Credit management is essential for firms that sell products or services on credit, and involves a

range of factors that impact a firm's financial health and operational efficiency. Here's an
overview of the necessity of credit management based on the provided sources:

1. Trade Credit as a Marketing Tool:

● Trade credit is a vital tool that facilitates the movement of goods through production and
distribution to the customers.
● Firms offer trade credit to remain competitive, attract new customers, and encourage
sales by providing favorable terms.
● Credit policies can help a firm retain old customers and attract new ones by
differentiating themselves from competitors.
● In a growing market, credit can expand market share, and in a declining market, it can
maintain the current market share.
● During competitive or recessionary periods, a firm may loosen its credit policy to
maintain or minimize the erosion of sales.

2. Creation of Accounts Receivable:

● When a firm sells on credit, it creates accounts receivable (also known as trade debtors
or book debts), which represent claims or assets that are expected to be collected in the
future.
● These debtors constitute a substantial portion of current assets for many firms,
sometimes representing about one-third of current assets.
● Granting credit ties up the firm's funds, as there's a time interval between the sale and
the payment, which must be financed via working capital. Thus, trade debtors are
considered an investment.

3. Credit Policy Goals:

● The main goal of a firm's credit policy is to maximize shareholder wealth by increasing
sales and improving profitability.
● This involves finding a balance between increasing sales and managing the costs and
investments associated with it.
● A firm may adopt a lenient or stringent policy based on its goals, with lenient policies
granting credit more liberally, while stringent policies are more selective.
● The credit policy is comprised of three decision variables: credit standards, credit
terms, and collection efforts.

4. Factors Influencing Credit Policy:

● The volume of credit sales is influenced by total sales and the percentage of credit sales,
which depends on factors like market size, competition, and industry norms.
● Credit standards determine which customers receive credit.
 ○ More slow-paying customers increase investment in receivables and the risk of
default.
● Credit terms specify the duration of credit and payment terms, and extended periods
increase receivables.
● Collection efforts directly affect the collection period, and shorter periods reduce
investment in receivables.

5. Reasons for Granting Credit:

● Competition pressures firms to offer credit, although exceptions exist.

● Companies with strong bargaining power may offer less or no credit.
● Buyers' requirements, such as in industrial products, often necessitate extended credit.
● Larger buyers may demand easy credit terms because of their bulk purchases and
increased bargaining power.
● Credit is used as a tool to build long-term relationships and reward loyalty with dealers.
● Companies also use credit to launch new products or push weak ones.
● Industry practice often dictates credit policies, especially for smaller firms.
● Transit delays can also necessitate extended credit periods.

6. Costs Associated with Credit Policy:

● Firms must evaluate credit policies in terms of both returns and costs.
● Costs include:
○ Production and selling costs which increase with sales expansion, including
variable and fixed costs.
○ Administration costs, such as credit investigation and collection costs which
increase when credit policy is loosened.
○ Bad-debt losses which rise when credit is extended to less creditworthy
customers.
● A tight credit policy can result in lost sales and contribution.
● The opportunity cost of lost contribution declines with looser credit policies.

7. Determining Optimum Credit Policy:

● An optimum credit policy is where the incremental return on investment equals the cost
of funds used to finance the investment.
● This policy is not necessarily one that maximizes operating profit, but maximizes the
value of the firm.
● Evaluation of investment in receivables should consider:
○ Estimation of incremental operating profit.
○ Estimation of incremental investment in accounts receivable.
○ Estimation of incremental rate of return.
○ Comparison of the incremental rate of return with the required rate of return.
 ● As a firm loosens its credit policy, its investment in accounts receivable becomes riskier
because of increases in slow-paying and defaulting accounts, which then increases the
required rate of return.
● Credit standards should be relaxed up to the point where the incremental return equals
the incremental cost.

8. Monitoring Receivables:

● Continuous monitoring and control of receivables are necessary to ensure successful

collections.
● Traditional methods include the average collection period (ACP) and the aging
schedule.
○ ACP compares the average time taken to collect payments with the firm’s stated
credit period.
○ Aging schedules break down receivables by the time they have been
outstanding.
● A better approach involves using a collection experience matrix, which relates
outstanding receivables to the sales of the same period.

9. Factoring as a Credit Management Tool:

● Factoring is a method of converting receivables into cash by selling them to a

specialized organization, which helps with cash flow.
● It provides financial and management support by purchasing a client's accounts
receivable and then managing credit, and administering sales ledgers.
● Factors provide services such as sales ledger administration, credit management, credit
collection, protection against bad debts, and financial accommodation against
receivables.
● Factoring differs from bill discounting, which is essentially borrowing, while factoring
involves the efficient management of book debts.

10. Types of Factoring:

● Full service non-recourse: the factor purchases book debts and assumes full credit
risk.
● Full service recourse: the client is not protected from bad debt risks and has to refund
money if a customer defaults.
● Bulk/agency factoring: the client continues credit administration and the factor finances
the debts.
● Non-notification factoring: the customers are not informed about the factoring
agreement.

11. Costs and Benefits of Factoring:

● Costs include the factoring commission or service fee, and interest on advances from the
factor.
 ● Benefits include specialized credit management services, cost savings due to economies
of scale and specialization, and a focus on manufacturing and marketing.
● Factors can employ specialists in credit control and management, leading to efficient
operations.

In summary, credit management is a complex area requiring careful planning and execution. It is
not just about increasing sales, but about optimizing the balance between sales growth, risk
management, and profitability. Firms must continuously evaluate their credit policies and adapt
to changing market conditions and internal capabilities.