9.5.A - Managing Credit

1. DETERMINING CREDIT STANDING

  1. A business offers credit as a service to customers and as a way of attracting additional sales. If credit issuance is not well managed, however, credit sales can result in problems and additional expenses. Every business offering credit should develop policies and procedures for approving customers who will be able to receive credit. Creditworthiness is a measure of an individual’s or business’s ability and willingness to repay a loan. Two methods commonly used to check applicants’ creditworthiness are (1) the four Cs of credit and (2) the point system.
  2. To determine the creditworthiness of people or other companies, businesses gather information as part of the credit application process. They then apply the “four Cs” of credit to analyze the information: character, capacity, capital, and conditions. A review of each factor helps to determine the answers to two important questions about the applicant’s creditworthiness: (1) Can the customer pay? and (2) Will the customer pay?
  3. Character is a measure of an applicant’s sense of financial responsibility or belief in the obligation to pay debts. It includes honesty, integrity, and attitude toward indebtedness. Credit-granting businesses check an applicant’s credit reputation, payment habits, and employment or business stability to judge the person’s character. The applicant who is always late in making payments or who frequently changes jobs is unlikely to be approved for credit.
  4. Capacity is a measure of earning power and reflects the applicant’s potential to pay, based on current income and other financial obligations (debts). To judge capacity for consumer credit, businesses look at the person’s employment history, income level, and number and amount of debts. For business credit, they carefully examine the business’s financial performance and financial statements.
  5. Capital, the third C, is a measure of the credit applicant’s current financial worth or ability to pay based on assets. For an individual, “capital” means assets such as savings, a car, or a home. For a business, “capital” means a healthy balance sheet—far more assets than liabilities. Capital is especially important if people lose their jobs or if businesses suffer losses or poor cash flow. With adequate capital, individuals or businesses can still pay for credit purchases. Creditors can also ask that assets be pledged as collateral for loans.
  6. Conditions, the last of the four Cs of credit, is an assessment of the economic environment, such as the economic health of a community or the nation and the extent of business competition. The local economy, for example, may be depressed. As a result, many people would be unemployed. Inflation and recessions also affect a business’s willingness to grant credit.
  7. As part of evaluating the four Cs of credit, businesses often use a point system. They assign points to each of the four C factors. Credit applicants provide information about these factors by answering questions on credit applications. Answers are assigned a specific number of points. To receive credit, an applicant must earn a predetermined score. For consumer credit, factors that are rated and assigned points include the type of job, the length of time the applicant has held the job, and the applicant’s income, savings, and total debts. The higher the person’s income, for example, the higher the number of points assigned. Having many late payments or a large number of credit cards can reduce the number of points. The most important factor in a business’s credit score is its credit history, whether it has made payments on time to all creditors. Other factors include the number of years the company has operated and the overall health of its finances. Credit experts agree that the best single measure of creditworthiness is the applicant’s past credit-paying record. For that reason, credit applicants need to build and maintain excellent credit records.
  8. After selecting a method for making decisions about credit applicants, businesses must collect information about them. They can obtain much of the information directly from the applicants and from credit agencies.
  9. Banks, credit card companies, consumer credit firms, and businesses that operate their own credit departments obtain information directly from applicants who complete a credit application using a printed form or by entering information online. An application for a consumer requests basic information such as name, address, phone number, date of birth, Social Security number, bank accounts, and employer’s name and phone number. The credit application for a business asks for company information, bank references, and trade references. After the business reviews the credit application, it either rejects the application, obtains more information from other sources, or approves the applicant for a limited amount of credit. If the customer demonstrates responsible use of that credit, the business will gradually increase the credit limit.
  10. Most businesses want more information than they can gather through a credit application. One of the best sources is a credit agency. A credit agency is a clearinghouse for information on the creditworthiness of individuals or businesses. In general, there are two types of credit agencies— those that provide credit information about individual consumers and those that provide credit information about businesses. Private credit agencies, or bureaus, regularly receive data from businesses and publish confidential reports for their subscribers, who are usually retailers or financial institutions. Most credit agencies are associated with the top three national credit reporting firms: Equifax, Experian, and TransUnion. Each national agency maintains vast amounts of computerized data about hundreds of millions of customers. A business subscriber to one of the agencies can get information almost immediately for making credit decisions, through direct computer or telephone access to credit reports. The credit agency provides a summary report of the individual’s credit and financial history and a credit score. Businesses that sell on credit to other businesses need different types of information than retailers that sell to consumers. An important source of information on the credit standing of retailers, wholesalers, and manufacturers is Dun & Bradstreet (D&B). As a service to subscribers, D&B regularly publishes and sells credit ratings and financial analysis reports. Those reports are used to make decisions about prospective business relationships as well as about granting credit. Two of the national consumer credit reporting agencies—Equifax and Experian—also have business divisions.
  11. Credit is governed to a great extent by state and federal laws. Provisions of federal laws that relate directly to credit are summarized in the Figure below. All 50 states have laws that regulate credit transactions. The legal profession created the Uniform Commercial Code (UCC) and the Uniform Consumer Credit Code (UCCC) to deal with matters not covered by federal legislation. While the Uniform Commercial Code has been adopted in all states, the Uniform Consumer Credit Code has been fully adopted in only a few. However, most states have incorporated important provisions of the UCCC into their laws. Because of the abundance of laws, businesses hire attorneys who are experts on state and federal credit law to review and approve credit policies, procedures, and forms. 



2. COLLECTIONS MANAGEMENT

  1. Any business that extends credit to customers is concerned about losses from uncollectible accounts. Some firms have effectively no bad-debt losses. Others have very high losses that reduce their financial capabilities in other parts of the business. Surveys show that the losses from uncollected debts can easily run 2 to 4 percent of net sales, even for well-managed businesses. Poor management of credit procedures can increase losses to 7 to 10 percent of sales, which exceeds the profit margins of many businesses. Even with good credit management, if economic conditions are poor, bad-debt losses increase, putting even more pressure on businesses. Effective credit policies and collection procedures can reduce losses and make credit services a valuable element of the business.
  2. Once a business establishes a credit system, it must decide how to collect money owed by customers. This is an important function, because it affects the financial health of the firm. Managers try to meet two objectives when establishing collection procedures: (1) collect the amount due and (2) retain the goodwill of the customer.
  3. Most credit customers pay their bills, but some will often be a few days late. Communicating and enforcing a policy that adds interest when payments are late is intended to encourage prompt payment. The usual collection procedures include sending a statement at the end of the billing period but well before payment is due, followed by reminders at 15-day intervals if the bill is not paid. Businesses often use letters and duplicate copies of invoices to remind customers when accounts are overdue. Those are followed by telephone calls to discuss the reason for late payment and to negotiate an alternative payment plan if payments still are not received. All collection steps should be done professionally and in accordance with laws that restrict how businesses can seek to collect debts owed, with the goal of retaining the customer if payment is made. After 60 to 90 days, if it appears that the customer is not going to send payment or agree to a payment plan, the final collection step is usually either to turn the account over to a collection agency or to bring legal proceedings against the customer. With installment credit, the business may have to repossess the merchandise that was sold on credit. These actions are a last resort but must be taken unless the amount due is so small it is not worth the cost of those actions. During the collection process, businesses should try to find out why customers are not paying their overdue accounts. Most people are honest and want help to develop a plan to pay. It is always better for the business to get paid late than not at all. Therefore, it is important to learn why an account is overdue and work out a payment schedule that the customer can meet.
  4. Part of the reason for overdue accounts may be that the business extends credit too easily. Overextension of credit is as much the lender’s fault as it is the borrower’s. Businesses sometimes issue credit cards to unqualified applicants who can get carried away by their new purchasing power. When these borrowers fall behind in their payments, some get new credit cards to pay off overdue balances on other cards. But more cards only get the customers into further debt trouble. Setting low credit limits for first-time customers until they show a history of on-time payments is a good way to protect against losses. Businesses can encourage customers to pay on time by explaining that an increase in their credit limit is contingent on their payment history. Collecting unpaid accounts is time-consuming and costly. It is better to spend the time developing effective credit policies and screening credit applicants before credit is extended than having to work to collect accounts that are not paid.
  5. It is important for every business to watch its accounts receivable (money customers owe to the business), so that the total does not grow out of proportion to the amount of credit sales. For example, if credit sales are not increasing but accounts receivable are growing larger each month, then the company is not collecting payments from customers quickly enough. Soon, the company may not have enough cash on hand to pay its own bills. Before accounts receivable get too large, the company must take action to collect accounts more efficiently. The total accounts receivable may not show the true picture. For instance, an analysis may show that most of the overdue accounts are only 30 or 60 days overdue, with only a few 90 days or more overdue. In this situation, the problem lies with just a few very delinquent customers. The company can take aggressive action with those customers and may not have to change overall collection policies. On the other hand, if an analysis of the accounts receivable record shows that most of the late accounts are 90 days or more overdue, the collection problem is much greater. In this case, the company may have to take stronger action to secure payments and to discourage other customers from falling behind on their accounts.
  6. One common method of studying accounts receivable is aging of accounts, a process in which customers’ account balances are analyzed in categories based on the number of days each customer’s balance has remained unpaid. An example of the first few lines of a report showing the aging of accounts for a business appears in the Figure below. In the example, the amounts owed by the Adams-Jones Company and the Artwell Company are not overdue. However, Brown & Brown owes $82.23, which has been due for more than 60 days but less than 90 days; $120, which has been due for more than 30 days but less than 60 days; and $157.50, which has been due less than 30 days. The $228.18 owed by Custer Stores has been due more than 60 days but less than 90 days. And the amount due from A. Davis, Inc., has been due more than 90 days. The report enables the manager to see clearly the status of all accounts receivable and to plan corrective actions. Another method of measuring the efficiency of collections is to compute the percentage of delinquent accounts in relation to the total unpaid credit sales. For example, if 10 percent of the accounts are delinquent in January, 15 percent are delinquent in February, and 20 percent are delinquent in March, this indicates an unfavorable trend. One study revealed that if accounts are not paid within three months, the chance of collecting is nearly 70 percent; after 12 months, it is less than 30 percent. By carefully analyzing credit sales, a business can learn which policies and procedures are most effective for increasing total sales while keeping uncollectible account losses to a minimum so that net profits will increase. When bad debts increase, a firm’s cash flow, profits, and credit reputation decline. 









Last modified: Tuesday, August 14, 2018, 8:30 AM