Question

MANAGEMENT OF CREDITORS

Managing creditors is a key part of working capital management. Trade credit is the simplest and most important source of short-term finance for most companies. The objective of creditor management is to ascertain the optimum level of trade credit to accept from suppliers. It should be used wisely since trade credit that is received influences the trade credit given.

Source: www.kaplan.co.uk

REQUIRED

In view of the extract above:

4.1 Provide THREE (3) reasons for using trade credit.

4.2 Explain the competing objectives associated with trade credit.

4.3 Suggest strategies for the effective management of creditors.

Answer 1

4.1

A trade credit is a business-to-business (B2B) agreement in which a customer can purchase goods on account without paying cash up front, paying the supplier at a later scheduled date. Usually businesses that operate with trade credits will give buyers 30, 60, or 90 days to pay, with the transaction recorded through an invoice. Trade credit can be thought of as a type of 0% financing, increasing a company's assets while deferring payment for a specified value of goods or services to some time in the future and requiring no interest to be paid in relation to the repayment period.

A trade credit is an advantage for a buyer. In some cases, certain buyers may be able to negotiate longer trade credit repayment terms which provides an even greater advantage. Often, sellers will have specific criteria for qualifying for trade credit.

A B2B trade credit can help a business to obtain, manufacture, and sell goods before ever having to pay for them. This allows businesses to receive a revenue stream that can retroactively cover costs of goods sold. Walmart is one of the biggest utilizers of trade credit, seeking to pay retroactively for inventory sold in their stores. International business deals also involve trade credit terms. In general, if trade credit is offered to a buyer it typically always provides an advantage for a company's cash flow.

The number of days for which a credit is given is determined by the company allowing the credit and is agreed upon by both the company allowing the credit and the company receiving it. Trade credit can also be an essential way for businesses to finance short-term growth. Because trade credit is a form of credit with no interest, it can often be used to encourage sales.

Since trade credit puts suppliers at somewhat of a disadvantage, many suppliers use discounts when trade credits are involved to encourage early payments. A supplier may give a discount if a customer pays within a certain number of days before the due date. For example, a 2% discount if payment is received within 10 days of issuing a 30-day credit. This discount would be referred to as 2%/10 net 30 or simply just 2/10 net 30.

4.2

A company’s policy on when its customers should pay for goods or services they have ordered a government’s policy at a particular time on how easy or difficult it should be for people and businesses to borrow and how much it should cost. Trade credit is probably the easiest and most important source of short-term finance available to businesses.

A sample credit policy contains a number of elements that are designed to mitigate the risk of loss from extending credit to customers that cannot pay.

Objectives of trade credit are:

(a) Effectively outlines policies and procedures that will help provide your customers with options when they cannot pay in full.

(b) Implements a plan that will enable your business to adequately provide reasonable credit limits for your customers that have revolving credit accounts.

(c) Outlines the steps to take to collect from past-due or late paying customers and how to eliminate bad debt.

(d) Provide guidelines to legally collect money that k due to your company from slow or non-paying customers and from bad checks.

(e) This is short-term finance that is relatively quick to arrange. The typical amount involved and the terms will depend entirely on your trading activity. The reverse is also common, where a business’s customers or clients will request trade credit terms.

These are the Objectives of trade credit. A credit policy is necessary to show the company’s intended way of doing business and avoids confusion and potential misunderstanding.

4.3

Credit Management

Credit management covers a diverse field of credit-related areas, from granting consumer credit requests to managing the credit options of large corporations to collecting delinquent debts. The accounts receivable are usually around 25% of total assets, although this ratio depends strongly on the business sector (trade, industry, services…).

It is therefore very significant for many businesses and very consumer of financial resources without being remunerated. It can be considered as a permanent financial weight for companies.

Accounts receivable are an amount of money at risk. This risk has to be managed so that financial resources of your company scattered among your customers (bills issued but not paid yet) do not create bad debts with negative consequences for your business.

We can identify four main risks associated with receivables:

• risk of losses and provisions for bad debts,

• risk about working capital requirement and cash flow,

• risk of depreciation of value due to inflation,

• risk of excessive consumption of financial resources with result an incapacity to make investments for your business.

It is more difficult to determine the opportunities of receivables:

• it is often a business requirement to grant a payment to your customers. By this way you finance the activity of your client. This is precisely what he is requesting even if he does not formulate this need in these terms,

• ability to discount your receivables to get cash faster compare to the due date of your invoices.

What is the strategy?

It can be defined as following:"The strategy is the definition of coherent actions involved in a logical sequence to achieve one or several goals." ».

The strategy has a long term objective.

So, you need to define your credit management strategy and answer to the questions: why do you want to do this and how you'll do it.

It depends mainly on your business' financial structure and profitability, the weight of your receivables and your business overall strategy.

Credit Management strategy shall be fully inserted into your business plan. It should be determined by financial constraints your business plan imposes to you.

In fact, the choices you have to take on the management of your accounts receivables have an impact on the profitability of your business and on its working capital and investment capacity.

Objective	Strategy	Method	Advantages	Disavantages
Improve its investment capacity	minimize the receivables	negotiate payment terms reductions with your customers against discount discount your receivables (factoring, discount of bills of exchange) agressive collection of your receivable negociate down payments	massive reduction of working capital and increase of your investment capacity	cost and profitabilty impact
Maximize profitability	secure your receivables	use credit insurance or bank guarantees systematically	limitation of risk of default low cost	high working capital negative commercial impact
Develop its sales	Flexibility towards customers	grant long payment terms no request of guarantees or down payments flexible collection process	contribute to the sales development at short term	high risk of unpaids and high working capital loss a credibility if collection is too flexible with customers

Obviously it is desirable to balance these objectives described here drastically. You have to define the direction you want to take and how far you go into your strategy.