Managing credit involves two basic steps. The first step is deciding who your company should offer credit to. In addition, what should the terms of that credit be? The second step involves managing the accounts receivable that are established as a result of extending that credit. In many respects, this step is similar to managing cash. This post describes those two steps with a clear illustration, enriched with tips and basic credit term. Read on…
You’ve probably seen the spectacle: A home electronics store advertises a year-end blowout21 sale, declaring,
”You can buy a $2,000 giant-screen television for no money down, and no interest payments for the next 12 months!”
A one-year interest-free loan? Are they crazy? Maybe. Maybe not.
Conceptually, the company is doing what all businesses that extend credit do: It is attempting to move inventory a little faster and to move a little more inventory. You’ll recall from the previous post [5 Steps To Proper Cash Managent] that there are three basic ways for companies to reduce their requirements for cash. They can: 1) speed up collections; 2) delay payments; or 3) increase the speed with which sales are made. We’ve discussed the first two already. One way your company can do the third is through strategic credit management.
What Is Credit?
When a company extends credit, it is in essence providing a loan to customers. For instance: when that home electronics store advertises a no-money down, no-interest credit special, it is offering a cheap loan to customers who don’t have $2,000. The same is true for suppliers who provide trade credit to businesses. In this relationship, the supplier is extending a 30-day, no-interest loan in exchange for getting your company’s business. Today, credit is a necessity. It must be extended to attract customers.
The Laws of Credit
A loose credit policy tends to . . .
- Increase sales.
- Increase days sales outstanding.
- Increase collection costs.
A tight credit policy, on the other hand, tends to . . .
- Reduce sales.
- Reduce days sales outstanding
- Reduce collection costs
Here are the two basic steps company should take to manage their credit:
Step 1: Establishing Credit Standards
Each company will determine, based on its relationships with its customers and its own needs, how liberal or conservative to be when it comes to extending credit. But all companies rely on some system to determine who should be eligible for these loans, and who should not. If yours is a large and sophisticated concern, it may rely on statistical methods, such as “Multiple Discriminant Analysis“.
Multiple Discriminant Analysis works something like this: Let’s say your company sells lug wrenches to 100 auto repair shops. Historically, about 80 of those shops have paid for supplies on time. The other 20, however, have been delinquent. Using Multiple Discriminant Analysis, your company would attempt to find similarities among the 20 delinquent shops.
- It may discover that the one thing that the 20 delinquent shops have in common is that their debt-to-equity ratio is 20 percent worse than their industry peers. Or perhaps all 20 score terribly when it comes to the acid test, otherwise known as the quick ratio. Your company then does the same thing with the 80 shops that aren’t delinquent.
- Then, based on its findings, it creates a credit scoring system. The higher a company’s income, for instance, the greater it might score in this system. The higher its debts, however, the lower it would score. Your company then decides what a minimum score must be for a customer to be awarded credit.
The benefit of such a system is that large companies that don’t have relationships with their customers can determine whom to extend credit to without much effort. Of course, such a system has its flaws. For instance: without ever meeting customers face-to-face and without talking to their banks and other creditors your firm may never really know whether or not a company is honorable enough to pay back the loan.
FYI: Conditional Credit
If your company sells big-ticket items such as heavy machineryto customers on installment plans, it may want to use a conditional sales contract. Under a conditional sales contact, your client has use of the product, but your firm maintains ownership until final payment is made. This way, should customers fail to satisfy their credit terms, your firm can reduce its losses by reclaiming the merchandise.
The Five C’s of Credit
Whether your company relies on a system like Multiple Discriminant Analysis OR uses a qualitative method to determine who is creditworthy, it ought to take the following considerations into account. These are known as “The five C’s of credit“, here they are:
- Character – Does this customer have a history of honoring its debts? One way to find this out is a useful source for gauging character, since bond rating agencies routinely check companies’ credit histories. You can also turn to credit reports. Dun & Bradstreet, for instance, issues credit reports on businesses that indicate their payment history and the amount of credit that companies currently have outstanding. Consumer credit companies, such as Equifax and Trans Union, publish similar reports on individuals.
- Capacity – Does the customer already rely on too much credit? If it does, then there’s a good chance that it might not be able to pay back its debts in a timely fashion. Good sources for this information include credit reports once again Dun & Bradstreet and the company’s own financial statements. The income statement, for instance, will indicate annual debt repayment obligations. And the balance sheet will show overall debt.
- Capital – What are the customer’s financial resources? You can request a customer’s bank account information to find this out. You can certainly conduct a background check on the company through credit reports. And you can rely on its balance sheet.
- Conditions – Is the customer’s business in an unstable economic or political region?
- Collateral – Does the customer have unsecured assets that it can use to back up the debt?
The Benefits of Loose Credit
What if your company decides to relax its credit standards? When a company loosens its credit policies, it can do one or both of the following:
- extend credit to a greater number of customers; or
- improve the terms of the credit it is willing to extend to customers. Both of these moves are likely to improve sales-at least in the short term.
Let’s go back to our example of the home electronics store. Let’s say you take the company up on its offer and agree to buy that $2,000 giant-screen TV. While you won’t have to make interest payments for the next 12 months, you will have to make monthly payments on the principal. So, let’s assume that at the end of 12 months, you pay for the set interest free. If the actual cost of goods sold on that television was $1,000 and the cost of extending credit represented another $500, the company still made $500 profit on the set based on the $2,000 you paid for it.
That’s despite the interest-free loan it floated to you. In this scenario, the company believes that earning a $500 profit today is better than $1,000 later.
The Costs of Credit
Offering credit costs your firm money. These costs include:
- The cost of capital (while your company’s money is tied up in accounts receivable)
- The cost of hiring personnel to manage credit accounts
- The cost of the computer systems needed to maintain those accounts
- The cost of collection agencies that may be required to assist in the collection process
- [. . . and the Hazards]
But what happens if, after taking possession of the TV, you miss several monthly payments? That could throw off the company’s cash flow.
Or what if you default on the loan? That could throw off the company’s profit.
In our example, if you fail to pay back the home electronics store, not only will the company be out the $500 profit it had booked. It will also have to spend money trying to recoup its money or take a loss on the inventory!.
For loose credit policies to work, then, companies must be assured of three things:
- The policy will boost sales enough to cover the expense of the credit.
- Customers who are extended credit can be trusted to pay back their loans.
- The policy will not make customers dependent on credit.
Setting a Collection Policy
Once your company establishes its credit policy, it must decide how it will handle delinquent accounts. Your company must determine:
- . . . if and when it will send a letter to remind customers of past due accounts. Many companies automatically issue a reminder note ten days after the official due date has passed.
- . . . if and when it will call delinquent customers. Many firms call customers once their accounts are close to being 60 days past due.
- . . . if and when it will rely on collection agencies to help recoup its money. Some companies hire collection agencies to handle accounts once they go three months past due. However, this costs money (collection firms often charge fees and/or take a percentage of the money they recover). Furthermore, your company risks angering customers by relying on these agencies.
- . . . at what point your company will decide to write off certain accounts receivable as “uncollectible. “Companies routinely write off these assets and expense them against the current year’s income statement figuring that it is no longer worth the money and time to try to collect the debt.
Step 2: Managing the Receivables
It is not unusual for companies to have a quarter or even half of their assets tied up in “accounts receivable“. Managing these receivables is similar to managing cash. Regardless of whether the actual credit policy is loose or tight, the credit manager’s job is: TO SPEED THE COLLECTION OF DEBT!. Companies rely on several techniques for this:
Monitor Its Days Sales Outstanding
The first thing your company does is monitor its days sales outstanding ratio. As I’ve mentioned in my other post; this ratio measures how quickly customers are paying their bills. The DSO can be calculated by taking a company’s accounts receivable and dividing that by sales per day.
Days Sales Outstanding = Accounts Receivable/(Sales/365)
Assuming your company has $10 million in accounts receivable and generates $500,000 in sales per day, its DSO would be 20 days. That means your customers tend to pay their bills within 20 days. It’s useful to monitor DSO ratios over time and to compare them to industry averages.
The Problem of Having Too Much Credit
According to figures published in Money Magazine:
- The typical American adult held nine credit cards in 1997.
- The typical American adult’s combined credit card balances totaled roughly $4,000.
- Credit card delinquencies are near 20-year highs.
- Consumer debt in 1997 reached $1.2 trillion. Roughly half of that, or $520 billion, consisted of credit-card balances and other forms of revolving credit.
Accounts Receivable Maintenance
Your company maintains a separate account receivable for each of its customers. Included in this account is the amount of credit outstanding and the age of the debt.
If Strauss’ Department Store owes Lie Dharma Inc for inventory, then Lie Dharma Inc ought to know how old the debt is and when the bill will become past due.
On the day the account becomes delinquent, Lie Dharma Inc’s computer system should be set up to notify the company of the delinquency. Lie Dharma Inc may choose to mail letters to Strauss’ reminding it of its obligation at this point. Or it may choose to call its managers directly. In fact, many companies have designed their computers to place routine reminder calls to customers every other day or so while the account remains delinquent.
Receivable Aging Schedules
Information from individual receivables accounts is posted to an aging schedule. An aging schedule, such as the one shown here, indicates how many days a company’s accounts receivable have been outstanding.
Accounts Receivable Aging Schedule Examples
Age of Accounts Value Percent of Industry
Receivable Total Accounts Average
0-10 days $1,500,000 11 15%
11-20 days 4,000,000 31 25
21-30 days 6,000,000 47 55
31-45 days 750,000 6 3
46-60 days 500,000 4 1
Over 60 days 100,000 1 1
The above aging schedule shows that 42 percent of its accounts are outstanding for less than 20 days. That’s slightly better than the industry average. However, 11 percent of its accounts are delinquent, compared with just 5 percent for the industry.
As we mentioned in the previous post [5 Steps To Proper cash Management], companies use discounts to get customers to pay their bills early. For instance: companies often extend favorable credit terms to businesses willing to pay their bills in ten days or less. Let’s say Lie Dharma Inc agrees to supply toys to Strauss’ Department Store. To get Strauss’ to clear its trade credit early, Lie Dharma Inc may extend it credit terms of 2/10 net 30. That’s shorthand!. Lie Dharma Inc is letting Strauss’ know that it is willing to give it a 2 percent discount if it pays its bill within ten days. The net 30 refers to the fact that the full payment is due in 30 days.