A company may have many customers—perhaps thousands of them. It must decide, for each one, how much credit it will extend, the time period before which each payment is due, and the size and nature of any discounts given. This can be a monumental task, and must be done properly, or else the organization may suffer from bad debts so large that its cash reserves are drained. Alternatively, an excessively restrictive credit policy can result in lost sales that interfere with corporate growth.
Given the critical nature of customer credit, I will review in this post the types of credit and credit terms most commonly used, how to conduct a credit evaluation of a customer, and how to collect overdue funds. You will see that a proper credit policy, when combined with credit extension and collection systems, can add to a company’s profitability. Enjoy!
Overcome Types Of Credit Decision
There are a wide array of credit types that can be extended to a customer, though merchandise credit and letters of credit [L/C] tend to be used in all but a few situations. Accordingly, I will concentrate on these two categories of credit.
Merchandise credit is used when products are sold to a customer against a promise by the customer of future payment, in accordance with a predetermined set of payment terms. Though merchandise credit can be extended on an order-by-order basis, it is more common to set up a customer with a pre-determined maximum amount of credit, beyond which shipments will not be made until the existing amount of unpaid invoices has been reduced. The decision to grant merchandise credit to a customer is usually made by the credit department, which is part of the treasurer’s staff. In a smaller company, this chore will fall within the purview of the accounting department. The techniques used to derive the amount of credit are described in the “Overcome Credit Examination” section of this post.
If merchandise credit is not available, or if there is difficulty in collecting on such credit, a company can work with its customer to create a “promissory note“, under which the customer agrees to pay the company a fixed amount, at a fixed or variable interest rate, and in accordance with a fixed schedule of payments. Promissory notes can usually be sold to a third party, and so are a reasonably liquid form of repayment. However, it can take a great deal of time to negotiate one.
A simpler variation on the promissory note is to “factor” one’s accounts receivable through a third party, which generates immediate cash at the price of a transaction fee. It is also common for the factoring organization to have recourse against the company if it cannot collect on an account receivable, so the risk of bad debt loss is still with the company. Though this is an expensive form of credit, it can dramatically accelerate a company’s cash flow.
Letter of Credit [L/C]
The letter of credit (L/C) is used almost entirely for international sales, since it gives the seller assurance that a shipment to another country will be paid for in full, without any credit problems arising. It is a major tool for the ongoing development of international trade, and so its terms are well-protected by many court cases that consistently rule in its favor.
The L/C is a document under which an entity can draw upon the credit of the bank that has issued the L/C for a specific amount, subject to a set of detailed performance conditions noted in the L/C.
How Does An L/C Work? [Example]
Lie Company wishes to purchase goods from Lou Company, which is located in a different country. Lou insists that the transaction be handled through an L/C. To do so, Lie goes to its Local bank and requests an L/C.
The bank shifts money from Lie’s bank account into an escrow account, where it will be held until drawn down by Lou. Lie’s bank then sends the L/C document to its correspondent bank in Lou’s country.
When Lou has shipped the goods itemized on the L/C to Lie, it takes its proof of delivery to the correspondent bank. Lie’s bank then sends the money to its correspondent bank, which pays Lou. In essence, this is an elaborate form of cash payment at the time of shipment, and can be construed as cash in advance, since many banks would require Lie Company to hand over the full amount of cash listed on the L/C prior to their sending the documentation to the correspondent bank.
- Given the high level of probability that cash will be paid if the terms of the L/C are met, the L/C is sometimes used domestically.
- An L/C is called “irrevocable” if the bank issuing it cannot cancel it until its stated expiration date.
- If the L/C is called “confirmed”, then both the originating and correspondent banks have guaranteed its payment. These are standard features.
A modification on most types of credit is to have the parent company of a customer or an individual within it guarantee payment of any credit issued. By doing so, the company has two sources from which it can demand repayment. Customers will not normally agree to this provision, but can be forced to do so if their credit options are limited or if the company is the sole source of a particular service or product.
Another credit option is to sell on consignment, so that the goods sent to a customer are still the legal property of the company, and therefore can be taken back if the customer does not pay for them subsequent to their sale. However, the usual terms of such an agreement are that the company cannot expect payment until the point of sale by the customer, which may mean that it is funding a large amount of finished goods inventory for a long period of time.
The type of credit granted will be highly dependent upon the type of credit strategy adopted by a company. If its goal is to keep bad debt losses to an absolute minimum, then it will keep credit levels low, or only accept cash payments.
However, if company managers want to greatly increase the rate of corporate growth, one approach is to offer credit to many more customers, and in larger quantities. By doing so, it can steal business away from competitors who have more restrictive credit policies, though at the cost of a higher level of bad debt. It may also want to loosen credit terms if it wishes to clear out an excessive amount of on-hand inventory, or to shut down a product line entirely. If the gross margin on a product sale is very high, then the associated credit terms can be loosened considerably, since the company stands to lose very little of its costs if the customer reneges on its payment.
Whatever the mix of selling terms may be, the most appropriate level of credit granted to customers is the point at which increased margins from the sale of merchandise on relaxed credit terms is exactly offset by the increased cost of delayed payments and bad debts.
Overcome The Selling Terms
There are a number of selling terms that can be used, as well as formats in which they are presented. The key factors in a set of selling terms are the time to maturity and the cash discount:
The time to maturity is the number of days from the date of the invoice to the day when payment is required.
Example: If the invoice date is March 1 and the terms are “net 30”, then it is due for payment on March 30.
The cash discount is the percentage that a customer can deduct from a payment if it pays before a pre-set date, which is useful for accelerating cash flows. The cash discount is not normally of much use for collections from customers with a history of payment delinquency, since they may not have enough cash on hand to take advantage of the discounts.
“2%/10,” means that the customer can take a 2% discount if it pays within 10 days of the invoice date. When the time to maturity and cash discount terms are combined from the previous examples, they would appear on an invoice as “2%/10 Net 30” or “2/10 N 30”.
Some customers will take a cash discount even when they are not paying early (and may pay quite late). If so, the customer has abrogated the payment terms, so it is reasonable to charge back the customer for the amount of the discount taken. At a minimum, the general ledger should be arranged so that all discounts taken are stored in a separate account, with a notation regarding the name of the customer and whether or not it was incorrectly taken. By collecting this information, the accountant can inform the purchasing staff of problem customers, which they can use to increase prices to a point that will compensate for the improper discounts.
A much less common form of selling term is to specify the number of days after month-end when the payment is due.
The terms could be “10 EOM” or “Net 10 PROX,” which means that the payment is due 10 days after the end of the month (hence the “EOM”, for “end of month”).
Note: The PROX is an abbreviation for proximo, which is an old commercial term that refers to the next month.
This selling term was more commonly used when computer systems were not available, since collection employees would not have to keep track of a wide range of invoice due dates, but instead knew that all invoices were due on the same day of each month, and could conduct collection activities in accordance with that information. This selling term assumes that some customers will be required to pay a little late, and others a little early, so that the average receivable period should be the same as under any other selling terms methodology; however, slow paying customers who are invoiced near the end of the month will still pay late, which results in a net days’ receivable figure that is somewhat longer under this system.
Seasonal dating can also be included in the selling terms. This is used when a company wants to sell goods that are out-of-season, both in order to clear out its warehouse and also to record some revenue during the slow part of the selling season. To do so, it guarantees its customers that they will not have to pay invoices until a specific date has been reached (usually well into the main part of the selling season), no matter when they took delivery. An example of such terms is “5 days, April 1st,” or “5 April 1,” which means that the invoice is due five days after April 1st.
There may also be a trade discount listed on an invoice, which is a discount given in exchange for either an especially large-volume order, or because the customer has agreed to purchase goods outside of the normal selling season. This discount is typically listed separately from the time to maturity and cash discount percentage.
An invoice may also state that an interest rate will be charged for payments that exceed a certain late date. Any notation regarding interest rates is typically added as a footnote to the bottom of the invoice. The upper range of this interest rate is bounded by each state’s interest rate cap laws.
Note: Commonly, the interest rate will begin to apply after a grace period of at least 10 days has passed after the maturity date of the invoice. The interest rate is calculated automatically by the accounting software, and will generate invoices containing the interest rate at the end of each month. The accountant should be prepared to write off the majority of these interest rate charges, since most customers will refuse to pay them. Nonetheless, it can be an effective tool for reminding customers to pay on time.
In situations where customers have a poor credit history, or if the company has an immediate need for cash, its terms will be “cash on delivery” (COD). Under this arrangement, the company retains title to the shipped goods until payment is made by the customer to the delivery company at the point of shipment delivery. However, this form of selling terms is expensive, since the delivery company charges a fee for collecting the funds, while the company is also liable for the freight on any returned goods if the customer decides not to pay.
The COD concept can be accelerated even more to include either cash in advance for an entire order, or progress payments that are doled out by the customer as its order reaches various milestones of completion at the company. These terms are typically used when the product being ordered is a custom one that the company cannot otherwise sell if the customer cancels its order, or if the completion date is so far in the future that the company needs cash in advance in order to have sufficient working capital to complete the order.
Overcome Credit Examination
It can be quite difficult to determine an appropriate credit level for a customer, since the amount of investigation required to develop an accurate picture of a potential customer’s financial situation may exceed the time available to the credit department. Accordingly, there are a number of shortcuts discussed in this section that yield good results while requiring less investigative effort. If the amount of credit contemplated is quite high, however, a full and detailed credit review is necessary. The contents of that review are also noted here.
If the amount of credit needed by a customer is quite low, then the credit department can authorize it by default, with no further investigation. However, in order to counterbalance this credit with the risk of loss, the amount given is usually very small.
In order to authorize a larger amount of credit, the customer should be asked to fill out a credit form, on which is itemized the contact name of the customer’s banker, as well as at least three of its trade references. If these references are acceptable, then the level of credit granted can be increased to a modest level. However, it is a simple matter for a customer in difficult financial straits to influence the credit “picture” that it is presenting to the company, by making sure that all of its trade references are paid on time, even at the expense of its other suppliers, who are paid quite late.
To avoid this difficulty, the credit department can invest in a credit report from one of the “credit reporting agencies“. The price can vary from $20 to $70 per report, depending upon the type of information requested and the number of reports ordered (the credit services strongly encourage prepayment in exchange for volume discounts).
These services collect payment information from many companies, as well as loan information from public records, financial information from a variety of sources, and on-site visits. The resulting reports give a more balanced view of a customer than its more sanitized trade references list.
Part of the credit report itemizes the average credit granted to the customer by its other trading partners. By averaging this figure, one can arrive at a reasonable credit level for the company to grant it, too.
The report will also itemize the average days that it takes the customer to pay its bills. If this period is excessively long, then the credit department can reduce the average credit level granted by some factor, in accordance with the average number of days over which the customer pays its bills.
Assume the average outstanding credit is $1,000, and the customer has a record of paying its bills 10 days late, then the credit department can use the average credit of $1,000 as its basis, and then reduce it by 5% for every day over which its payments are delayed. This would result in the company granting credit of $500 to the customer.
However, credit reports can be manipulated by customers, resulting in misleading or missing information. For example, a privately-held firm can withhold information about its financial situation from the credit reporting agency. Also, if it knows that there are some poor payment records listed in its credit report, it can pay the credit agency to contact a specific set of additional suppliers (presumably with a better payment history from the customer), whose results will then be included in the credit report. Also, the information in the average credit report may not be updated very frequently, so the company purchasing the information may be looking at information that is so dated that it no longer relates to the customer’s current financial situation.
If the amount of credit requested is much higher than a company is comfortable with granting based on a credit report, then it should ask for audited financial statements from the customer on an annual basis, and subject them to a review that includes the following key items:
- Age of receivables – If a customer has trouble receiving its invoices, then it will have less cash available to pay its suppliers. To determine receivables turnover, divide annualized net sales by the average balance of accounts receivable. In order to convert this into the number of days of receivables outstanding, multiply the average accounts receivable figure by 360 and divide the result by annualized net sales.
- Size and proportion of the allowance for doubtful accounts – If the customer is reserving an appropriate amount for its expected bad debts, then by comparing the amount of the allowance for doubtful accounts to the total receivable balance, one can see if the customer has over-committed itself on credit arrangements with its own customers. However, many organizations will not admit (even to themselves) the extent of their bad debt problems, so this figure may be underestimated.
- Inventory turnover – A major drain on a company’s cash is its inventory. By calculating a customer’s inventory turnover (annualized cost of goods sold divided by the average inventory), one can see if it has invested in an excessive quantity of inventory, which may impair its ability to pay its bills.
- Current and quick ratios – By comparing the total of all current assets to the total of current liabilities, one can see if a customer has the ability to pay for its debts with currently available resources. If this ratio is below 1:1, then it can be considered a credit risk, though this may be a faulty conclusion if the customer has a large, untapped credit line that it can use to pay off its obligations. Amore accurate measure is the quick ratio (cash plus accounts receivable, divided by current liabilities). This ratio does not include inventory, which is not always so easily liquidated, and so provides a better picture of corporate liquidity. Of particular concern when reviewing these ratios is over-trading. This is a situation in which the current ratio is poor and debt levels are high, which indicates that the customer is operating with a minimum level of cash reserves, and so is likely to fail in short order. This type of customer tends to have a good payment history up until the point where it completely runs out of available debt to fund its operations, and abruptly goes bankrupt.
- Ratio of depreciation to fixed assets – If a customer has little available cash, it tends not to replace aging fixed assets. The evidence of this condition lies on the balance sheet, where the proportion of accumulated depreciation to total fixed assets will be very high.
- Age of payables – If a customer has little cash, its accounts payable balance will be quite high. To test this, compare the total accounts payable on the balance sheet to total non-payroll expenses and the cost of goods sold to see if more than one month of expenses is stored in the payables balance.
- Short-term debt payments – If a customer cannot pay for its short-term debt requirements, then it certainly cannot pay its suppliers. To check on the level of debt repayment, go to the audited financial statements and review the itemization of minimum debt payments L/Cated in the footnotes. This should be compared to the cash flow report to see if there is enough cash to pay for upcoming debt requirements.
- Amount of equity – If the amount of equity is negative, then warning bells should be ringing. The customer is essentially operating from debt and supplier credit at this point, and should not be considered a candidate for any credit without the presence of a guarantee or security.
- Debt/equity ratio – If investors are unwilling to put in more money as equity, then a customer must fund itself through debt, which requires fixed payments that may interfere with its cash flow. If the proportion of debt to equity is greater than 1:1, then calculate the times interest earned, which is a proportion of the interest expense to cash flow, to see if the company is at risk of defaulting on payments.
- Gross margin and net profit percentage – Compare both the gross margin and net profit percentages to industry averages to see if the company is operating within normal profit ranges. The net profit figure can be modified by the customer through the innovative use of standard accounting rules, and so can be somewhat misleading.
- Cash flow – If the customer has a negative cash flow from operations, then it is in serious trouble. If, on the other hand, it is on a growth spurt and has negative cash flow because of its investments in working capital and facilities, and has sufficient available cash to fund this growth, then the presence of a strong cash outflow is not necessarily a problem.
The key factor to consider when using any of the preceding credit review items is that the information presented is only a snapshot of the customer’s condition at a single point in time. For a better understanding of the situation, the credit department should maintain a trend line of the key financial information for all customers to whom large lines of credit have been extended, so that any deleterious changes will be obvious.
If the financial statements are based on one time of year when the seasonality of sales may be affecting the reported accuracy of a company’s financial condition, it may be better to request copies of statements from different periods of the year. For example, the calendar year-to-date June financial statements for a company with large Christmas sales will reveal very large inventory and minimal revenue, which does not accurately reflect its full-year condition.
The presence of potential credit problems will typically appear in just one or two areas, since the customer may be trying to hide the evidence from its suppliers. Fortunately, other sources of information can be used to confirm any suspicions aroused by a review of a customer’s financial statements. For example, the sales staff can be asked for an opinion about the visible condition of the customer; if it appears run down, this is strong evidence that there is not enough money available to keep up its appearance.
Also, if the customer is a publicly held entity, a great deal of information is available about it through EDGAR On-line, which carries the last few years’ worth of mandatory filings by the customer to the Securities and Exchange Commission. This information can be used to supplement and compare any information provided directly to the company by the customer.
It is critical that the financial information provided by a customer for review is fully audited, and not the result of a review or compilation. These lesser reviews do not ensure that the customer’s books have been thoroughly reviewed and approved by an independent auditor, and so may potentially contain incorrect information that could mislead the credit department into issuing too much credit to the customer.
This post has shown that there is a variety of ways in which a company can creatively extend credit to its customers, as well as different terms under which that credit can be paid back. A variety of analytical tools can also be used to determine the most appropriate level of credit that should be granted to a customer, while the collections function can be organized in such a way that bad debt losses are kept to a minimum. The key factor running through all of these tasks is that the customer credit function requires constant vigilance and careful management to ensure that credit losses are reduced, consistent with corporate credit policies.