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.

Credit Management

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. As per the first concept, it is placed under the direct responsibility of chief finance officer for it being a function primarily financed by nature. Further, credit and collection policies lay direct influence on the solvency of the firm. For these reasons the credit and collection function should be placed under the direct supervision of the individuals who are responsible for the firm’s financial position. There are other who suggest that business firms should strictly enforce upon their sales departments the principles that sales are isolate until the value thereof is realized.  Those favoring this aspect plead to place the authority of allocation under the direct charge of the marketing executive or the sales department. To conclude the reasonability to administer credit and collections policies may be assigned either to a financial executive or to a marketing executive or to both of them jointly depending upon the organizational structure and the objectives of the firm.

2. Selection of Proper Credit Terms

The receivables management of an enterprise is required to determine the terms and conditions on the basis of which trade credit can be sanctioned to the customers are of vital importance for an enterprise. As the nature of the credit policy of an enterprise is decided on the basis of components of credit policy. These components include; credit period, cash discount and cash discount period. In practice, the credit policy of firms, vary within the range of lenient and stringent. A firm that tends to grant long period credits and its debtors include even those customers whose financial position is doubtful. Such a firm is said to be following lenient credit policy. Contrary to this, a firm providing credit sales for a relatively short period of time that too on highly selective basis only to those customers who are financially strong and have proven their credit worthiness is said to be following stringent credit policy.

3. Credit Investigation

A firm if desires to maintain effective and efficient receivables management of  receivables must undertake a thorough investigation before deciding to grant credit to a  customer. The investigation is required to be carried on with respect to the credit worthiness  and financial soundness of the debtors, so as to prevent the receivables for falling into the category of bad debts later on at the time of collection. Credit investigation is not only carried  on beforehand. But in the case of firms practicing liberal credit policy such investigation may  be required to be conducted when a debtors fails to make payments of receivables due on him  even after the expiry of credit sale so as to save doubtful debts from becoming bad debts.

4. Sound Collection Policies and Procedures

Receivables management is linked with a good degree of risk. As a few debtors are slow payers and some are non-payers. How-so-ever efficient and effective a receivables management may be the element of risk cannot be avoided altogether but can be minimized to a great extent, it is for this reason the essence of sound collection policies and procedures arises. A sound collection policy aims at accelerating collection form slow payer and reducing bad debts losses. As a good collection polices ensures prompt and regular collection by adopting collection procedures in a clear-cut sequence.

Objectives  of  Credit Management

The objective of receivables management is to promote sales and profit until that is reached where the return on investment in further finding of receivable is less than the cost of funds raised to finance that additional credit (i.e., cost of capital). The primary aim of receivables management vet in minimizing the value of the firm while maintaining a reasonable balance between risk (in the form of liquidity) and profitability. The main purpose of maintain receivables is not sales maximization not is for minimization of risk involved by way of bad debts. Had the main objective being growth of sales, the concern, would have opened credit sales for all sort of customers. Contrary to this, if the aim had been minimization of risk of bad debts, the firm would not have made any credit sale at all. That means a firm should indulge in sales expansion by way of receivables only until the extent to which the risk remains within an acceptably manageable limit.

All in all, the basic target of management of receivables is to enhance the overall return on the optimum level of investment made by the firm in receivables. The optimum investment is determined by comparing the benefits to be derived from a particular level of investment with the cost of maintaining that level. The costs involve not only the funds tied up in receivables, but also losses from accounts that do not pay. The latter arises from extending credit too leniently.

A brief inference of objectives of management of receivables may be given as under:

  • To attain not maximum possible but optimum volume of sales.
  • To exercise control over the cost of credit and maintain it on a minimum possible level.
  • To keep investments at an optimum level in the form or receivables.
  • To plan and maintain a short average collection period.

Granting of credit and its proper and effective management is not possible without involvement of any cost. These costs are credit administrative expenses, bad debts losses, opportunity costs etc. As mentioned before these costs cannot be possibly eliminated altogether but should essentially be regulated and controlled. Elimination of such costs simply mean reducing the cost of zero i.e. no credit grant is permitted to the debtors. In that case firm would no doubt escape form incurring there costs yet the other face of coin would reflect that the profits foregone on account of expected rise in sales volume made on credit amounts much more than the costs eliminated. Thus, a firm would fail to materialize the objective of increasing overall return of investment. The period goal of receivables management is to strike a golden mean among risk, liquidity and profitability turns out to be effective marketing tool. As it helps in capturing sales volume by winning new customers besides retaining to old ones.

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