Credit Management: Policy, Appraisal and Collection
The order-to-cash cycle
Credit management spans credit policy design, customer appraisal, limit setting, invoicing, monitoring and collection. The appraisal toolkit includes the 5 Cs - character, capacity, capital, collateral and conditions - plus credit scoring, credit reference bureau reports, trade and bank references, and ratio analysis (current ratio, gearing, interest cover, cash flow cover). Remember that capacity and character predict repayment; collateral is only a recovery fallback and should never be the reason a weak account is approved.
Monitoring metrics
DSO = (trade receivables ÷ credit sales) × 365. Aged debtor schedules split balances by bucket (0–30, 31–60, 61–90, 90+); a swelling 90+ bucket warns of collection failure before DSO shifts. Cost of credit includes funding cost, bad debts, administration, and the opportunity cost of tied-up cash. Mitigation tools: credit limits, cash discounts, interest on overdue accounts, guarantees, credit insurance, factoring and covenants.
Traps examiners set
- Feeding total sales into a DSO formula that requires credit sales.
- Treating collateral as the primary repayment source.
- Confusing a credit limit (a control ceiling) with a credit period (a payment term).
- Mixing specific provisions (identified doubtful accounts) with general provisions (a percentage of the remaining book).
Worked example: the real cost of a cash discount
Terms 2/10, net 30. Forgoing the discount costs 2/98 over the 20 days between day 10 and day 30: (0.02 ÷ 0.98) × (365 ÷ 20) = 37.2% per annum. If overdraft finance costs 15%, borrowing to pay early is cheaper. Always annualise before comparing with a borrowing rate - comparing 2% with 15% directly is the classic error.