Credit management

Credit management is a process in which a company or financial institution sells

product/service or lends money to customer on Credit basis, the terms it’s granted on
and recovering this credit when it’s due. The company or financial institution collects or
retrieves payments from customer or borrower at a later time, after the sale of
product/service.

There are many definitions that have been proposed to describe the institution of credit.
Among these we find:

• Credit is the ability of an individual or business enterprise to obtain economic value on

faith, in return for an expected payment of economic value in the future. (Christie and
Bracuti, 1986)

• Credit is a medium of exchange with limited acceptance. After a period of time, the
value initially received by the buyer is returned to the seller in the form of payments.
(Cole and Mishler, 1995).

• Credit is a privilege granted by a creditor to a customer to defer the payment of a

debt, to incur debt and defer its payment, or to purchase goods and services and defer
payment. (ICA, 2003).

Principles of Credit Management

Credit management plays a vital role in the banking sector. As we all know bank is one of
the major source of lending capital. So, Banks follow the following principles for lending
capital −

Liquidity
Liquidity plays a major role when a bank is into lending money. Usually, banks give money
for short duration of time. This is because the money they lend is public money. This
money can be withdrawn by the depositor at any point of time.
So, to avoid this chaos, banks lend loans after the loan seeker produces enough security
of assets which can be easily marketable and transformable to cash in a short period of
time. A bank is in possession to take over these produced assets if the borrower fails to
repay the loan amount after some interval of time as decided
A bank has its own selection criteria for choosing security. Only those securities which
acquires enough liquidity are added in the bank’s investment portfolio. This is important
as the bank requires funds to meet the urgent needs of its customers or depositors. The
bank should be in a condition to sell some of the securities at a very short notice without
creating an impact on their market rates much. There are particular securities such as
the central, state and local government agreements which are easily saleable without
having any impact on their market rates.
Shares and debentures of large industries are also addressed under this category. But
the shares and debentures of ordinary industries are not easily marketable without
having a fall in their market rates. Therefore, banks should always make investments in
government securities and shares and debentures of reputed industrial houses.

Safety
The second most important function of lending is safety, safety of funds lent. Safety
means that the borrower should be in a position to repay the loan and interest at regular
durations of time without any fail. The repayment of the loan relies on the nature of
security and the potential of the borrower to repay the loan.
Unlike all other investments, bank investments are risk-prone. The intensity of risk
differs according to the type of security. Securities of the central government are safer
when compared to the securities of the state governments and local bodies. Similarly, the
securities of state government and local bodies are much safer when compared to the
securities of industrial concerns.
This variation is due to the fact that the resources acquired by the central government
are much higher as compared to resourced held by the state and local governments. It is
also higher than the industrial concerns.
Also, the share and debentures of industrial concerns are bound to their earnings.
Income varies according to the business activities held in a country. The bank should also
consider the ability of the debtor to repay the debt of the governments while investing
in their securities. The prerequisites for this are political stability and peace and
security within the country.
Securities of a government acquiring large tax revenue and high borrowing capacity are
considered as safe investments. The same goes with the securities of a rich municipality
or local body and state government of a flourishing area. Thus, while making any sort of
investments, banks should decide securities, shares and debentures of such governments,
local bodies and industrial concerns which meets the principle of safety.
Therefore, from the bank’s way of perceiving, the nature of security is very essential
while lending a loan. Even after considering the securities, the bank needs to check the
creditworthiness of the borrower which is monitored by his character, capacity to repay,
and his financial standing. Above all, the safety of bank funds relies on the technical
feasibility and economic viability of the project for which the loan is to be given.

Diversity
While selecting an investment portfolio, a commercial bank should abide by the principle
of diversity. It should never invest its total funds in a specific type of securities, it
should prefer investing in different types of securities.
It should select the shares and debentures of various industries located in different
parts of the country. In case of state governments and local governing bodies, same
principle should be abided to. Diversification basically targets at reducing risk of the
investment portfolio of a bank.
The principle of diversity is applicable to the advancing of loans to different types of
firms, industries, factories, businesses and markets. A bank should abide by the maxim
that is “Do not keep all eggs in one basket.” It should distribute its risks by lending loans
to different trades and companies in different parts of the country.

Stability
Another essential principle of a bank’s investment policy is stability. A bank should prefer
investing in those stocks and securities which hold a high degree of stability in their
costs. Any bank cannot incur any loss on the rate of its securities. So it should always
invest funds in the shares of branded companies where the probability of decline in their
rate is less.
Government contracts and debentures of industries carry fixed costs of interest. Their
cost varies with variation in the market rate of interest. But the bank is bound to
liquidate a part of them to satisfy its needs of cash whenever stuck by a financial crisis.
Else, they follow their full term of 10 years or more and variations in the market rate of
interest do not disturb them. So, bank investments in debentures and contracts are more
stable when compared to the shares of industries.

Profitability
This should be the chief principle of investment. A bank should only invest if it earns
sufficient profits from it. Thus, it should, invest in securities that have a fair and stable
return on the funds invested. The procuring capacity of securities and shares relies on
the interest rate and the dividend rate and the tax benefits they hold.
Broadly, it is the securities of government branches like the government at the center,
state and local bodies that hugely carry the exception of their interest from taxes. A
bank should prefer investing in these type of securities instead of investing in the shares
of new companies which also carry tax exception. This is due to the fact that shares of
new companies are not considered as safe investments.
Now lending money to someone is accompanied by some risks mainly. As we know that bank
lends the money of its depositors as loans. To put it simply the main job of a bank is to
rent money from depositors and give money to the borrowers. As the primary source of
funds for a bank is the money deposited by its customers which are repayable as and
when required by the depositors, the bank needs to be very careful while lending money
to customers.
Banks make money by lending money to borrowers and charging some interest rates. So, it
is very essential from the bank’s part to follow the cardinal principles of lending. When
these principles are abided, they assure the safety of banks’ funds and in response to
that they assure its depositors and shareholders. In this whole process, banks earn good
profits and grow as financial institutions. Sound lending principles by banks also help the
economy of a nation to prosper and also advertise expansion of banks in rural areas.

THE CREDIT POLICY

The credit policy is a critical document for any business, but especially one in the credit-
heavy construction industry. Your company should clearly lay out its philosophy on
extending terms to customers and collecting on overdue accounts. If there’s no plan,
there’s no hope for survival.

Features/ Aspects of Optimum Credit Policy

The optimum credit policy of an organization represents the best credit efforts to
maximize the returns from the use of the policy as a marketing tool. Usually, it depends
upon the organization as to how much control over the credit policy must be exerted.

A too-tight credit policy will lead to loss of opportunities while a too lenient credit policy
may lead to an extension of bad debts. Therefore, an optimum credit policy is required
by companies to excel in business operations.

The main features of an optimum credit policy are as mentioned below −

  Credit policy variables
 Evaluation of credit
 Decision of granting credit
 Control of receivables

Credit Policy Variables

The credit policy variables that affect the policy in the long term are as follows −

Credit Standards − This variable represents the firm’s stand on whether to grant credit
or not to a customer. The organization may decide not to grant credit to a customer even
if the credit history of the customer is very good.

On the other hand, a firm may grant credit to firms even if their creditworthiness is
doubtful.

Liberal credit policies tend to attract more customers and it may increase sales and
profitability. However, there are more risks of bad debt associated with a liberal credit
policy. A tight policy, on the other hand, losses the opportunity of earning more revenue
as it rejects many potential customers.

Credit Period − It is the time a firm allows its customers to pay the credit amount. A
liberal credit policy will allow more time for customers to pay back the money.

So, it will increase sales as customers will buy more from the firm, and hence
profitability may go up too. This however will require more investment in receivables and
a higher incidence of bad debt losses.

Shortening the period, on the other hand, will lower sales, decrease the investments in
receivables and reduce the bad debts.

Cash Discount − This is offered by firms in order to make customers pay early. Usually,
larger discounts are paid to customers who pay within a certain period. This helps reduce
bad debts and increases the sales of the firm by the customers as more goods can be
bought by spending the same amount.

Collection Efforts − Collection efforts increase the collection of revenue and a tight
collection process may reduce bad debts and other costs associated with a credit sale. It
is usually combined with a legal term to pay the credit within a given period.
Evaluation of Credit
The firm must evaluate the character, capacity, and collateral to evaluate the
creditworthiness of the customers. Character refers to the customer’s intention to obey
legal terms. Capacity refers to the ability to pay back the credit and collateral is the
security offered by the customer as a form of a mortgage.

Credit Granting Decision

The decision of granting credit lies with the management. Before granting the credit, a
firm may check the variables mentioned above. It may also look at factors that affect
the creditworthiness of a customer and their willingness to pay back the money in time.

If a company is lenient, it will take the granting decision earlier and without much
analysis. On the other hand, a company that is stringent will make a decision later after
analyzing various factors.

Control of Receivables
Two methods are usually used for this. They are as follows −

Days of sales outstanding − It is a ratio of receivables outstanding to average daily

sales at a particular time. According to DSO, the accounts receivables are considered to
be in control if the DSO is equal to or less than a given norm.

Aging Schedule − This creates different age brackets to pay the credits or the accounts
receivables. In this method, the actual AS is compared with a standard to check whether
the receivables are in control.

Conclusion
The payment pattern (PP) approach is more practical and used in modern times. The PP
approach overcomes the defect of aggregation of sales and receivables over a specific
period of time. It focuses on the payment behavior which is key in calculating accounts
receivables. It is expressed as proportions or in percentages.

COMPONENTS OF A CREDIT POLICY:

Business clients often prefer to be billed for purchases rather than paying upfront. That
means you may need to establish receivable accounts for most business-to-business
transactions. Unfortunately, it also means cash flow complications or worse if you take
on commercial clients who don’t pay on time, or at all. Luckily, you can minimize the risk
of delinquent accounts by creating strong payment and credit policies.

Consider these four methods:

1. Credit eligibility standards:

Research new clients by purchasing business credit reports or contacting credit
departments in your industry. Before extending credit, confirm that they have made
good on previous obligations.

2. Credit terms:
Consider industry practices and the creditworthiness of individual customers when
crafting your policy. In some industries, new

Customers might start with a “net 30” standard, allowing them 30 days before payments
become delinquent. But one size doesn’t necessarily fit all. Your best customers may
warrant longer payment terms, such as 60 to 90 days. Some industries have their own
billing practices, such as the construction industry, where customers are usually billed
with a series of invoices.

3. Clear documentation:
Requirements for purchase orders, contracts, credit applications, sales agreements and
invoices should all be documented and made clear to the client. The policy should include
examples of each type of form, and specify the circumstances under which each would be
appropriate and/or mandatory. Having formal procedures in place will make clear to your
clients that you are diligent about the payment process and expect timely payment.