Credit Policy in Receivable Management

Concept of Credit Policy

The discharge of the credit function in a company embraces a number of activities for which the policies have to be clearly laid down. Such a step will ensure consistency in credit decisions and actions. A credit policy thus, establishes guidelines that govern grant or reject credit to a customer, what should be the level of credit granted to a customer etc. A credit policy can be said to have a direct effect on the volume of investment a company desires to make in receivables.

A company falls prey of many factors pertaining to its credit policy. In addition to specific industrial attributes like the trend of industry, pattern of demand, pace of technology changes, factors like financial strength of a company, marketing organization, growth of its product etc. also influence the credit policy of an enterprise. Certain considerations demand greater attention while formulating the credit policy like a product of lower price should be sold to customer bearing greater credit risk. Credit of smaller amounts results, in greater turnover of credit collection. New customers should be least favored for large credit sales. The profit margin of a company has direct relationship with the degree or risk. They are said to be inter-woven. Since, every increase in profit margin would be counterbalanced by increase in the element of risk.

Credit policy of every company is at large influenced by two conflicting objectives irrespective of the native and type of company. They are liquidity and profitability. Liquidity can be directly linked to book debts.… Read the rest

Credit Management – Managing Trade Credit and Accounts Receivable in Business

“The purpose of any commercial enterprise is the earning of profit, credit in itself is utilized to increase sale, but sales must return a profit.” – Joseph L. Wood

The primary objective of management of receivables should not be limited to expansion of sales but should involve maximization of overall returns on investment. So, receivables management should not be confined to mere collection or receivables within the shortest possible period but is required to focus due attention to the benefit-cost trade-off relating to numerous receivables management.

Principles of Credit Management

In order to add profitability, soundness and effectiveness to receivables management, an enterprise must make it a point to follow certain well-established and duly recognized principles of credit management. The first of these principles relate to the allocation of authority pertaining to credit and collections of some specific management. The second principle puts stress on the selection of proper credit terms. The third principles emphasizes a through credit investigation before a decision on granting a credit is taken. And the last principle touches upon the establishment of sound collection policies and procedures.

In the light of above discussion, the principles of credit management can be stated as:

1. Allocation or Authority

The determination of sound and effective credit collection policies management. The efficiency of a credit management in formulation and execution of credit and collection policies largely depends upon the location of credit department in the organizational structure of the concern. The aspect of authority allocation can be viewed under two concepts.… Read the rest

Microfinance Through Self Help Groups (SHG)

Microfinance

In India, the Task Force on Supportive Policy and Regulatory Framework for Microfinance has defined MF (Microfinance) as the “Provision of thrift, credit and other financial services and products of very small amounts to the poor in rural, semi-urban or urban areas for enabling them to raise their income levels and improve living standards”.

Major characteristics of Microfinance are:

  • Small amounts of saving and credit
  • Collateral free credit through collateral substitute like peer pressure
  • Group formation to create peer pressure and bring discipline
  • Easy access
  • Less and simplified procedures and documentations
  • Credit for both investment and consumption needs
  • Poor are bankable
  • Affordable interest rates
  • Sustainability

There are different methodologies for delivering microfinance like Grameen bank model of Prof. Yunus, SHG-Bank linkage model, Micro finance institutions (for profit and non profit),NBFC model, NGO model etc. In India SHG-Bank linkage model is the most popular model.

Self Help Groups (SHG) Model

Linking SHGs directly to banks is the basic model in which an SHG, promoted by an NGO or other institution, can access a multiple of its savings in the form of loan funds or a cash credit limit from the local rural bank.

Characteristics:

  • Self Help Groups are small groups of 10- 20  people staying in the same area(village),coming from the same economic background and  facing the same type of problems.
  • The members of the group decide to come together for  helping each other.
  • They also decide to save a small amount regularly and use the same as common kitty for helping the more needy members of the group by giving loans of very small amount on the terms and conditions mutually agreed upon by the group.
Read the rest

Reasons for Liquidity Fluctuations in Indian Banking System

Liquidity risk is inherent in bank’s core business because banking organizations employ a significant amount of leverage in their business activities and need to meet contractual obligations in order to maintain the confidence of customers and fund providers. The first step in measuring and managing liquidity risk is the identification of the most important sources of risk.

In the Indian context of banking, unexpected liquidity fluctuations are driven mainly by the following items:

  • Behavior of non-maturity deposits: A large fraction of deposits, in an Indian bank, consists of low-cost current and savings deposits which do not have any contractual maturity. Moreover, the depositor has the option to introduce or withdraw funds at any point of time. This makes the analysis of future cash inflows and outflows quite difficult. However, it is extremely crucial because the main reason for the closure of banks has been the inability to pay depositors on sudden demand. Therefore, the bank needs to know how much of these deposits is volatile, i.e. likely to flow out at short notice and how much is core or stable, i.e. unlikely to leave the bank. In the absence of contractual maturity, the bank needs to analyze the behavioral maturity of these deposits.
  •  Renewal patterns of term deposits: If the actual proportion of renewal is more than what the bank expects, it is left with surplus funds which might have to be reinvested at lower rates. If the actual fraction is less than anticipated, the bank faces a liquidity deficit, which might entail higher financing costs.
Read the rest

Advantages and Disadvantages of Activity Based Costing (ABC)

Activity based costing (ABC) is a costing model that recognizes activities in a company and assigns the cost of each activity resource to all products and services according to the actual use by each: it assigns more indirect costs overhead into direct costs. In this method a company can exactly estimate the cost of its individual products and services for the purposes of recognizing and reducing those which are unbeneficial and lowering the prices of those which are overpriced. In a business organization, the Activity based costing method assigns an organization’s resource costs through activities to the products and services given to its consumers. It is commonly used as a device for understanding product and consumer cost and profitability. As such, Activity based costing has predominantly been utilized to support strategic decisions such as pricing, outsourcing and recognition and measurement of procedure enhancement initiatives.

Activity based costing is basically a change in accent. People perform activities and activities use resources. Thus, by controlling activities the manager is making sure that costs are controlled at their source. A wise manager will not focus on how to estimate product costs, but will focus more on why the costs were there in the first place. When intending an activity based costing system this should be utilized as a departure point.

Advantages of Activity Based Costing System
  • The first and most significant benefit is the accuracy in the procedure of costing with regards to the product line, the consumers of the product, the stock-keeping units employed by the administration and the channel and group which streamline the flow of the product from the maker to the consumer.
Read the rest

Opportunity Cost of Capital

The opportunity cost of capital is defined as the return on capital which might be obtained by its employment when the central objective of planning policy is to use capital so its return to employment in any one investment is at least as high as its return from employment in any alternative investment. Similar to the cost of capital to equity shareholders, we have to allow for any risk differential.

In other words, the opportunity cost of capital is the marginal productivity of additional investment in the best alternative uses. It is, therefore, not surprising that the marginal productivity of capital in the private sector is frequently suggested as an appropriate value for the opportunity cost of capital to be used in public investment projects. It seems reasonable to say that if the marginal investment can earn x percent in the private sector, no public investment project should be allowed to earn less, and vice versa. However, the suggestion does not lead to a solution, since measurement of marginal productivity of capital is a formidable (if not impossible) task due to the fact that capital is not a homogeneous good. That is, marginal products from different capital goods may differ. A more practical way to determine the value of the opportunity cost of capital is to use some market rate of interest.

The use of a market rate of interest corresponds to the neoclassical approach of perfect competition, which assumes the existence of a capital market that generates efficient prices. That is, the price system equates marginal costs and benefits and results into efficient allocation of resources.… Read the rest