When a company makes a sale, it can either collect payment right away in cash, or extend credit to the customer and collect payment later.
Granting credit can provide a company with increased sales but it also carries costs.
Costs of granting credit include the:
- Delayed receipt of cash from sales
- Costs incurred for the management of accounts receivable
- Losses from bad debts
Granting credit increases sales because:
- Of added convenience for the customer
- Customers may spend more using credit than they would with cash
- It “signals” potential customers that the product is of high quality because time is given to return the product if it is deemed unsuitable or defective
Credit policy has several components:
- Terms of sale
- The decision to grant credit
- Optimal credit policy
- Assessing customers’ credit worthiness
- Collecting payment on overdue accounts
In this article, we take a look at these components.
Terms of Sale
The terms of sale are the conditions for which credit is granted to customers. This includes the payback time period and cash discounts (if any).
If you offer customers credit terms of “2/10, net 30”, this means that invoices must be paid within 30 days and that a 2% discount applies to invoices paid within 10 days. If the terms are “net 60”, this means invoices must be paid within 60 days and there is no discount for early payments.
Cash discounts are often provided as part of the terms of sale. Cash discounts help speed up the collection of the receivables. It’s important to balance the cash discounts with the cost of the discount.
Credit periods vary widely among industries. A consumer electronics wholesaler might provide terms of “2/10, net 30”, while a jewelry retailer may sell diamond necklaces for 5/30 net 5 months.
Important factors to consider when establishing a credit time period are:
- The size of the account: Customer who buy small amounts are less important and managing credit for these customers is more expensive. Smaller accounts generally have shorter credit periods.
- The probability customers won’t pay: In industries with high-risk customers, businesses often offer more restrictive credit terms.
- The perishability of the products: If the collateral value of the goods can be sustained for only short periods (such as fresh fruits and vegetables), normally less credit is granted.
Usually, the only formal credit instrument between companies is the invoice. Credit offered in this way is said to be on “open account”.
For large orders or when a company thinks there may be a problem collecting payments, there are several credit instruments available that may help avoid controversies.
- Commercial draft: The seller writes a commercial draft calling for the customer to pay a specific amount by a certain date. The draft is sent to the customer’s bank with the sellers invoices. The bank has the buyer sign the draft and then gives the buyer the invoices. The goods are then shipped to the customer. In cases where immediate payment is required, the draft is called a slight draft.
- Banker’s acceptance: When a commercial draft isn’t good enough for the seller, the seller might require that the customer’s bank pay for the goods and then collect the money from the customer. When the bank agrees to do this in writing, it’s called a banker’s acceptance.
- Conditional sales contract: An arrangement where the seller delivers the product but retains ownership of the goods until it is paid for in full is called a conditional sales contract. The customer usually pays in installments with interest costs built into them.
The Decision to Grant Credit
When deciding whether or not to grant credit, companies can try to asses the potential increase in sales and the costs associated to granting credit. If it’s found that the benefit exceeds costs, credit should be granted.
In practice this assessment can be complicated because it means taking into account various factors including:
- The delayed revenues from granting credit
- The immediate costs of granting credit (cost per sale that is not paid for)
- The probability of payment
- The rate of return for delayed cash flows.
- The cost of better estimating the probability of default for any given customer
- Long-term future sales increase by granting credit
The above factors are sometimes linked, which adds further complexity to the assessment. For example, expenses incurred to find the credit worthiness of customers have the benefit of weeding out high-risk ones. This decreases the overall probability of default.
Optimal Credit Policy
It’s helpful to think of the decision to grant credit in terms of opportunity costs and carrying costs.
- Opportunity costs are the lost sales from not granting credit.
- Carrying costs of granting credit include the delay in receiving cash, the losses from bad debts and the costs of managing credit.
Opportunity costs of lost sales decrease the more credit is extended. Carrying costs of granting credit increase the more credit is extended. In theory, the optimal amount of credit is where the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable. In practice, the optimal amount of credit can be tricky to find.
Usually, firms extend credit when it’s advantageous for them to do so. Extending credit tends to be advantageous if the firm:
- Has a cost advantage over other potential lenders
- Has monopoly power it can exploit
- Can reduce taxes by extending credit
- Sells products with quality is difficult to determine
In general, a firm should extend credit more liberally than others if it has:
- Has excess capacity
- Has low variable operating costs
- Has repeat customers
- Is in a high tax bracket
Assessing Customers’ Credit Worthiness
Several sources of information are available to help determine whether or not a customer will pay.
- Financial statements: When granting credit, you can ask for the customer’s balance sheet and income statement. Use the financial statements to see if the company looks healthy and perform some liquidity ratio tests as discussed in our article on financial statement analysis.
- Credit reports: Many companies sell credit information of business firms. Dun & Bradstreet is a well-known credit reporting agency. Others can be found on this list of credit reporting agencies. Ratings and information are available for a many firms, large and small.
- Banks: As a business customer, your bank may provide information on the credit worthiness of other firms.
- The customer’s payment history: A good predictor of future behavior is past behavior. If collecting from a given customer has been problematic in the past, consider reducing or revoking credit.
Once customer information has been collected it’s time to evaluate the customer and decide whether or not to grant credit.
Financial institutions have developed elaborate statistical models for credit scoring. This involves the studying the relevant and observable information available about a large pool customers to find their historic relation to default rates. This method has the advantage of being more objective but it may be out of reach for most firms.
Once information is gathered, many companies use the more traditional and subjective guideline known as “the five Cs of credit”:
- Capacity: The customer’s ability to pay credit obligations out of operating cash flows. This is the most important of the five factors.
- Character: The customer’s willingness to meet obligations. It’s primarily a subjective impression the potential customer makes on the lender.
- Capital: How much net worth the borrower has, or the borrower’s financial reserves.
- Collateral: Pledged assets in the case of default
- Conditions: General business conditions surrounding the customer that affect the customer’s ability to pay.
Collecting Overdue Payments
Collection of past due accounts requires the credit manager to first keep a record of the payment history of each customer. Credit managers will set up an “aging schedule” to tabulate receivables by age of account. Many accounting packages do this automatically. The aging schedule shows which customers have overdue accounts.
Many firms use the following procedure for customers that are overdue:
- A delinquency letter informing the customer of its past-due status is sent
- A phone call is made to the customer
- A collection agency is hired
- Legal action is taken against the customer
Firms sometimes hire an independent company (referred to a “factor”) as an “outside credit department”. The factor checks the credit of new customers, authorizes credit and handles collections and bookkeeping. As accounts are paid, the factor keeps a small percentage as compensation. If any accounts are late, the factor still pays the seller after an agreed upon time.
Factoring is conducted by many small businesses. It is especially popular with manufacturers of retail goods because it lets outside professionals deal with the headaches of credit.