Credit Management Duties of Credit Department

Credit Management is an approach consisting of ●​ risk assessment

multiple techniques to assure that buyers pay on ●​ credit ratings
time, credit costs are kept low, and poor debts are ●​ credit risk categories
managed in such a manner that payment is ●​ opening new customer accounts
received without damaging the relationship with ●​ maintaining and updating the customer data
that buyer. file
●​ over-limit situations
It is a function performed within a company to ●​ order referrals
improve and control credit policies that will lead to ●​ credit insurance bad debts and insolvencies
increased revenues and lower risk including ●​ legal action customer meetings
increasing collections, reducing credit cost, ●​ support for marketing information
extending more credit to creditworthy customers ●​ cash collection
and developing competitive credit terms. It is also ●​ cash allocation
called credit control (WebFinance, Inc., n.d). ●​ planning levels of debtors
●​ planning departmental expense
The aim of good credit management is the ●​ reporting, departmental and corporate
maximization of profitable sales over the shortest
acceptable period and with the minimum of bad Goals and Objectives of Credit Department
debt losses. Five key credit department objectives:
●​ Develop an optimal level of sales and cash
Organizations and Functions of Credit flow, while limiting delinquencies and bad
Department debt losses and working effectively with
The credit function is a valuable asset to a sales and other departments.
company's business. It makes a significant ●​ Minimize the carrying costs for accounts
contribution to sales and profit maximization. receivable.
●​ Minimize risk and bad debt losses while
However, improper handling of the credit function maintaining a competitive advantage
might lead to potential risks and losses. Therefore, ●​ Monitor the costs incurred by the credit
establishing a properly organized credit department department such as operating costs and
is necessary. expenses within the credit department to
benchmark standards.
The properly-organized credit department plays a ●​ The credit department must convert
critical role in managing accounts receivable accounts receivable to cash as quickly as
portfolio risk, prevent potential losses, and help the possible and communicate the condition,
company sell more products or services. It also cost and trend of the company's investment
helps in ensuring that the role of credit contributes in receivables to management.
to the overall success of the company
Organizing Credit Department
Functions of Credit Department ●​ Centralized - Credit Controlled and
Five main areas of operation cover: Administered at the Headquarters Office
●​ Assessment of credit risk ●​ Decentralized - Credit Controlled at
●​ Establishment of credit terms and limits Headquarters but Administered from
●​ Monitoring and control of debt Decentralized Location(s)
●​ Maintenance of the sales ledger ●​ Decentralized - Credit Controlled and
●​ Collection of Payment Administered from Decentralized
Location(s) with Staff Office at Headquarters
Credit Department Relationship with other Credit Manager
Departments The credit manager should identify with overall
company policies and be a convinced and
1.​ Credit / Sales Relationship enthusiastic proponent of the contribution which
●​ Fostering a symbiotic credit/sales good credit management can make towards their
relationship is one of the most important achievement. He/ She should be, both by nature
goals of the credit manager. and by virtue of the responsibility vested in him, a
●​ A primary objective of the credit department decision maker whose judgements will respected
is to support sales; with that support, sales and opinions be sought by his directors and fellow
can be made that otherwise would not have managers (Williams, 1991).
taken place.
●​ The credit/sales relationship should be Functions of Credit Manager
evaluated on a regular basis to ensure that "Protection of the company's investment in
the expectations and goals of the debtors."
organization are being met. One of the
major contributions of the credit department Principal Tasks:
to the sales function is to work with ●​ Assessment of credit standing of both new
customers and sales representatives and to and existing customers
find ways to approve orders. For example, a ●​ Establishment of terms, having regard to the
credit manager may be able to suggest a risk involved and the potential profit
financing method not previously considered ●​ Maintenance of the sales ledger.
by the customer or may be helpful in ●​ Monitoring and control of customer
locating sources of capital for a customer. balances.
●​ Collection of business as close to terms as
2.​ Credit / Information System Relationship possible without jeopardizing future
●​ As a company implements new technology, business.
the first goal of the credit department is to
get involved early in decision-making and Objective of the Credit Manager
planning in order to present valuable data Duties are aimed at achieving objectives and those
about the credit process. Applying objectives for the credit manager can be more
technology to the credit process requires a easily broken down into:
detailed examination of what information is ●​ The assessment of the creditworthiness of
necessary and what is not. Breaking down customers; helping sales staff to obtain
key processes into primary activities, maximum business within acceptable limits
including actions, decision points and of risk
information/transportation flows, is referred ●​ Protecting the investment in debtors via
to as process mapping which is critical to daily credit and collection controls
implementing new technology. ●​ Achieving the planned intake of cash by
●​ Technology can improve the flow of competitive methods to achieve cash
information, speed decision-making and targets
standardize the credit process which will ●​ Keeping within an acceptable level of bad
continue to increase efficiencies and reduce debts by closely monitoring risky sales
cost. ●​ Improving the return on assets by reducing
●​ Electronic Data interchange is the the debtors ratio to sales over agreed
movement of data electronically from one time-scales, and
computer to another in a structured process ●​ Increasing customer loyalty via personal
able format. contacts and constructive attitudes.
Credit Policy sales and profits; and thus the need to
●​ A well-defined credit policy allows a support it fully.
business to achieve established goals and
serves as a guide in determining how to Developing Credit Policy
handle a variety of situations. In the Four essential elements of credit policy.
decision-making process, credit policy is ●​ Establishing credit standard
interpreted and applied to actual situations ●​ Determining credit availability
with guidelines or procedures that are ●​ Setting credit terms
devised by credit professionals to ●​ Defining collection policy
standardize the requirements assigned to
the department. Foundational Components of Credit Policy
●​ A credit policy is designed to provide
consistency across departmental functions. There are several key questions which builds the
It is usually established by top foundational components of credit policy:
management. ●​ What is the credit department's mission?
●​ Credit Policy concerns the company as a ●​ What are the goals?
whole and serves as a general course of ●​ What are the roles and specific authorities
action developed for recurring situations of the credit management and staff?
and established obiectives. ●​ What are the primary criteria for evaluating
●​ Implied Credit Policy, a policy that exist customer credit?
but not officially stated (or written). It ●​ What are the company's term of sale?
depends on oral communication or on ●​ What are the credit limits?
inference from the decisions made by senior ●​ What does monitoring of accounts consist
credit personnel. of?
●​ Written Credit Policy, a policy that is set ●​ What are the normal collection procedures?
forth in writing and usually has the support ●​ When is the account considered to be a bad
and approval of senior management. A debt?
written policy is useful because it can be a ●​ What does reporting to management consist
source of stability and continuity in the of?
operation, not only of the credit department
but also of the company as a whole Additional criteria by which credit policy is set:
●​ What is the extent of available borrowing, or
Benefits of Credit Policy likely available borrowing?
●​ An effective credit policy permits and ●​ What will be the intended level of debtors?
encourages the fullest development of the ●​ What is the company's market strength?
opportunities in administering credit. ●​ What are the current and likely business
●​ It sets out the company's intentions for the conditions and business prospects?
granting of credit ●​ What will be the availability of good quality
●​ Uncertainties about the authority levels and staff and the cost associated?
responsibilities for the setting of credit ●​ What will be the process for credit
amounts, payment terms, and risk checking?
categories and for accepting orders will be ●​ What are competitors doing?
prevented ●​ What will be the required level of
●​ It provides an operating guide for credit staff collaboration between sales and credit?
and helps to eliminate 'special' credit deals ●​ What will be the cost of over dues and bad
by unauthorized staff. debts, and what will the effect be on net
●​ It recognizes the importance of the role of margins?
credit management and its contribution to ●​ Will the credit control function be centralized
or decentralized?
 ●​ What will be the line of command for credit ●​ Over Limit Fee is a penalty charged by
responsibilities? credit card companies when cardholders'
purchase exceed their credit limit.
Nature of Cost of Credit
'Money cost money' Effect of Credit on Profitability and Liquidity
●​ Cost element is not restricted to ●​ Overdue accounts may cause direct erosion
non-payment, or bad debt losses, but of profit.
applies also to cost of the credit period itself ●​ Debts not being turned into cash fast
and the cost incurred in late payment. enough affects the business' liquidity.
●​ Cost can be passed on in prices or
absorbed by the seller, but can never be Positive Effects on Profit and Liquidity
ignored. ●​ Increase in sales - an increase in sales
may or may not happen when you start
Cost of Credit selling on credit. If your competitors are not
offering credit terms, then you will gain
a.​ Interest rate and Grace periods sales by offering credit terms, because your
●​ Interest rate is defined as the proportion of customers will buy from you instead of
an amount loaned which a lender charges having to pay cash from competitors.
an interest to the borrower. Credit products ●​ Better Customer Loyalty - this will
tend to have either a fixed or a variable positively affect company's profit and
interest rate. liquidity because offering credit to
●​ A fixed rate is a set when credit is customers indicates that you respect and
approved and will not change during the trust them to pay their bills before their due
term, unless you default. dates.
●​ A variable interest rate is a loan in which
the interest rate charged on the outstanding Negative Effects on Profit and Liquidity
balance varies as market interest rates ●​ Reduced Cash Flow - you may wait for
change. customer payments, which reduces your
ability to purchase replacement products
b.​ APR, Finance and Origination Fees from suppliers
●​ Annual Percentage Rate is the yearly rate ●​ Reduced Profit Margin
of interest that an individual must pay on ●​ Large Debts - unpaid debts can pose risk
loan, or that they receive on a deposit to business.
account. It includes not only the interest ●​ Keeping up with accounts receivables -
expense on the loan but also all fees and someone needs to keep up with the status
other costs involved in procuring the loan. of your accounts receivable. The reality is
APR is expressed as percentage. that customers don't always pay on time,
●​ Finance charges and origination fees refer and somebody needs to make calls or to
to a wide variety of additional costs of send out past due notices. If there isn't
obtaining credit. Other types of fees include already an employee in the office who can
application fees, documentation fees, notary do this, you may need to hire a new
fees, recording fees, and brokerage fees. employee.

c.​ Late fees and Over the limit penalties Bad Debts
●​ A late fee is a charge imposed on a ●​ Bad debts is a receivable that is
consumer who fails to make the payment on irrecoverable from the person who was
a debt or other financial obligation by the supposed to pay the obligation.
due date.
Reasons for Bad Debt Credit Risk Assessment
●​ Debtor's poor finance management. ●​ The modern approach is to judge the credit
●​ Debtor's inability or unwillingness to pay. risk from a total risk model. Such model
●​ When the creditors are unable to collect. considers two categories or risks: a.
●​ When disputes arise regarding the price, systematic and b. unsystematic.
quality, delivery, product, credit term. ●​ Systematic Risk is also referred as
undiversifiable risk or market risk, and
Methods to Account Bad Debt sometimes also known as macroeconomic
●​ Direct Write-off Method: When a risk. This risk embody the interest rate,
receivable is considered not collectible, it is exchange rate, and inflation
directly expensed in the Income Statement. ●​ Unsystematic Risk is sometimes referred
●​ Allowance Method: This is an estimate of as unique risk. It is particularly tied to the
the receivable made at the end of each business specifics and some to its
fiscal year. These amounts are then immediate competitors. Examples: company
accumulated in a provision account. The profit, Product services. Geographical
specific receivables are reduced every year areas, the market where the company
by these amounts as per the requirement. operates, management issues and
operating costs structure.
Credit Risk
●​ Credit Risk refers to the probability of the Credit Management Principles
loss (due to non-recovery of emanating from
the credit extended as a result of the 1.​ Independence
non-fulfilment of contractual obligations ●​ Independence is the ability to provide an
arising from unwillingness or inability of the objective report of facts and to form
counterparty or for any other reasons. impartial opinions.
●​ Is the risk that a borrower makes defaults in ●​ Without independence, the effectiveness of
his/her repayment (of principal/ interest) control units may be in jeopardy. It requires
obligations in accordance with agreed generally a separation of duties and
terms. reporting lines
●​ Also called as default risk or risk of default. ●​ Independence of the credit risk department
of a bank depends on the corporate culture
Where does credit risk arise from? and the promotion of objective criticism
●​ Non repayment of interest or loan principal within the bank so as to improve or
●​ Inability to meet contingent liabilities such modernize the operations.
as L/C, guarantees issued by the bank on
behalf of the client. 2.​ Credit Policy Administration Guidelines
●​ Default of the counterparty in meeting the ●​ The credit policy administration is
obligations in terms of treasury operations. responsible for the day-to-day supervision
●​ Not meeting settlement in terms of security of the loan policy
when it is due. ●​ If policy needs to be supplemented or
●​ Not meeting settlement in terms of security modified, credit policy administration drafts
when it is due. the changes for consideration by the
●​ Default due to restrictions imposed on management and the Board of Directors.
remittances. ●​ Such a unit- if exist, should establish a
●​ Default from the flow of foreign exchange in formal process for developing, implementing
terms of cross border operations. and reviewing policy derivatives from time to
time.
 3.​ Loan Review Guidelines operations achieve positive results as set
●​ Loan review is a mainstay of internal control out in the plan
of the loan portfolio. Periodic reviews of ●​ Credit analysis: This is the most basic
credit risk levels and risk management content of credit risk management. Credit
processes are essential to effective portfolio analysis is the collection and processing of
management. information, and consideration and
●​ To ensure the independence loan review, assessment of factors affecting a client's
the unit should report administratively and ability to pay loans as a basis for making
functionally to the Board of Directors or appropriate lending decisions.
standing committee with audit ●​ Scattering credit risks: This activity
responsibilities. includes performing well the process of
classifying and setting up credit risk
4.​ Audit of Transactions provisions as well as regulations on
●​ Audit activities in lending departments prudential ratios in credit activities,
usually focus on the accounting controls in establishing internal scoring and ranking
the administrative support functions. While customers system on the basis of regular
loan review has primary responsibility for monitoring of customer performance with
evaluating risk management controls, audit early warning indicators including financial
will generally be responsible for validating analysis indicators and related information.
the lending related models.
●​ Audit should be done at least annually and Other Measures of Mitigating Risks
whenever models are revised or replaced 1.​ Covenants
●​ Lenders may outline the terms and
5.​ Administration and Documentation conditions of a loan (covenants) into
●​ Credit administration is the operations arm agreements, which stipulates specific
of the lending function. The responsibilities demands on the borrower such as:
for credit risk administration vary from bank ○​ Furnishing the lender with periodic
to bank. This is in line with the overall financial statements.
corporate objectives of the bank in question. ○​ The borrower desisting from making
further borrowings, paying out
6.​ Use of External Reports dividend to shareholders or
●​ The use of external reports is an invaluable repurchasing shares as well as any
tools for the credit management department other actions that may undermine
of a bank. The report from a rating agency the borrower's financial position.
would indicate the degree of risk, which the
bank faces towards its clientele from macro- 2.​ Diversification
economic analysis viewpoint. ●​ When lenders end up lending to a small
●​ Likewise, reports from specialist analyst section of borrowers, they subject the
would indicate the latest evaluation of a financial institution to an extrinsic risk called
borrower's performance. concentration risk. The surest way to
mitigate the risk is through diversification of
Credit Management Techniques the pool of borrowers.
●​ Planning credit strategy, building credit
processes and policies: Credit strategy is 3.​ Risk Based Pricing
the development plan in a defined time ●​ When lenders identify a risky borrower they
period of a bank. The operational strategy tend to charge a higher interest rate on the
reflects the bank's willingness to take risks. borrower's loan since they are more likely to
Through the credit strategy, credit process default.
policies are in place to ensure that credit
●​ The estimation of the interest rate is
determined using the purpose of the loan,
credit rating of the borrower and loan to
value ratio of the loan facility.

4.​ Tightening
●​ Lenders reducing credit risk by limiting the
amount of loan extended to a particular
individual borrowers.

5.​ Credit Insurance

●​ Lenders and bondholders in order to
minimise the loss that may arise from credit
risk, hedge their credit risk by purchasing
credit insurance. It allows the lenders to
transfer the risk to the insurance company
in exchange for payment of premium