3.4 Management of Working Capital 45to use their borrowing capacity to play a financial intermediary role for firms that
cannot raise capital as easily. The commercial reason is that the use of trade credit
(which reduces costs as well as cash requirements for customers) may be an active
strategy to support sales or price segmentation (price differentiation).
Trade credit and risk. There is therefore a difference between bank credit and
trade credit. A traditional creditor regards credit as a separate investment and
wants that investment to be profitable. For a trade creditor the sale of goods and
the extension of credit are part of the same customer relationship.
The extension of trade credit means that the firm is exposed to counterparty
credit risk. A firm that sells on credit terms must usually write off some sales as
uncollectible (due to the customer’s insolvency) and suffer payment delays be-
yond credit terms.
Accounts receivable functions are closely connected with other functions such
as: verification of product quality (the seller must ensure that the quality is what
the seller promised^92 and that the buyer may not invoke breach of contract^93 , be-
cause the buyer may otherwise have a right to refuse to pay^94 ); the use of efficient
payment tools (cash management); and currency management (there may be a
credit arbitrage opportunity for the seller if the accounts receivable are denomi-
nated in a foreign currency).
Credit policy. The management of accounts receivable is focused on the trade-
off between the incremental profits from the sales generated by the different credit
policies and the costs of such policies.
The firm has many conflicting objectives. The firm tries to: maximise sales;
minimise losses caused by bad debts; minimise operative credit costs; and mini-
mise financial costs due to investment in accounts receivable.
The firm should expand credit facilities as long as the profitability of additional
sales exceeds the costs of accounts receivable (financial costs, operative costs,
cost of delays, credit losses). When comparing the profitability of different credit
policies, the firm will take into account the following things: change in profit =
change in sales revenue – change in monetary production costs – change in credit
costs.
Risk categories and credit limits. Typically, the firm places its customers in dif-
ferent risk categories. The internal credit guidelines of the firm should set out how
customers’ orders can be credit approved on the basis of the risk category to which
the customer belongs. Those guidelines should also set out how a credit limit is
determined for each customer on the basis of the risk category of the customer.
The choice of risk category will be done in advance on the basis of the cus-
tomer’s estimated payment behaviour but monitored during the business relation-
ship.
(^92) CISG Article 35.
(^93) CISG Article 39(1) (notice within a reasonable time); CISG Article 39(2) (statute of
limitation); CISG Article 40 (effect of knowledge).
(^94) See, for example, CISG Article 50.