Trade credit is a common practice in the B2B business landscape, with the World Trade Organization suggesting 80 to 90 per cent of world trade relies on trade finance (trade credit and insurance/guarantees).
While it facilitates the ease of doing business, it also carries the risk of debt and financial troubles. Given credit's impact on cash flow and the financial health of a business, its management simply cannot be overlooked. Credit management is a crucial process to navigate credit risks, bad debt, late payments, and to ensure good relations with customers.
In this blog, we’ll delve into the various facets of credit and credit management, including the different types of credit risk and how effective credit management practices can combat them.
Understanding credit and credit management
In finance, the term credit can have many meanings. However, most commonly, it refers to a payment arrangement where a supplier, vendor, or creditor agrees to provide goods, services, or money immediately. This is done with the expectation of receiving payments from the buyer at a later date, as defined in the agreed-upon terms.
Additional fees or interest may be levied, especially when money is loaned on credit. But in the case of trade credit, businesses can defer payments to a later date, typically without incurring upfront interest on the amount owed. Such transactions are recorded through an invoice with buyers getting a window of 30, 60, or 90 days.
Due to unique timescales and varying revenue cycles, businesses often prefer it when suppliers offer trade credit. This allows them to better manage cash flow by deferring payments. For suppliers, providing trade credit can be beneficial too. It offers a competitive edge, facilitates sales, and helps build stronger customer relationships by demonstrating trust and flexibility.
Credit management meaning
Business credit management is the process of overseeing and controlling the extension of credit to customers or clients. It involves evaluating potential customers or borrowers and their creditworthiness over time, setting credit terms and limits, monitoring its utilisation, collecting payments on outstanding balances, and managing credit risks to ensure the financial health of a business.
Credit control meaning
Credit control and credit management may seem similar but credit management is a broad term overseeing the entire credit lifecycle within the organisation. Whereas credit control specifically deals with regulating and managing the credit extended to customers to ensure timely payments and minimise bad debts. Its primary focus includes the credit period, cash discounts, credit standards, and collection policy, and in a way, it is one of the many activities that come under credit management.
Importance of credit management
Effective credit management plays a crucial role in keeping an organisation’s financial health steady. It is instrumental in decision-making, in terms of what credit terms to offer (and who to). It allows for the methodical evaluation of potential customers, ensuring creditworthiness (based on facts and historical data) and helping to identify/assess the credit risks associated with each customer.
It increases timely payments from customers by establishing clear credit terms and closely monitoring receivables. This improves cash flow, liquidity, and customer relationships. It safeguards both the business and the customer from the negative effects of late or defaulted payments. All the efforts of credit management are diverted towards the underlying objective of maximising sales while minimising risks.
The 5 C's of credit
The five C's is a system used by creditors to categorise the different elements of credit. By evaluating each of the following components, they can determine the creditworthiness of borrowers and potential customers:
1. Character
Character represents the customer's credit history and debt repayment track record (as seen on their credit report). This report carries information for about 7-10 years, detailing past borrowing, repayment behaviour (including timely payments), collection accounts, and bankruptcies. This data is crucial in assessing the credit risk linked to potential customers and for generating a credit score. A credit score simplifies creditworthiness and predicts the likelihood of repayment. It also influences loan rates and terms, with higher scores correlating to greater chances of approval and better terms.
2. Capacity
Capacity reflects the customer’s financial strength and ability to generate revenue and repay dues. This metric is based on their debt-to-income ratio, comparing their income, positive cash flow, and financial stability against recurring debts.
3. Capital
This refers to the borrowing company’s financial reserves, investments, retained earnings, owned assets, and other valuable resources. In trade credit management, capital may entail the business's liquidity and access to additional capital for repayment.
4. Collateral
Collateral is less relevant when offering trade credit compared to traditional lending. However, for high-risk transactions or those with a larger value, creditors may seek additional security or collateral in the form of personal guarantees, letters of credit, or security deposits.
5. Condition
Conditions encompass the terms and conditions of the credit agreement, including repayment schedules, early payment discounts, additional fees or interest rates, penalties, and other contingencies. Macroeconomic factors, such as the state of the economy or industry trends that could impact repayment, are also considered.
What is the credit management process?
The process of effective credit management can be summed up in the following five steps:
1. Establish credit policy
A robust credit policy is crucial for streamlining and standardising the decision-making process of extending credit. This policy should clearly define rules and regulations, including critical information like credit limits, payment terms, late fees and exceptions, early payment discounts, and other terms and conditions. Additionally, the policy should establish criteria for customer evaluation, guidelines for setting credit limits that vary based on customer profiles, and procedures for handling overdue and delinquent accounts.
2. Collect customer credit application
Obtaining information on prospective customers, including annual sales, financial statements, payment history, point of contact for accounts payable, requested credit amount, bank references, and trade references, is essential. This information is gathered through a credit request application submitted by customers and is critical for evaluating their creditworthiness and making informed decisions about extending credit.
3. Research for credit analysis
The five C's of credit come into the picture at this stage, with the credit management team carrying out due diligence and verifying the information provided in the credit application. They can also gather more information from credit bureaus to perform further credit analysis.
4. Approve or deny credit request
Post credit analysis, the next step is to decide whether to approve or decline the customer’s request for credit. The value of the request may determine the number of stakeholders involved in the decision.
5. Continuous monitoring
The process doesn’t stop at approval. Ongoing monitoring of the borrower’s payments and creditworthiness is necessary to protect cash flow and mitigate risks. This should include regular customer credit checks and periodic reviews of existing customer accounts, to assess any changes in their financial health.
Types of credit risks
Extending credit inherently carries the risk of financial losses to the creditor. These risks can present themselves in various forms, including:
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Default risk
This is the risk of customers failing to make payments on time as per the contractual agreement.
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Concentration risk
Dependency on a handful of key customers for the majority of revenue is risky, given that any financial troubles encountered by these clients could translate into significant losses for the company.
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Industry risk
This risk stems from having customers concentrated in one industry. Any disruption in that industry, such as shifting market trends or economic downturns, can impact most of the customers' ability to generate revenue and repay, leading to severe cash flow shortages.
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Credit migration risk
There’s the potential for a decline in the customer's creditworthiness over time, typically triggered by shifts in their financial circumstances. This decline can detriment their capacity to fulfil payment commitments.
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Interest rate risk
Variations in interest rates can cause issues. While not directly impacting trade credit, it can greatly impact the financial stability of both the customer and the creditor, potentially obstructing their ability to repay debts or provide credit.
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Liquidity risk
This occurs when creditors endanger their own financial health by extending credit above their capacity, without ensuring that they themselves have sufficient liquidity to cover their operational expenses or other financial commitments.
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Political risk
This includes the disruptions and risks arising from political instability or changes in government policies (e.g., difficulty enforcing contracts, unexpected tax changes).
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Currency risk
This is the risk associated with foreign currency payments declining in value owing to fluctuations in exchange rates.
Role of credit management in mitigating credit risks
Effective credit management can significantly minimise the consequences these risks pose for creditors. Through thorough credit analysis, businesses can avoid defaults by identifying applicants with a history of late payments or low credit scores. For higher-risk customers, stricter contingencies like penalties and security deposits can be implemented. Diversifying the customer base across various industries through proper research and risk assessment is essential for mitigating concentration and industry risks.
Setting credit limits based on customer creditworthiness further mitigates default and concentration risk. Continuous monitoring and policy review allow for adjustments to terms, effectively combating credit migration risk and protecting the creditor from losses.
Involving multiple stakeholders in the credit application review process enables comprehensive risk evaluation, helping to avoid liquidity risks. A robust credit policy establishes contingency plans to address disruptions due to political instability, currency fluctuations, transfer restrictions, and cash flow challenges. By proactively implementing these measures through dedicated credit management, businesses can minimise financial stress and maintain stability.
Best practices for effective credit management
- Regularly update credit policies to reflect changing business needs.
- Make it convenient for customers to pay by offering various options such as online payments or automatic debits.
- Enhance communication and customer interactions by implementing a customer relationship management system.
- Improve invoice dispute resolution by establishing a dedicated team and a streamlined process.
- Send timely reminders to customers for prompt payments.
- Leverage technology to automate finance tasks and improve efficiency in credit analysis and management.
Optimise credit management with financial management software
Implementing a robust financial management system, such as OneAdvanced’s Financials, streamlines operations for finance teams. This software offers a suite of fully integrated modules designed to simplify accounting tasks, including accounts payable, credit management, and bank reconciliation.
With features like automated bank reconciliation, comprehensive invoice management, purchasing management, and payment facilities, it provides efficiency and accuracy across the whole financial management process. This Cloud-based accounting solution offers real-time data and easy-to-understand reports, simplifying cash flow monitoring and ensuring transparency.
Additionally, this technology enables comprehensive financial analysis, budgeting, forecasting, and planning, so that finance teams have a clear understanding of cash reserves, assets, and credit extension capabilities.
Empower your finance team and optimise credit management with Financials.