Establish Effective Credit and Collection
Policies
EXTENDING CREDIT TO YOUR
CUSTOMERS
Advantages of Trade Credit In
Your Business
Encourage customers to buy
more
Improve customer loyalty and
build good customer relations;
Make your customers less
sensitive to price and more
focused on the services you offer
Advantages of Trade Credit In
Your Business
You can factor or finance
receivables
Well designed accounts
receivable management
policies impress potential
creditors and investors
Disadvantages of Trade Credit
Accounts receivable often constitute a
significant portion of assets.
Receivables may not be highest quality
given firm’s recent financial condition.
Controlling the accounts receivable
process demands the development of
policies that are compatible with an
enterprises profit, liquidity and market
share.
Accounts Receivable Policy
 Granting credit is actually the practice of
making an investment in your customers.
 You have to decide what customers are
worthy of that investment.
 If you do a cost/benefit analysis and make the
important decision to extend credit you need
to establish procedures for credit and
collecting accounts.
Accounts Receivable Policy
Let’s begin with the Acceptance
Rejection Model linked to Excel
The Acceptance/Rejection Costs
model serves as a framework for
evaluating decisions on changing
credit policies;
Accounts Receivable Policy
Since the accounts
receivable policy has a
broad impact, it must be
managed carefully and
assessed frequently.
Output Screen
Acceptance Cost
$4,449
Rejection Cost
$38,400
Accept/Reject Credit:
ACCEPT CREDIT
Pr obabi l i t y B/ E
0.380
Problems
in
individual
Accounts Receivable Aging
accounts can be detected
through analysis of your
receivables by aging.
A receivables aging divides
each customer's account into
amounts that are 0-30 days
old, 31-60 days old, 61-90
days old.
Number of Days
Outstanding
0 - 30
30 -4 5
45 – 60
60 – 90
90 or more
Total
Amount
Percent
$45,000
$11,000
$6,500
$3,200
$1,900
$67,900
66.27%
16.64%
9.57%
4.71%
2.80%
100.00%
Aging Schedule of Accounts
Receivable
Phase
One: Review
Customer
Financial
The Credit
Check:
Scope
and
Statements
Details
Phase Two: Follow Through Receivables Key
Points
–Examination of receivables: classification of
accounts and aging.
–Obtain credit reports and checkings on
largest accounts.
–Verify receivables. Compute collection
period for each account.
–Classify accounts into acceptable and
unacceptable categories.
Scope and Details
Before acceptance into borrowing base
need measurements of receivable
management:
Average Collection Period
The delinquency ratio = past due
receivables over credit sales
The bad debt ratio: = write-offs over
net receivables
Scope
and
Details
Check files of past
due
accounts.
Review recent
correspondence and
collection efforts.
Review large positions.
Review Accounts
Receivable Policy In
Detail
Broad Picture
 Consider sound credit policy issues
 Quality standards
 Terms
 Limitations
 Instruments and payment methods
 Explore collections and credit insurance
as well as internal and external financing
options
Broad Picture
 Effective procedures for credit
approval, collection, processing
payments and past due accounts
are identified
 Proper evaluation is emphasized
 analytical methods to improve
the accounts receivable policy.
Internal and External
Constraints
 Accounts receivable policy requires
careful evaluation of potential impact on:
 sales volume
 cash management objectives and
procedures;
 direct and indirect costs of receivables
management; and customer relations.
The Core Of Accounts
Receivable Management
Credit Policy
Credit
Period
Credit
Terms
Credit
Quality
Standards
Discounts
and
Surcharges
Credit Policy
 Factors that influence credit policy:
 Ability to finance the credit policy.
 Costs of financing receivables estimated
to determine which approach is feasible;
 Industry credit terms.
 Terms tend to be alike throughout
industry. However, if enterprise has a
superior product or service, consider more
restrictive credit terms than industry
average;
Credit Policy
 Competitive issues.
credit policy often
limited by competitor
and customer reactions
Credit Policy
 The size of customer base and
relative risk profile of customers.
 Credit policy take into account
major, high-risk customers and
the weighting that should be
given to them in relation to the
total customer base
Credit Policy
 Sales volume
 If a new or changing credit policy is
expected to increase sales volume,
ability to meet customer demand
considered;
 Late payments and defaults.
 As a firms credit policy is eased, latepayment and default risk usually
increase;
Credit Policy
 Sovereign risk and credit
policy on export sales.
 Export sales credit policy
consider political, economic,
and local practices.
Credit Quality Standards
 To evaluate overall credit quality, five
Cs of credit are considered. Each is
weighted relative to its importance to
the enterprise and the availability of
information for constructing
probability estimates.
The Credit Report
 Corporate summary financial statements
 key ratios
 appropriate trend analyses
 Credit history showing
 payment timing
 credit limit
 legal
The Credit Report
 Customers credit quality ratings
reassessed on a regular basis,
particularly major customers
whose default could have serious
financial consequences for the
seller.
 Consider credit migration
probabilities
The Credit Report
 Consider amount of credit granted
and used, the industry class, and
general economic conditions.
 Management should also regularly
review critical factors chosen like
financial factors and weighting
assigned to each factor
Credit Period
 The credit period is length of
time credit is granted (for
example, from invoice date to
due date), and is normally
established according to an
industry standard.
Credit Period
 The credit period has direct impact on cost of
financing receivables and on collection risk.
An enterprise may elect to deviate from the
industry standard for one or more reasons:
 to obtain a competitive advantage
 to reflect the enterprises classification of
customer quality
 or to adjust to longer-term economic or
business changes.

.
Payment Terms
 Credit terms normally specified on contractual
documents, or on customer invoice or
statement.
 Cash before delivery (CBD) or cash on
delivery (COD) required when buyer
classified as poor credit risk.
 In cases of an unknown or one-time
customer, certified check may be required
when order is placed, or before goods or
services delivered.
Payment Terms
 Cash terms permit buyer payment period of
about five to 10 days and used for high-turnover
or perishable goods.
 Invoice terms often stipulate net due date and
discount date calculated from various starting
dates: invoice, delivery, or client acceptance
dates.
 The terms may be quoted, for example, as 2/10, net 30
meaning a payment discount of 2% is given if the
invoice is paid within 10 days. Full payment is required
after 10 days but within 30 days.
Payment Terms
 Watch Consignment sales
 require holder of the goods to pay the
supplier only when the goods sold.
 Supplier retains ownership of goods until
sold and may reclaim them or take legal
action in cases of default.
 The holder must maintain segregated
inventory and sales records, and provide a
periodic inventory reconciliation.
Discounts and Surcharges
 Cash discount policies may be
established for a number of reasons:
 to conform to the industry norm
 to stimulate sales
 to expedite receipt of cash
Credit Limits
 Credit limit categories codify total credit
granted to customers in each credit
quality classification.
 credit limits regularly reviewed.
 Periodic reassessments simplified by
automatically reassigning customers to a
higher credit limit level after specified
period of satisfactory payment
experience.
Credit Limits
Credit factors used to calculate single
numerical value to assign credit limits and
payment periods to different customers.
Credit score tempered by informed
management judgment because acceptreject decision implicitly includes economic
trade-offs: to minimize rejection of an
acceptable credit customer (with loss of
future business) versus to accept a poor
credit risk (and resulting debt losses)
Credit Instruments
 Written payment contracts agreed to
by the enterprise and customers.
 Instruments range from simple
invoices to formal credit
arrangements.
 When selecting an instrument to be
used consider industry standards,
market norms, and buyer risks.
Payment Methods
 Example: Electronic Funds Transfer
 Factors to consider when determining
possible payment methods are:
 provisions of the Federal Currency Act
concerning legal tender;
 standard trade practices;
 cost of processing;
 cash flow implications; and
 impact on collection risk.
Collection Policy
 The collections policy should specify:
 the employees directly responsible for
maintaining the policy;
 cash management techniques to be used to
optimize cash inflow (including prompt
invoicing);
 a statement routine and payment processing
method;
 a detailed procedure for handling past-due
accounts
Credit Insurance
 Collection risk can be reduced by
purchasing credit insurance, thus
shifting some of the risk of bad debt
losses to a third party.
 Risk level has to be high enough to
warrant the insurance premium.
 For example, receivables
concentration
Overdue Accounts
 Following is action of mid-sized firm:
 request prompt payment of the account;
 withhold approval or refuse to ship further goods
(or provide service) until past due payments are
made;
 withhold approval until partial payment is made;
or
 refuse further credit.
Overdue Accounts
 When partial payments required, policy
should specify whether payments applied
to oldest amounts outstanding, to
smallest outstanding invoices (a process
called shorting), or largest overdue
amount.
 payments should be made against
specific invoices where possible.
Evaluation of Sales
Policies
Detailed
analysis of
customer sales
records
Phase
Evaluation
ofrecords
Sales
A
detailed Three:
analysis of the
borrower's sales
Policies
are essential during the initial audit.
 Typical methods will reduce sales into categories
that include:
–Geographic analysis where sales are separated
by location. Determine geographical distribution of
sales and concentration.
–Product analysis. Size of package, and grade.
–Class of trade.
–Price.
–Method: mail, telephone, direct selling.
–Terms: cash or charge.
Order size.
Product Analysis
and Product Policies
Detailed analysis of
product analysis and
product policies are
essential during
workout
Phase Four: Product Analysis
Product
Policies should
be reviewed and generally
and Product
Policies
include:
–Sales volume,
–Type and number of competitors,
–Technical opportunity,
–Patent protection,
–Raw materials required,
–Production load,
–Value added
–Similarity to major businesses
–Effect on other products.