MODULE 2

CREDIT AND COLLECTION

CREDIT POLICY

Credit policy development is a fundamental aspect of financial management within any business that
extends credit to customers. It involves creating a set of guidelines and procedures to govern how credit
is granted, managed, and monitored throughout the customer lifecycle. A well-designed credit policy
serves as a roadmap for credit decisions, ensuring consistency, efficiency, and risk mitigation.

Components of Credit Policy

1. Credit Terms and Conditions: Defines the terms under which credit is extended, including payment
terms, interest rates (if applicable), and penalties for late payments.

2. Credit Approval Process: Specifies the procedures and criteria for evaluating credit applications and
granting credit to customers.

3. Credit Limits: Establishes the maximum amount of credit that can be extended to a customer based
on their creditworthiness and risk profile.

4. Payment Terms: Outlines the timing and method of payment, such as net payment terms (e.g., net 30
days), installment plans, or revolving credit arrangements.

5. Credit Evaluation Criteria: Identifies the factors used to assess customer creditworthiness, such as
credit history, financial stability, and payment behavior.

Certainly! Setting credit limits and terms is a crucial aspect of credit management, influencing both the
company's cash flow and its risk exposure. Here's a breakdown of setting credit limits and terms:

1. Credit Limits:

Credit limits refer to the maximum amount of credit that a company is willing to extend to a customer.

Factors Considered:

 Customer's Creditworthiness: Assessing the customer's credit history, financial stability, and
payment behavior helps determine an appropriate credit limit.
 Risk Appetite: Companies consider their tolerance for risk when setting credit limits, balancing
the desire to attract customers with the need to mitigate credit risk.
 Financial Capacity: The company's own financial health and liquidity influence its ability to offer
higher credit limits.

Methods of Determination:
 Credit Scoring Models: Utilizing credit scoring algorithms based on quantitative data such as credit
scores, financial ratios, and payment history.

 FINANCIAL RATIOS

Certainly! When a creditor evaluates a borrower's creditworthiness, they use financial ratios to assess
the borrower's ability to repay the debt. Here are some key financial ratios that creditors commonly
consider when evaluating borrowers:

1. Debt-to-Income Ratio (DTI):

- Formula: Total Monthly Debt Payments / Gross Monthly Income

- Interpretation: Measures the percentage of a borrower's monthly income that goes toward debt
payments. A lower DTI ratio indicates that the borrower has more disposable income available to meet
debt obligations.

2. Debt Service Coverage Ratio (DSCR):

- Formula: Net Operating Income (NOI) / Total Debt Service

- Interpretation: Measures the borrower's ability to generate enough income to cover debt payments.
A DSCR above 1 indicates that the borrower's income is sufficient to cover debt obligations.

3. Loan-to-Value Ratio (LTV):

- Formula: Loan Amount / Appraised Value of Collateral

- Interpretation: Indicates the percentage of the property's value that is financed by the loan. A lower
LTV ratio suggests lower risk for the lender, as there is more equity in the collateral.

4. Credit Utilization Ratio:

- Formula: Total Credit Card Balances / Total Credit Card Limits

- Interpretation: Measures the percentage of available credit that a borrower is currently using. A
lower credit utilization ratio indicates that the borrower is not heavily reliant on credit and may be less
risky.

5. Fixed Charge Coverage Ratio (FCCR):

- Formula: (Net Operating Income + Non-Operating Income) / (Total Debt Service + Fixed Charges)

- Interpretation: Measures the borrower's ability to cover fixed expenses, including debt service
payments and other fixed charges. A higher FCCR ratio indicates better financial stability and ability to
meet obligations.

These financial ratios provide creditors with valuable insights into a borrower's financial health
and ability to repay debt, helping them make informed decisions about extending credit and managing
credit risk.

Manual Assessment: Reviewing qualitative factors and making subjective judgments based on
customer relationships and industry knowledge.
 Adjustments and Reviews:

- Credit limits should be periodically reviewed and adjusted based on changes in the customer's
creditworthiness, payment behavior, and the company's risk tolerance.

2. Credit Terms:

Credit terms specify the conditions under which credit is extended to customers, including
payment deadlines, discounts for early payment, and penalties for late payment.

Components of Credit Terms:

Payment Deadlines: Setting clear deadlines for when payments are due, such as net 30 days or net 60
days.

Discounts: Offering incentives for early payment, such as a percentage discount for paying within a
certain timeframe (e.g., 2/10, net 30).

Late Payment Penalties: Establishing consequences for late payments, such as interest charges or
suspension of credit privileges.

How credit policy influences business operations and financial health:

1. Cash Flow Management:

- Credit policy directly impacts cash flow by determining the timing of cash inflows from customers.

- It outlines payment terms and conditions, influencing when payments are received for goods or
services provided on credit.

- Effective credit policies strike a balance between offering favorable credit terms to customers while
ensuring timely cash collections to support ongoing operations.

2. Revenue Generation:

- A well-designed credit policy can stimulate sales and revenue generation by making it easier for
customers to purchase goods or services on credit.

- By extending credit to customers, businesses can attract new customers and encourage repeat
business, thereby contributing to overall revenue growth.

3. Risk Management:

- Credit policy plays a crucial role in managing credit risk, which arises from the potential for customers
to default on their payment obligations.
 - By establishing criteria for assessing customer creditworthiness and setting appropriate credit limits,
businesses can mitigate the risk of bad debt and financial losses.

4. Customer Relationships:

- Credit policies can impact customer relationships by influencing the customer experience during the
purchasing process.

- Clear and transparent credit terms can enhance trust and confidence in the business, fostering
stronger relationships with customers.

- However, overly restrictive or burdensome credit policies may strain customer relationships and lead
to dissatisfaction.

5. Operational Efficiency:

- A well-defined credit policy streamlines business operations by providing clear guidelines for credit-
related processes.

- It standardizes credit evaluation procedures, credit approval workflows, and collection practices,
promoting efficiency and consistency across the organization.

6. Financial Health:

- The effectiveness of credit policy directly affects the financial health of the business.

- A prudent credit policy helps maintain a healthy balance between risk and reward, ensuring that
credit extensions contribute positively to the bottom line.

- By minimizing bad debt exposure and optimizing cash flow, a sound credit policy supports overall
financial stability and sustainability.

7. Compliance and Governance:

- Credit policies ensure compliance with regulatory requirements and internal governance standards.

- They incorporate legal and regulatory considerations, such as consumer protection laws and industry
regulations, to mitigate legal and compliance risks.