customer to meet credit obligations from the
operating cash flows.
 Capital :The financial reserves of the customer. If the customer has problems
in meeting credit obligations from operating cash flow, the focus shifts to its
capital.
 Collateral :The security offered by the customer in the form of pledged assets.
 Conditions: The general economic conditions that affect the customer.
To get information on the five C's, a firm may rely on the following:

 Financial Statements Financial statements contain a wealth of information. A

searching analysis of the customer's financial statements can provide useful
insights into the creditworthiness of the customer. The following ratios seem
particularly helpful in this context: current ratio, acid-test ratio, debt-equity
ratio, EBIT to total assets ratio, and return on equity.
 Bank References The banker of the prospective customer may be another
source of information. To ensure a higher degree of candour, the customer's
banker may be approached indirectly through the bank of the firm granting
credit.
 Experience of the Firm Consulting one's own experience is very important. If
the firm had previous dealings with the customer, then it is worth asking: How
prompt has the customer been in making payments? How well has the
customer honoured his word in the past? Where the customer is being
approached for the first time, the impression of the company' sales personnel
is useful.
 Prices and Yields on Securities For listed companies, valuable inferences can
be derived from stock market data. Higher the price-earnings multiple and
lower the yield on bonds, other things being equal, lower will be the credit risk.
 Numerical Credit Scoring ( Weights X Rates 1-5 or
1-7)

In traditional credit analysis, customers are assigned to various risk classes somewhat
judgmentally on the basis of the five C's of credit. Credit analysts may, however, want to use a
more systematic numerical credit scoring system. Such a system may involve the following
steps:
1. Identify factors relevant for credit evaluation.
2. Assign weights to these factors that reflect their relative importance.
3. Rate the customer on various factors, using a suitable rating scale (usually a 5-point
scale or a 7-point scale is used).
4. For each factor, multiply the factor rating with the factor weight to get the factor
score.
5. Add all the factor scores to get the overall customer rating index.
6. Based on the rating index, classify the customer.

Exhibit 25.2 illustrates the use of this procedure for assigning a rating index.
6
Risk Classification Scheme
 On the basis of information and analysis in the credit
investigation process, customers may be classified
into various risk categories.
 A simple risk classification scheme is shown in
Exhibit 25.4.
 The risk classification scheme described in Exhibit
25.4 is one of the many risk classification schemes
that may be used. Each firm would have to develop a
risk classification scheme appropriate to its needs and
circumstances.
CONTROL OF ACCOUNTS RECEIVABLE

 Traditionally, two methods have been commonly suggested

for monitoring accounts receivable ( Bills Receivables -----
bills against which money is due to be received :
 days sales outstanding and ageing schedule.
 While these methods are popularly used, they have a serious
deficiency: they are based on an aggregation of sales and
receivables.
 To overcome the weakness of the traditional methods, the
collection matrix approach has been suggested. This section
discusses the traditional methods and the collection matrix
approach.
Days Sales Outstanding
 Days sales outstanding (DSO) is the average number of days
that receivables remain outstanding before they are collected.
 It is used to determine the effectiveness of a company's credit
and collection efforts in allowing credit to customers, as well
as its ability to collect from them.
 When measured at the individual customer level, it can
indicate when a customer is having cash flow troubles, since
the customer will attempt to stretch out the amount of time
before it pays invoices.
 The measurement can be used internally to monitor the
approximate amount of cash invested in receivables.
Ageing schedule
 is an accounting table that shows a company’s
accounts receivables, ordered by their due dates.
Often created by accounting software, an aging
schedule can help a company see if its customers
are paying on time. It’s a breakdown of receivables
by the age of the outstanding invoice, along with
the customer name and amount due.
 An ageing schedule often categorizes accounts as current
(under 30 days), 1-30 days past due, 30-60 days past due,
60-90 days past due and more than 90 days past due.
 Companies can use aging schedules to see which bills are
overdue and which customers it needs to send payment
reminders to or, if they are too far behind, send to
collections.
 A company wants as many of its accounts to be as current
as possible because the longer the account is delinquent,
the likelier it is it will never be paid, leading to a loss. 
Collection Matrix
 The average collection period and the ageing schedule have
traditionally been very popular measures for monitoring receivables.
 However, they suffer from a limitation in that they are influenced by
the sales pattern as well as the payment behaviour of the customers.
 If sales are increasing, the average collection period and the ageing
schedule will differ from what they would be if sales are constant.
 This holds even when the payment behaviour of customers remains
unchanged.
 The reason is simple: a greater portion of sales is billed currently.
Similarly, decreasing sales lead to the same results. The reason here is
that a smaller portion of sales is billed currently.
 In order to study correctly the changes in payment
behaviour of customers, it is helpful to look at the
pattern of collections associated with credit sales.
Exhibit 25.7 shows an illustrative collection matrix
 For example, the credit sales during the month of January are
collected as follows: 13 percent in January (the month of
sales), 42 percent in February (the first following month), 33
percent in March (the second following month), and 12
percent in April (the third following month).
 From the collection pattern, one can judge whether the
collection is improving, stable, or deteriorating.
 A secondary benefit of such an analysis is that it provides a
historical record of collection percentages that can be useful
in projecting the pattern of collections from future sales.
Review Questions
1. Describe the major terms of payment in practice.
2. What are the important dimensions of a firm's credit policy?
3. Discuss the consequences of lengthening versus shortening of the
credit period.
4. Discuss the effects of liberal versus stiff credit standards.
5. What are the effects of liberalizing the cash discount policy?
6. Describe the five C's of credit.
7. What shortcomings of the DSO and AS methods?
8. Describe the collection matrix approach to receivables analysis and
control. How does it overcome the deficiencies of the DSO and AS
methods?
9. Explain the methods or approaches used in monitoring and controlling
accounts receivables?
10. Explain the methods or approaches used in evaluation Credit Risk?