Credit terms granted to customers

　　Although sales representatives work under the premise that all sales are good (particularly， one may add， where commission is involved!)， the credit manager must take a more dispassionate view.(S)he must balance the sales representative's desire to extend generous credit terms， please customers and boost sales， with a cost/benefit analysis of the impact of such sales， incorporating the likelihood of payment on time and the possibility of bad debts. Where a customer does survive the credit checking process， the specific credit terms offered to them will depend upon a range of factors. These include：

　　· Order size and frequency companies placing large and/or frequent orders will be in a better position to negotiate terms than firms ordering on a one-off basis.

　　· Market position the relative market strengths of the customer and supplier can be influential.For example， a supplier with a strong market share may be able to impose strict credit terms on a weak， fragmented customer base

　　· Profitability the size of the profit margin on the goods sold will influence the generosity of credit facilities offered by the supplier. If margins are tight， credit advanced will be on a much stricter basis than where margins are wider.

　　· Financial resources of the respective businesses ? from the supplier's perspective， it must have sufficient resources to be able to offer credit and ensure that the level of credit granted represents an efficient use of funds. For the customer， trade credit may represent an important source of finance， particularly where finance is constrained. If credit is not made available， the customer may switch to an alternative， more understanding supplier.

　　· Industry norms unless a company can differentiate itself in some manner (e.g.， unrivalled after sales service)， its credit policy will generally be guided by the terms offered by its competitors. Suppliers will have to get a ?feel? for the sensitivity of demand to changes in the credit terms offered to customers.

　　· Business objectives where growth in market share is an objective， trade credit may be used as a marketing device (i.e.， liberalised to boost sales volumes).

　　The main elements of a trade policy are：

　　· Terms of trade the supplier must address the following questions： which customers should receive credit? How much credit should be advanced to particular customers and what length of credit period should be allowed? (See Example 1 for an illustration of a typical credit policy decision faced by a company).

　　· Cash discounts suppliers must ponder on whether to provide incentives to encourage customers to pay promptly. A number of companies have abandoned the expensive practice of offering discounts as customers frequently accepted discounts without paying in the stipulated period.

　　· Collection policy an efficient system of debt collection is essential. A good accounting system should invoice customers promptly， follow up disputed invoices speedily， issue statements and reminders at appropriate intervals， and generate management reports such as an aged analysis of debtors. A clear policy must be devised for overdue accounts， and followed up consistently， with appropriate procedures (such as withdrawing future credit and charging interest on overdue amounts). Materiality is important. Whilst it may appear nonsensical to spend time chasing a small debt， by doing so， a company may send a powerful signal to its customers that it is serious about the application of its credit and collection policies. Ultimately， a balance must be struck between the cost of implementing a strict collection policy (i.e.， the risk of alienating otherwise good customers) and the tangible benefits resulting from good credit management.

　　Problems in collecting debts

　　Despite the best efforts of companies to research the companies to whom they extend credit， problems can， and frequently do， arise. These include disputes over invoices， late payment， deduction of discounts where payment is late， and the troublesome issue of bad debts. Space precludes a detailed examination of debtor finance， so this next section concentrates solely on the frequently examined method of factoring.

　　Factoring ? an evaluation

　　Key features

　　Factoring involves raising funds against the security of a company's trade debts， so that cash is received earlier than if the company waited for its credit customers to pay. Three basic services are offered， frequently through subsidiaries of major clearing banks：

　　· sales ledger accounting， involving invoicing and the collecting of debts;

　　· credit insurance， which guarantees against bad debts;

　　· provision of finance， whereby the factor immediately advances about 80% of the value of debts being collected.

　　There are two types of factoring service. Non-recourse factoring is where the factoring company purchases the debts without recourse to the client. This means that if the client?s debtors do not pay what they owe， the factor will not ask for his money back from the client.

　　Recourse factoring， on the other hand， is where the business takes the bad debt risk. With 80% of the value of debtors paid up front (usually electronically into the client?s bank account， by the next working day)， the remaining 20% is paid over when either the debtors pay the factor (in the case of recourse factoring)， or， when the debt becomes due (non-recourse factoring). Factors usually charge for their services in two ways： administration fees and finance charges. Service fees typically range from 0.5 ? 3% of annual turnover. For the finance made available， factors levy a separate charge， similar to that of a bank overdraft.

　　Advantages

　　· provides faster and more predictable cash flows;

　　· finance provided is linked to sales， in contrast to overdraft limits， which tend to be determined by historical balance sheets;

　　· growth can be financed through sales， rather than having to resort to external funds;

　　· the business can pay its suppliers promptly (perhaps benefiting from discounts) and because they have sufficient cash to pay for stocks， the firm can maintain optimal stock levels;

　　· management can concentrate on managing， rather than chasing debts;

　　· the cost of running a sales ledger department is saved and the company benefits from the expertise (and economies of scale) of the factor in credit control

　　Disadvantages

　　· the interest charge usually costs more than other forms of short-term debt;

　　· the administration fee can be quite high depending on the number of debtors， the volume of business and the complexity of the accounts;

　　· by paying the factor directly， customers will lose some contact with the supplier. Moreover， where disputes over an invoice arise， having the factor in the middle can lead to a confused three-way communication system， which hinders the debt collection process;

　　· traditionally the involvement of a factor was perceived in a negative light (indicating that a company was in financial difficulties)， though attitudes are rapidly changing.

　　The question of whether to factor debts is one which Examiners frequently pose (see paper 8， Question 2， June 1999). Attempt Example 2 yourself， before checking the answer.

　　Conclusion

　　Working capital management is of critical importance to all companies. Ensuring that sufficient liquid resources are available to the company is a pre-requisite for corporate survival. Companies must strike a balance between minimizing the risk of insolvency (by having sufficient working capital) with the need to maximize the return on assets， which demands a far less conservative outlook. In this paper， one of the elements of the working capital equation， debtor management， has been considered. Students should ensure that they can not only tackle computation-type questions， but also be able to discuss the numerous facets of operating a credit management policy.