Credit: Assessment, Security and Collection
Credit management examines how an organisation decides whom to lend to and how to recover money owed. Understand the credit cycle: setting credit policy, assessing applicants, setting limits, monitoring and collecting. Learn the five Cs of credit (character, capacity, capital, collateral and conditions) and the tools of assessment: trade references, bank references, credit bureau reports and financial statement analysis.
Know the credit terms and how to evaluate a discount policy. A common question asks whether a customer should take a cash discount, or whether a firm should relax credit standards. Compute the cost of giving a discount and compare it with the cost of financing receivables. Understand ageing schedules, days sales outstanding, and the operating cycle. Collection tools include reminders, statements, telephone follow-up, debt collectors and legal action.
Traps include confusing the cost of a discount with its face value, ignoring bad debt risk when relaxing standards, and treating a bank reference as a guarantee. Security questions test the difference between a pledge, a mortgage, a lien and a guarantee, and the priority of claims.
Worked example: cost of forgoing a discount
Terms are 2/10, net 30. Forgoing the discount costs 2/98 x 365/20, approximately 37.2% a year. Rule of thumb: if the firm's borrowing cost is below that figure, borrowing to take the discount is cheaper.