BUSF_A01.qxd

Trade receivables

Assessing the potential customer’s creditworthiness

It is usual before granting credit to a new customer, or perhaps when increasing the

credit limit of an existing customer, to assess creditworthiness. This is usually done by

seeking references from the customer’s bank and from other traders who have already

granted credit to that customer. The assessment might include examination of the cus-

tomer’s published financial statements, for clues as to liquidity and financial rectitude,

and paying a credit rating agency for a report on the customer.

Carrying out these procedures reduces the risk of bad debts, but it costs money,

though to a large extent the cost, once incurred, is unlikely to need to be repeated.

Typically, a business, once having granted credit to a particular customer, reassesses

that customer on the basis of its own experience of the customer’s track record of

payment.

Administration and record-keeping costs

Most businesses that grant credit find it necessary to employ people to act in the role

of credit controllers, that is, to devote themselves to the administration and collection

of trade receivables. Granting credit usually involves a greatly increased volume of

accounting transactions.

Bad debts

Unless the business adopts an extremely cautious credit-granting policy it is almost

inevitable that some trade receivables will never pay, owing, for example, to the

defaulting customer’s financial collapse. This risk can be insured against, though typic-

ally it is borne by the supplier; either way there is a cost.

Discounts

It is quite common for businesses to offer their credit customers a discount if they

settle quickly. For example, a 2.5 per cent discount may be offered if customers pay

within 30 days of receipt of the goods or service. What the effective cost of such a

policy would be depends upon how long the customers who pay quickly and claim

the discount would take to pay were no discount available. If, say, in the above

example they would on average take 40 days but the discount causes them to pay

exactly on day 30, the effective cost of the discount is 2.5 per cent per 10 days, or about

100 per cent p.a. (compounded). Clearly, giving discounts for prompt payment can

represent a significant cost, so its use should be treated with caution. We should bear

in mind, however, that discount-induced prompt payment might well reduce some of

the costs that we have already discussed, particularly those associated with the risk of

bad debts and administration of trade receivables.

Exchange rate costs

Any business will expose itself to risk and cost by making credit sales in an overseas

currency. The risk can be managed effectively, but this will involve further cost. This

topic will be explored in Chapter 15.

The costs and risks of denying credit

There are various costs and risks associated with denying credit. These are considered

below.