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| Monday, 10 May 2010 14:39 |
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Dr. Salima y paul - credit policies and processes After she took her first degree in accounting and finance at the Ecole Superieure de ommerce, Algiers (the oldest business school in Africa) and was awarded a postgraduate studies scholarship for “best overall student”, Dr. Paul went to undertake an MSc at Cardiff University, an MPhil at the University of Lancaster, a Post Graduate Certificate in Higher Education at the University of the West of England and a Doctorate at Leeds University Business School. Dr. Paul is a fellow of the Higher Education Academy, UK and the Institute of Credit Association, Nigeria. She is member of the Institute of Learning and Teaching, the Institute of Credit Management, UK, the British Accounting Association, the European Accounting Association and the Consultative Board of the British/West African Forum for Trade and Business Partnerships. There is a widespread recognition that corporate credit managers control one of the biggest, riskiest and most important assets companies are likely to have. The management of accounts receivable can have an impact on firms’ balance sheet structure, their liquidity, efficiency and profitability. So the development, implementation and management of formal credit policies and procedures can contribute to firms’ long-term survival. Furthermore, business leaders in all organisations, but especially small and medium enterprises, need to understand the contribution that credit policies and processes can make to their cash conversion cycle which is the ‘lifeblood’ of any business. If used effectively and proactively, formal credit policies have the potential to reduce this cycle that hold the key which can unlock very precious cash resources, especially in time of recession. In addition, credit management is gradually becoming an important element of firms’ strategic decisions and a potential source of competitive advantage. 1. The Value of Policies and Procedures The volume of credit trading between businesses, and hence the value of account receivable in firms’ balance sheet may determines the importance given to credit policies and processes within an organisation. In virtually all developed and industrialised countries, the volume of trade credit exceeds by far that of short-term bank credit. In the UK, for instance, trade credit exceeds the primary money supply by a factor of 1.5. Similarly in the US, trade credit exceeds the lending of the entire banking system. In South Africa, according to the figures released by the National Credit Regulator as at June 2008, the gross value of the debtors book stands at R1.12 trillion. However, accounts receivable are one of the riskiest assets a company can hold, with many firms severely affected by late payment and bad debts, especially in downturns. This problem can have a devastating impact on companies, especially small and medium enterprises. Consequences slow or non payment can erode and, in some cases where profit margins are tight, even eliminate firms’ profitability altogether. However, many studies show that firms with sound credit management policies and procedures made a contribution towards reducing late payment. Often, profitable businesses fail through lack of cash-flow caused by being paid late especially those whose main priority is to preserve customers’ relationship rather than collect cash. Many studies also report that firms with credit policies tend to put much effort into achieving long-term growth objectives such as return on capital employed, growth in assets, entering new markets and reducing the risk of business failure. It has been proved that businesses that invest in their credit management policies and procedures minimise the risks of bad debts and slow payment, improve cash-flows and credit performance and not only gain but more importantly sustain competitive advantage. So, the implementation of credit policies and processes should be considered as an investment decision with strategic implication; firms may conduct a cost-benefit analysis and invest in their credit management policy if the future discounted benefits are higher than the present costs of establishing it. Obviously, in some instances, it may be more economical for the credit function to be managed by a third party if resources and expertise are lacking. The main reasons found for late payment are often related to the mismanagement of credit operations, misunderstanding of the credit terms and the failure to communicate these terms in writing to the customers before the sale takes place. This is often due to the lack of credit policies or the incorrect use of credit processes and practices. Therefore the existence of effective credit policies, processes and practices are vital to businesses and their objectives should include the: •protection of profit and security of cash-flow •development of good customer relationships, and good credit reputation •organisation and control of credit granting •protection of the accounts receivable, a major asset in most businesses •way to ‘educate’ customers to pay to terms. All of this can be achieved by the implementation of a credit strategy which should aim mainly to maximise sales with prompt payment and minimum bad debts. However, this can only be obtained if well documented credit policies and procedures are developed. 2. Policy Development The starting point for any successful credit function is the development of credit policies and processes which, if proactively used, can contribute to the internal organisational efficiency and the sophistication of the credit management process. A credit policy that is designed as part of the firm’s overall goals can be used as a powerful strategic weapon that can build and sustain long-term relationships with both customers and suppliers and influence corporate performance in the long-run. This should be at the heart of the credit management and it is thus expected to be central to the credit decision making. Furthermore, the fundamental role of the credit policy is to provide a framework for consistent credit decisions to be made compatible with goals of the credit function. Thus a company’s credit policy should be an important link in its communication chain. It should include screening (vetting policy), risk reduction methods, terms and conditions of credit, financing, collection and monitoring policies. In addition, one has to realise that there is much more to trade credit then just a short term decision and the financing of customers’ inventory. Trade credit is more of a long-term strategic issue and should be part of any organisation’s mission. If managed properly through sound credit policies and processes, trade credit management can be a competitive tool for: •Quality assurance: when giving credit, firms have enough confidence in their quality to let their customer ascertain the product/service before payment. On this basis, once customers get to know suppliers’ produce, they may not need long credit term to test the quality. Subsequently, suppliers can reduce the credit period thus reduce cost of financing customers’ inventory in the long term. Credit is both a tool for quality and also a reduction of financing costs. •Flexible approach to pricing: it is more difficult to vary prices then to vary credit terms to match and/or beat competition. Offering two-part-terms for instance (2%/10 net 30, where customers are given 2% discount if they pay within 10 days if not they pay within the normal terms of 30 days) will allow firms to differentiate between customers by adjusting the discount rate, the brought forward term and even allow them to take ‘unearned’ discounts (when the customer does not pay within the two-part-terms but still gets a discount). This may arise when customers with potential may have a temporarily cash-flow problem where suppliers will finance them further with the hope of ‘saving’ them to retain their customs. Suppliers establish a way of helping customers, by providing more flexible arrangements, if they are having temporary financial difficulties, but review credit terms offered to them, if they are unlikely to ‘pull out’. •Supporting the supply chain: sellers only benefit from repeated business if their customers stay in business and grow successfully, trade credit can play this role as explained in the point above. •Financing purposes: the ‘helping hand’ theory posits that firms that are well-established tend to be creditworthy and are more likely to have access to external finance hence tend to grant more credit. This suggests that firms with easy access to capital markets are more likely to extend credit to firms that have difficulty accessing funds, especially during downturns. So sellers step in to fill the financing gap by offering trade credit to those that are rationed with the aim of building a long-term relationship and benefiting from future revenues from sales. Moreover, buyers that are rationed see trade credit as an alternative and attractive way to finance their inventory. •Transaction costs: with credit transactions, separation of the exchange of goods from the exchange of cash creates operating efficiency (reduces payment transaction costs). Instead of paying every time there is a delivery, firms may accumulate bills in one transaction, reducing costs. This may also have the added advantage of making cash-fl ow forecasts more manageable and effective. Trade credit enables firms to forecast future cash with greater certainty and therefore simplifies their cash-flow management. All the above can be achieved through the development of sound credit policies and processes that can be used pro-actively as a competitive device. If well structured and designed, credit policies can be a powerful tool that contributes to internal organisation efficiency and the sophistication of the credit management processes. Moreover, as companies operate in a dynamic environment, pro-active credit management is necessary to cope with constant change to adapt to market and economic conditions and that may result in the need to the change in any credit policy. A well-designed and documented credit policy is, therefore, expected to include scope for change and room for flexibility and adaptability. Credit policy should define: Responsibility for different credit tasks, Level of authority for agreeing credit terms and payments, timetable for action and intervals for collection, performance objectives, training for credit manager and credit staff. Large firms are more likely to have a written credit policy than smaller ones. One reason for this may be that within small firms, lack of resources prevents them from having a well documented credit policy; or simply that small firms may have their credit function outsourced. In addition, small firms may find it cheaper to allow a third party, with expertise, to mange their credit function, fully or partially, than to do it themselves, especially if the volume of their credit sales in not large and thus does not justify the investment in the credit function. 3. Policy Management Any firm that engages in credit granting have to decide on the way to organize its credit management processes. There is a wide scale of strategies to manage credit policy, ranking from total vertical integration within the organization to a complete outsourcing to specialised institutions (e.g. credit reference agencies, debtor recovery agencies, credit insurers, tracing agents, factors, invoice discounting). A written credit policy should include ways of protecting accounts receivable, one of the biggest but riskiest assets in the company and special attention should be given to its organisation and management. This can be achieved by setting credit controls that ensured that receivables remain collectable and protecting profits. Procedures and relevant documentation must be clearly stated with the aim of increasing not all sales, but only profitable sales by investing more in risk assessments of potential customers in order to reduce/eliminate late payment and bad debts. In addition, the communication of details of policies to everyone involved directly or indirectly with the credit function is likely to help in achieving credit targets. This involves the development of teamwork so that trade credit is used pro-actively in conjunction with the sales, marketing and finance departments. This will help to enhance the trading and reputation of the business and ensure the highest levels of customer service. The credit managers should have an active role and their time should not be spent on ‘back-end’ credit activities (e.g. chasing overdue accounts) but devoted to front-end tasks such as checking customers’ ability to pay. Used in this way, a formal written credit policy can: •limit bad debts and improve cash-flow, •ensure a degree of consistency (common set of goals for all departments), •specify the responsibility and authority of credit personnel, •lead to a consistent approach towards customers, •provide some recognition of the credit department (devote resource to upper credit management). Research find that often firms with no written credit policy in place agree credit terms prior to sale verbally rather than in writing and some even do so after sales, by invoice. Without such a formal policy, credit decisions tend to be taken on an ad hoc basis. This contributes to misunderstanding of the credit terms and conditions and often leads to dissatisfied customers, unwilling to pay on time. Late payment problems can break companies and small and medium ones that make up most economies, are more vulnerable, especially in time of recession. Basic procedures to tackle this problem have to be clearly stated in the credit policies designed to educate and train customers to pay to terms. Many businesses with written credit policies managed to overcome the late payment problems by following simple procedures and taking recovery action when necessary. However, if credit policies are in place, firm must unsure that they are enforced. It has been proved that an effective application of credit policies and processes leads to improvement in cash-flows, minimisation of bad debts/slow payment and increase in profits.  Investment in a good credit management function should be at the heart of companies’ strategic decisions. However, as explained before, when deciding on credit policies/practices and the management of the credit function, companies have to consider whether the credit administration process is managed internally, to delegate fully or partially some tasks to external specialists, or to outsource the whole credit function. So the different organizational choices open to firms are:•vertical integration, where companies will obviously need expertise, knowledge and credit management skills, •outsourcing, in which case this function is run by specialists who have both the knowledge, expertise and experience, or •outsourcing some aspects of the credit function, where, for instance, non-core tasks can be easily a third party’s responsibility, leaving the credit manager to concentrate on more important decisions such as the mitigation of credit risk. This decision depends on how trade credit is perceived and how credit information is used by organisations. The diagramme below highlights the different organizational choices open to firms and clarifies the different credit activities. As can be seen by the diagramme above, the credit management tasks are divided into two main categories: •Front-end activities are more related to credit risk minimisation and should be at the heart of the credit function to reduce late payment and bad debts write off, •Back-end activities are more related to what is called ‘after the event’ activities which are usually performed by a credit collector and are mainly related to chasing overdue accounts and resolving disputed bills. The first category is usually performed by credit managers who get involved in the credit decision right at the beginning before the sale is agreed and thus are proactively involved while the latter often involves the credit controllers, when there are problems such as customers default and therefore the credit staff have a passive role. Although the organisational management of the credit tasks depends on many factors (the company’s size, expertise, resources available), when faced with the choice of outsourcing or vertically integrating the credit function, managers should compare the costs of contracting the credit function with the costs arising from integrating the credit management tasks within the business’ process. Furthermore, factors such as percentage of sales on credit, nature of products/services (specialised, technical, complex), industry specific, distribution channels, all influence the credit function is managed. There are certain benefits in managing the credit function internally: sellers get to know buyers and will seek to build long-term relationship more effectively if they deal with them directly on a regular basis. Credit managers may get the opportunity to be directly involved in the front-end credit activities before sales are agreed; consequently they become part of the all important task of debtors portfolio management (spread of risk so firms are not solely reliant on one specific customer, sector, market, segment or country). Despite all these benefits for internal management, a third party with expertise in the credit management field can be more economical for some firms. Moreover, outsourcing or vertically integrating the credit function is not mutually exclusive decision as companies can opt for a combination of both and this depends on the organisational circumstances. For instance, firms can use a third party when required for an annual accounts review, collection, dispute resolution and benefit from expertise and technology of the service provider. If routine credit tasks are outsourced, this brings a different emphasis to the job of credit managers by allowing them to concentrate on strategic credit issues. Researchers have shed light on the profile of some firms with written credit policies. They find that firms that have a written credit policy may have more incentive to use it for better credit management and monitoring of the credit granting and cash collection processes. They are more likely to: •set credit limits •use Accounts Application Forms •offer two-part credit terms •have fewer invoices and credit notes paid late •conduct formal analyses / reports of credit notes •set cash collection targets, especially in a weak period •use commercial credit scoring to assess and monitor customer risk. So the existence of a formal written credit policy may be considered as a sign of good credit management. Furthermore, firms with a written credit policy are more likely to use all the means (above) that are considered to be an inherent part of good credit management practice and so have better monitoring of the credit function than those without such a policy. For instance, if firms agree terms verbally, the lack of proof of the ‘agreed terms’ and condition of credit sales may lead to costly problems that require much time spent in the back-end activity of the credit function. In addition, the credit decisions of those without a credit policy tend to be taken ad hoc and are often determined by specific customer demands and so the credit managers’ time is wasted on negotiating credit terms. The investment in credit staff to implement, update and communicate the content of credit policies is another important factor in credit management. The number of credit managers/controllers within an organisation indicates the importance companies give to the credit management function. Often, those with no credit staff have their credit function managed by one of the other departments, such as sales, marketing or finance. This may lead to a conflict of interests between credit objectives and others. For instance, there may be incentives for the sales department to maximise the turnover and therefore sales staff may offer more generous credit terms than the industry norm or even offer credit to risky customers. Consequently, more time and resources may be spent chasing unpaid bills. This seems to create difficulties in relation to the credit management function since its main aim is to minimize risk and thus the creditworthiness of a customer may determine whether the sale takes place or otherwise. Sales can only be profitable if they are turned into cash that is collected promptly within the agreed credit terms, ‘sales are vanity but profits are sanity’. So credit policies can be used as a communication tool between the credit department and others to resolve/minimise the conflict of interest that may exist between them. Thus, the overall objectives of any business may be redefined in the light of the importance of management of credit function. This may lead to the potential of creating value by being part of the profit centre and adding a new dimension to the term ‘success’ and ‘stability’ for an organisation. If credit policies and processes are formulated effectively, understood and used wisely, thy will promote success in the most competitive of circumstances. Conversely, those who accept credit granting without strategic direction, their credit management, or the lack of it, will risk credit related disasters arising without warning. Furthermore, companies need foundations on which to build accounts collection by a simple credit extension procedure. To make the collection more effective, the terms and conditions of sale must be clearly stated in their credit policy. This would include items such as when payment is due and the right to interest on late payment, the time for raising queries and disputes, quality issues, retention of title. The use of credit accounts application forms should provide customer information as required where terms and conditions are set out clearly. Firms must also have collection sanctions included in the credit policy and communicated to customers. This must clearly define actions to be taken when accounts are overdue. Firms can consider stopping supply after a certain time, reviewing the credit facility for that customer, considering charging interest for late payment, or if condition of sale include retention of title, get the product back (if possible) and consider collection agencies and legal action. A credit collection programme, in which firms spell out actions to be taken at different stages, should be part of credit policy management and a guide to satisfactory collection processes. Collection device and sanction procedures combined can be turned into a powerful, fast, consistent and effective collection programme. However, many factors can influence collection performance. Credit staff needs to have knowledge, skill and determination to collect on time. It is therefore important to empower credit staff to collect their debts effectively. Credit strategies need to be determined and should include how credit assessment is going to be carried out, for instance, how to develop fast and consistent collection methods that allow firms to sell as much as possible and get paid on time. However, firms must not consider credit as a collection function; trade credit is an investment decision that involves risk and return, and its mismanagement can impact substantially on companies’ performance. So the use of performance indicators, their management and control can contribute to firms’ performance generally and to better credit management specifically. The constant review of issues such as: risk evaluation, creditworthiness assessment methods, credit terms, credit reference information, collection of customer information, monitoring of debtor days and late payment are all vital to the effective management of the credit function. In addition information technology is changing very rapidly and efficient systems can be put in place to make the most of the credit information available and to obtain up-to-date intelligence on customers; the use of effective computer systems can help operating efficiency. Sophisticated IT tools make the management of the credit policies far more straight forward than it used to be and credit rating information is available on most organisations. Those companies with more resources can enhance their credit management by acquiring databases and implementing sophisticated statistical methods that are able to track payment patterns, analyse risk trends and benchmark credit performance. In addition, the use of credit risk mitigation techniques, quality information, and computerised decision support system for granting and managing credit can make credit management a very different activity. Risk assessment is of paramount importance in credit management; mismanagement of this can impact substantially on companies’ performance. As with any investment decision, firms may only consider investing in accounts receivable if added value is likely to be created in either the short or long-term. Firms that lack credit management expertise must assess the cost and benefit of using a third party to manage the credit function against internal integration and the use of services such as credit insurance and credit information provision, collection agencies. But to benefit from all these services businesses must have basic credit procedures in place. In addition, there are many situations where firms may have to learn to forgo short-term financial benefit for long-term growth opportunities such as an increase in sales volume or market share and the potential for generating repeated purchase behaviour and long-term relationships. To conclude we can say that given that trade credit can threaten the viability of firms, it is necessary to consider the motivation for offering it at all. Firms might have to comply with industry norms with regard to extending trade credit if they are to achieve necessary levels of sales and to stay competitive. For some companies, especially small and medium enterprises, growth and survival depended on whether they are able to grant competitive trade credit terms to attract customers with the aim of building long-term relationships. However, unless credit policies and processes are developed and managed effectively to protect accounts receivable, thus ensure that receivables remain collectable and protect profit, firm should find alternative ways to manage this all important asset. |
| Last Updated on Monday, 10 May 2010 14:58 |