18: Cash Conversion, Inventory and Receivables ManagementThe first decision a company must make is whether it will offer trade credit at all. There are many
reasons for offering credit, including increasing sales, meeting terms offered by competitors, attracting
new customers and providing general convenience. In a typical business-to-business environment, a
company may have to offer trade credit just to generate sales. This is especially the case for a large
company selling to smaller companies, where the smaller company needs the credit period in order to
sell merchandise so it can pay the supplier. The small company would not usually have access to other
types of credit, so if the supplier does not offer credit then there is no sale.
As mentioned previously, many companies see trade credit and credit terms as simply an extension
of the sales price. They may use credit terms to motivate customers or to compete with other suppliers.
In many cases, industry practices dictate whether companies offer credit and under what terms. In
today’s financial environment, there are also many opportunities for companies to outsource part or all of
the credit and accounts receivable process. Outsourcing alternatives include the use of credit cards, and
third-party financing and factoring, which involves the outright sale of receivables to a third-party factor
at a discount.
Once a company has decided to offer trade credit, it must do the following:
1 Determine its credit standards: Who is offered credit, and how much?
2 Set its credit terms: How long do customers have to pay, and are any discounts offered for early
payment?
3 Develop its collection policy: How should delinquent accounts be handled?
4 Monitor its accounts receivable on both an individual and aggregate basis: What is the status of each
customer and the overall quality of its receivables?
In addition, the company must have effective cash application procedures in place (these are discussed
in Section 18-5c).
18- 4b CREDIT STANDARDS
The first and most important aspect of A/R management is setting credit standards. This process involves
applying techniques for determining which customers should receive credit and how much credit should
be granted. Much of the focus is on making sure that a company does not accept substandard customers –
potential defaulters on trade credit. However, a company must take care not to set the standards so
high that potential good customers are rejected. A company’s accounts receivable default rates should
generally be in line with those of other companies in the same industry if it wants to remain competitive.
Granting Credit to Customers
In analysing credit requests and determining the level of credit to be offered, the company can gather
information from both internal and external sources. The usual internal sources of credit information are
the credit application and agreement and, if available, the company’s own records of the applicant’s payment
history. External sources typically include financial statements, trade references, banks or other creditors,
and credit-reporting agencies. Each of these sources involves the internal costs of analysing the data; some
sources, such as credit reporting agencies, also have explicit external costs (a charge for obtaining the data).
The company must also take into account the variable costs of the products it would be selling on
credit. For example, a company selling a product with a low variable cost (such as magazine subscriptions)
will often grant credit to almost anyone without a credit check. Such a company doesn’t have much to
factoring
The outright sale of
receivables to a third-party
factor at a discount