MODULE I

CHAPTER 1

INTRODUCTION TO CREDIT AND COLLECTION

MANAGEMENT
Chapter Outline

1 Learning Objectives
2 Topics
1.1 INTRODUCTION
1.2 CONCEPT OF CREDIT
1.3 CREDIT DEFINITIONS
1.4 CHARACTERISTICS OF CREDIT
1.5 TYPES OF CREDIT
1.6 CREDIT INSTRUMENTS
1.7 ADVANTAGES OF CREDIT
1.8 DISADVANTAGES OF CREDIT
1.9 CREDIT PROVIDERS
1.10 ROLE OF CREDIT IN ECONOMY
3 Summary

Learning Objectives

1. Understand the meaning and nature of credit.

2. Understand the different classifications of credit.
3. Discuss the importance of credit and collection management.

1.1 Introduction

Credit is important in a business because it helps to finance business transactions when

the business is short of funds. Banks and financial institutions mobilize deposits and utilize them
for lending. Generally lending business is encouraged as it has the effect of funds being
transferred from the system to productive purposes which results into economic growth. The
borrower takes fund from bank in a form of loan and pays back the principal amount along with
the interest. Sometimes in the non – performance of the loan assets, the fund of the banks gets
blocked and the profit margin goes down. To avoid this situation, bank should manage its
overall credit process. Bank should deploy its credit in such a way that every sectors of
economy can develop. Credit management comprises two aspects; from one angle it is that how
to distribute credit among all sectors of economy so that every sector can develop and banks
also get profit and from the other angle, how to grant credit to various sectors, individuals and
businesses to avoid credit risk.

Credit management is concerned mainly with using the bank’s resource both
productively and profitably to achieve a preferable economic growth. At the same time, it also
seeks a fair distribution among the various segments of the economy so that the economic
fabric grows without any hindrance as stipulated in the national objectives, in general and the
banking objectives, in particular.

1.2 Concept of Credit

The word “credit” has been derived from the Latin word “credo” which means “I believe”
or “I trust”, which signifies a trust or confidence reposed in another person. The term credit
means, reposing trust or confidence in somebody. In economics, it is interpreted to mean, in the
same sense, trusting in the solvency of a person or making a payment to a person to receive it
back after some time or lending of money and receiving of deposits etc.
Credit is the trust which allows one party to provide resources to another party where
that second party does not reimburse the first party immediately (thereby generating a debt), but
instead arranges either to repay or return those resources (or other materials of equal value) at
a later date. The resources provided may be financial (e.g. granting a loan), or they may consist
of goods and services (e.g. consumer credit). Credit encompasses any form of deferred
payment.  Credit is extended by a creditor, also known as a lender to a debtor also known as a
borrower.

In other words, the meaning of credit can be explained as, a contractual agreement in
which, a borrower receives something of value now and agrees to repay the lender at some
later date. The borrowing capacity provided to an individual by the banking system, in the form
of credit or a loan. The total bank credit the individual has is the sum of the borrowing capacity
each lender bank provides to the individual.

1.3 Credit Definitions

1. Prof. Kinley: “By credit, we mean the power which one person has to induce another
to put economic goods at his deposal for a time on promise or future payment. Credit is thus an
attribute of power of the borrower.”
2. Prof. Gide: “It is an exchange which is complete after the expiry of a certain period of
time”.
3. Prof. Cole: “Credit is purchasing power not derived from income but created by
financial institutions either as on offset to idle income held by depositors in the bank or as a net
addition to the total amount or purchasing power.”
4. Prof. Thomas: “The term credit is now applied to that belief in a man’s probability and
solvency which will permit of his being entrusted with something of value belonging to another
whether that something consists, of money, goods, services or even credit itself as and when
one may entrust the use of his good name and reputation.” On the basis of above definitions, it
can be said that credit is the exchange function in which, creditor gives some goods or money to
the debtor with a belief that after sometime he will return it. In other words, “Trust” is the
“Credit”.
5. Vasant Desai: “To give or allow the use of temporarily on the condition that some or
its equivalent will be returned.”

1.4 Characteristics of Credit

Some characteristics of credit are of prime importance while extending credit to an
individual or to a business enterprise.

1. Confidence: Confidence is very important for granting or extending any credit. The
person or authority must have confidence on debtor.
2. Capacity: Capacity of the borrower to repay the debt is also very crucial thing to be
considered. Before granting or extending any advance, creditor should evaluate the borrower’s
capacity.
3. Security: Banks are the main source of credit. Before extending credit, bank ensures
properly about the debtor’s security. The availability of credit depends upon property or assets
possessed by the borrower.
 4. Goodwill: If the borrower has good reputation of repaying outstanding in time,
borrower may be able to obtain credit without any difficulty.
5. Size of credit: Generally small amount of credit is easily available than the larger one.
Again it also depends on above factors.
6. Period of credit: Normally, long term credit cannot easily be obtained because more
risk elements are involved in its security and repayments. It involves futurity; has a maturity
date.

1.5 Types of Credit

The credit assistance provided by a banker is mainly of two types, one is fund based
credit support and the other is non-fund based. The difference between fund based and non-
fund based credit assistance provided by a banker lies mainly in the cash out flow. Banks
generally allow fund based facilities to customers in any of the following manners.

1.5.1 TRADITIONAL CREDIT PRODUCTS

1. Cash Credit

Cash credit is a credit that given in cash to business firms. A cash credit account is a
drawing account against a fixed credit limit granted by the bank and is operated exactly in the
same manner as a current account with all overdraft facilities. It is an arrangement by which, a
bank allows its customers to borrow money up to a certain limit against tangible securities or
share of approved concern etc. cash credits are generally allowed against the hypothecation of
goods/ book debts or personal security. Depending upon the nature of requirement of a
borrower, bank specifies a limit for the customer, up to which the customer is permitted to
borrow against the security of assets after submission of prescribed terms and conditions and
keeping prescribed margin against the security. It is on demand based account. The borrowing
limit is allowed to continue for years if there is a good turnover in account as well as goods. In
this account deposits and withdrawals may be affected frequently. In India, cash credit is the
most popular mode of advance for businesses.

2. Overdraft

A customer having current account, is allowed by the banks to draw more than his
deposits in the account is called an overdraft facility. In this system, customers are permitted to
withdraw the amount over and above his balance up to extent of the limit stipulated when the
customer needs it and to repay it by the means of deposits in account as and when it is
convenient. Customer of good standing is allowed this facility but customer has to pay interest
on the extra withdrawal amount.

3. Demand Loans

A demand loan has no stated maturity period and may be asked to be paid on demand.
Its silent feature is, the entire amount of the sanctioned loan is paid to the debtor at one time.
Interest is charged on the debit balance.

4. Term Loans

Term loan is an advance for a fixed period to a person engaged in industry, business or
trade for meeting his requirement like acquisition of fixed assets etc. the maturity period
depends upon the borrower’s future earnings. Next to cash credit, term loans are assumed of
great importance in an advance portfolio of the banking system of country.

5. Bill Purchased

Bankers may sometimes purchase bills instead of discounting them. But this is generally
done in the case of documentary bills and that too from approved customers only. Documentary
bills are accompanied by documents of title to goods such as bills of loading or lorry and railway
receipts. In some cases, banker advances money in the form of overdraft or cash credit against
the security of such bills.
 6. Bill Discounted

Banker loans the funds by receiving a promissory note or bill payable at a future date
and deducting that from the interest on the amount of the instrument. The main feature of this
lending is that the interest is received by the banker in advance. This form of lending is more or
less a clean advance and banks rely mainly on the creditworthiness of the parties.

1.5.2 INNOVATIVE CREDIT PRODUCTS

Since the liberalization period there have been drastic changes in the way loans have
been granted to individual customers and businessmen. The changing pattern of banks from
universal to branch banking after the liberalization period also forced banks to adopt easy
lending. Due to the increase in the number of mergers and acquisitions in this sector,
expectation went very high. Banks have come under immense pressure to meet the targets of
deposits and loans. Post globalization, Liberalization and Privatization, bankers began to focus
on both corporate and retail banking activities. The international financial markets have
witnessed a sea change in the last decade. Banks are likely to undergo more changes in the
future. In view of these developments, banks in India are also adopting certain new practices
and technology based services to cater to the needs of people. This is because it enables
customers to perform banking transactions at their convenience.

Technology has supported the development of financial service industry and reduced the
cycle of money to the shortest possible duration. A number of financial institutions, including
banks have started online services. The growth of innovative retail products offered by banks is
increasing sharply.

1. Credit Cards

Credit cards are alternative to cash. Banks allow the customers to buy goods and
services on credit. The card comprises different facilities and features depending on the annual
income of the card holder. Plastic money has played an important role in promoting retail
banking.

2. Debit Cards

Debit card can be used as the credit card for purchasing products and also for drawing
money from the ATMs. As soon as the debit card is swiped, money is debited from the
individual’s account.

3. Housing Loans

Various types of home loans are offered by the banks these days for purchasing or
renovating house. The amount of loan given to the customer depends on the lending policies
and repayment capacity of the customer. These loans are usually granted for a long period.

4. Auto Loans

Auto loans are granted for the purchase of car, scooter etc. it may be granted for
purchasing vehicle.

5. Personal Loans

This is an excellent service provided by the banks. This loan is granted to the individuals
to satisfy their personal requirements without any substantial security. Many banks follow simple
procedure and grant the loan in a very short period with minimum documents.

6. Educational Loans
 This loan is granted to the student to pursue higher education. It is available for the
education within the country or outside the country.

7. Loans Against Securities

These loans are provided against fixed deposits, shares in bonds, mutual funds, life
insurance policy etc.

8. Consumption loans for purchase of durables

Banks fulfill the dreams and aspirations by providing consumer durable loans. These
loans can be borrowed for purchasing television, refrigerator, laptop, mobile etc.

9. Hybrid Loan Products

For improving the business environment and to win in the competition, banks must adopt
new technologies. With fluctuating interest rates and inflation, there is a need for the banks to
protect the interest of the borrowers. So banks now offer hybrid products to their customers.
These products have the virtues of both fixed and floating interest rate loans. The products
introduced by the different banks have their own distinctive features.

1.6 Credit Instruments

Credit instruments prove very helpful in encouragement and the development of credit
and help in the promotion and development of trade and commerce. Some of the credit
instruments are:
1. Cheque is the most popular instrument. It is an order drawn by a depositor on the
bank to pay a certain amount of money which is deposited with the bank.

2. Bank draft is another important instrument of credit used by banks on either its
branch or the head office to send money from one place to other. Money sent through a bank
draft is cheaper, convenient and has less risk.

3. Bill of exchange. It enables a seller of commodity to issue an order to a buyer to

make the payment either to him or to a person whose name and address is mentioned therein
either on the site of the bill or within a period of time specified therein.

4. Promissory note is an instrument in writing containing an unconditional undertaking

signed by the maker to pay a certain sum of money only to or the order of certain person or the
bearer of the instrument.

5. Government bonds. Government issues a sort of certificate to the person who

subscribes to these loans. Such certificates are called government bonds. Some of them are
income tax free.

6. Treasury bills. These bills are also issued by the government. They are issued in
anticipation of the public revenues.

7. Traveler’s cheque. This is the facility given by bank to the people. It was most useful
when recent technological instrument like ATMs were not available. A customer was used to
deposit money with the banks and banks give traveler‟s cheque in turn. It was used to avoid risk
of having cash while travelling.

1.7 Advantages of Credit

Credit plays an important role in the gross earnings and net profit of commercial banks
and promotes the economic development of the country. The basic function of credit provided
by banks is to enable an individual and business enterprise to purchase goods or services
ahead of their ability. Today, people use a bank loan for personal reasons of every kind and
business venture too. The great benefit of credit with a bank is probably very low interest rates.
Majority people feel comfortable lending with bank because of familiarity.

1. Exchange of ownership: Credit system enables a debtor to use something which

does not own completely. This way, debtor is provided with control as distinct from ownership of
certain goods and services.

2. Employment encouragement: With the help of bank credit, people can be

encouraged to do some creative business work which helps increasing the volume of
employment.

3. Increase consumption: Credit increases the consumption of all types of goods. By

that, large scale production may stimulate which leads to decrease cost of production which in
turn also lowers the price of product which in result rising standard of living.

4. Saving encouragement: Credit gives encouragement to the saving habit of the

people because of the attraction of interest and dividend.

5. Capital formation: Credit helps in capital formation by way that it makes available
huge funds from able people to unable people to use some things. Credit makes possible the
balanced development of different regions.

6. Development of entrepreneurs: Credit helps in developing large scale enterprises

and corporate business. It has also helped the different entrepreneurs to fight with difficult
periods of financial crisis. Credit also helps the ordinary consumers to meet requirements even
in the inability of payment. One can borrow money and grow business at a greater return on
investment than the interest rates of loan.

7. Easy payment: With the help of various credit instruments people can pay without
much difficulty and botheration. Even the international payments have been facilitated very
much. 8. Elasticity of monetary system: Credit system provides elasticity to the monetary
system of a country because it can be expanded without much difficulty. More currency can be
issued providing for proportionate metallic reserves.

9. Priority sector development: Credit helps in developing many priority sectors

including agriculture. This has greatly helped in rising agriculture productivity and income of the
farmers. Banks in developing countries are providing credit for development in rural areas and
other priority sectors too.

1.8 Disadvantages of Credit

Credit is a mixed consent. It involves certain advantages and some dangers also at the
same time. Credit is useful as well as harmful to the user even. So it should be used very
cautiously otherwise it may spoil all industries and enterprises. Credit, if not properly regulated
and controlled it has its inherent dangers.

1. Encouragement of expenditure: Credit encourages wasteful expenses by the

individuals as well as commercial institutions. As people irresponsibly think that the money is
not their own. Easy availability leads to over trading over exposure that ultimately leads to bad
debts.

2. Encourage weakness: Credit encourages big entrepreneurs to continue to hide their

weakness. Their own shortcomings are met by the borrowed capital. Even the loosing concerns
continue with the help of borrowed capital in the hope to survive. In this condition, if business
fails, it not only leads the borrowers in dangers but also thousands of those people who
advanced credit to such people.

3. Economic crisis: In several occasions credit is directly responsible for economic

crisis. It leads to recession and depression in an economy as boom of credit facilities has its
own evil effect on the economy. Financially weak concern having credit facility takes the
economy to weaker effects.
 4. Dangers beyond limit: Credit in a country expanded beyond certain limits which
results in over investment. Over issue credit takes beyond safe limits that result in over
investment, over production and rise of prices. This danger has been emphasized by Prof.
Thomas in his “Elements of Economics,” in his words: “There is no automatic limit to the
expansion of a credit system as there is to an expansion of a metallic circulation through the
intervention of human element. Uncertainty and variableness is the chief source of danger in a
credit organization”.

5. Evil of monopoly: Credit system has also resulted in the creation of monopolies;
monopolistic exploitation is due to money placed at the disposal of individuals or companies that
leads to monopolist exploitation. The different organizations have growth with the emergence of
credit and have worked to the damage of both the consumers and the workers.

6. Encourage inefficient: Credit gives encouragement to certain inefficient and

worthless producers. Inefficient business concerns availing the credit and not using efficiently,
accumulate money in their hands. People come into the market with the feeling that they have
nothing to do but just to play only with other’s money. So, by this it can be said that it is clear
that the government or the central banking authorities must keep the credit within limit so that no
evil is allowed to crop up in the economy.

1.9 Credit Providers

1.9.1 Banks
A bank is an organization licensed to take deposits and extend loans. In the UK the
operation of banks is regulated under the 1979 and 1987 Banking Acts which are overseen by
the Financial Services Authority. Banks that focus on providing personal banking and consumer
credit services, and which typically maintain large branch networks are described as commercial
or retail banks, whereas merchant banks tend to be more involved with corporate and
international finance. Traditionally, retail banks tended to focus on obtaining funds via deposits
and current accounts that were then used to fund commercial lending to business. The granting
of personal loans and overdrafts did occur, but was not common. Many banks now offer
mortgages, secured and unsecured personal loans and credit cards as a central part of their
banking operations.

1.9.2 Building societies (savings and loan companies)

Building societies are profit-making organizations owned by their members, who are the
individuals who have either savings accounts or loan agreements with the society. In the UK,
building societies are regulated by the Building Societies Act 1986 which is overseen by the
Financial Services Authority. Traditionally, building societies had a narrow focus of operation,
funding mortgage lending via the savings deposited by their members. After the implementation
of the 1986 Act, building societies were in a position to offer the same range of consumer
services as banks. From a consumer perspective the difference between a bank and a building
society is virtually non-existent, with both offering a broadly similar range of credit products. In
the US, savings and loan companies can be considered broadly equivalent to UK building
societies.

1.9.3 Finance houses

Finance house is a general term, used to describe a broad range of lending institutions
licensed to provide consumer credit. They do not tend to provide savings or deposit accounts;
rather they obtain funds to support their lending activities through commercial loans obtained
from merchant banks or other large financial institutions. Finance houses mainly provide credit
in the form of secured and unsecured personal loans, hire-purchase agreements and card
accounts. They are not generally involved in mortgage lending, although a few do provide
mortgage products. Large finance houses commonly act as third party credit providers, acting
on behalf of retailers and merchants for the provision of store cards and retail credit.

1.9.4 Credit unions

Credit unions first appeared in Germany in 1849 and operate as mutually owned
financial cooperatives. They have become widely popular in many countries; for example, in the
US around 30 percent of the adult population belong to a credit union and in Ireland the figure is
approximately 45 percent. Credit unions share many of the features traditionally associated with
building societies and savings and loan companies in that they are member-owned, and funds
contributed by members are used to provide credit services to other members. Credit unions are
often created around specific interest groups sharing some ‘common bond,’ such as those
working within one profession, or located within a certain geographical area, such as teachers
or residents of a town or city. US credit unions offer a wide range of credit products including
mortgages, personal loans and credit cards and are known for offering competitive credit terms
because they are run on a not-for-profit basis and enjoy a tax exempt status.

1.9.5 Utility companies

Although credit is not the main concern of utility companies, most utility supplies (water,
gas, electricity and telecoms) are provided on a credit basis, with bills being issued in arrears at
regular intervals, usually monthly or quarterly. Credit is usually provided interest-free and
penalties are not charged for late or reduced payment. However, collections activity for late or
unpaid bills forms a significant part of the administrative function of utility providers. While UK
legislation limits the actions utility companies can take to recover sums owing, the ultimate
sanction of disconnection of supply is probably a sufficient incentive for customers to make
payments if they are in a position to do so.

1.9.6 Pawnbrokers
Pawnbrokers have existed since ancient times, offering short term credit secured against
the borrower’s possessions. In recent years many pawnbroking operations have diversified into
payday lending and cheque cashing services. While pawnbroking is much less prevalent than it
once was, and almost disappeared entirely from the UK in the 1970s, there has been something
of a revival since the 1980s. In 2004 there were estimated to be over 800 pawnbrokers
operating in the UK, with a customer base numbering several hundred thousand.

1.9.7 Government agencies

The UK government provides credit in a number of circumstances. This includes student
loans, and for those in receipt of certain state benefits, cash loans via the social fund. Social
fund loans are unsecured and interest-free, and are provided for the purchase of essential
items, such as a bed, cooker or children’s clothing. Loan repayments are deducted directly from
future benefit payments.

1.9.8 Licensed moneylenders (home credit companies)

Any individual or organization who has obtained a credit license can be described as a
licensed moneylender. However, the term is usually associated with individuals and
organizations specializing in the provision of small unsecured cash loans.

1.9.9 Unlicensed moneylenders

Unlicensed moneylenders, or loan sharks, have operated alongside licensed lenders for
as long as regulated credit markets have existed, with references to loan sharking to be found in
Greek texts dating to the second and third centuries B.C. (Homer and Sylla 1996 p. 38). The
market is characterized by very high rates of interest, often for small amounts, for short periods
of time. Given its illegal or semi-legal status, the exact size of this market is difficult to ascertain.

1.10 Role of Credit in Economy

Commercial banks continue to remain in the forefront of financial system. Banks provide
necessary finance for planned development. In developed and developing countries both, credit
is the foundation upon which the economic structure is strengthening. Bank credit would play a
significant role by influencing the types of commodities and quantum of their output. To achieve
high rate of economic growth over a long period, agriculture and industrial credit should be
increased. At the time of sanctioning the credit, the purpose should be investigated by the bank
to ensure that the end use of funds confirms to overall national objectives. Banks also give
credit to the priority and neglected sectors by which the sectoral development can be possible.
Easy availability of credit promotes the entrepreneurial and self-employment venture in the
country.

Credit instruments are used as media of exchange in place of metallic or paper currency.
These instruments are more effective and convenient in all business transactions. Bank credit
provides assistance to production and business process. Institutional credit provides a ready
flow of money to the business. Bank credit fulfills the capital requirement of an entrepreneur
which increases the production at higher level by which production cost decreases and as a
result price of product also decreases that affects the economy positively.

Credit provides financial ability to use advanced technology in the production. So the
quality of production and product may increase. And business can survive in an international
market too. Credit makes common person to change into entrepreneur. Surplus fund utilized for
credit bring return that further increase the volume of funds. Credit makes it easy and
convenient for the consumers to purchase or hire durable goods. In the period of declining
market, there is greater availability of cheaper source of funds through credit. Corporate
borrowers paid greater attention towards banks for their financial requirements. This enables the
entrepreneurs to run their business and day to day transactions very smoothly. Bank’s power to
create money is of great economic significance. This gives an elastic credit system which is
necessary for steady economic progress. This system geared to the seasonal demands of
business. Bank lending operation acts as a governor controlling the economic activity in the
country. Bank lending is very important to the economy, for it makes possible the financing of
the agricultural, industrial and commercial activities of the country. According to an economist,
“Credit has done more to enrich nations than all the gold mines in the world put together.”

SUMMARY

In this chapter, it has been discussed the different meanings of credit and how credit
affects each country’s economy. From those definitions, it has been established that the most
important element of credit is “trust”. Credit covers the provision of goods and services provided
to individuals in lieu of payment. For many, credit is an integral part of modern life, provided by a
large and established credit industry, employing significant numbers of people from a variety of
backgrounds and with a wide range of expertise. However, while credit is widely perceived as
bringing benefit to consumers and the wider economy, the pressures of debt affect a significant
proportion of the population. There are a considerable number of households struggling
financially and in arrears with their credit commitments, and every year hundreds of thousands
of people are taken to court, are declared bankrupt or have their homes repossessed as a direct
consequence of their debt situation. There is also evidence that the effects of debt are not just
material, but that the psychological effects can have a serious impact on an individual’s mental
and physical health.

In many countries a significant proportion of the population do not have access to

standard forms of credit that most people take for granted, such as a credit card, mortgage,
overdraft or a personal loan. If these people need credit they are generally forced to seek it on
unfavorable terms, from sources that demand considerably higher interest rates and/or fees for
the privilege of borrowing.
 CHAPTER 2
CREDIT AND COLLECTION OPERATIONS
Chapter Outline

1 Learning Objectives
2 Topics
1.1 INTRODUCTION
1.2 OVERVIEW OF CREDIT AND COLLECTION MANAGEMENT
1.3 ORGANIZING CREDIT AND COLLECTION DEPARTMENT
1.4 THE CREDIT AND COLLECTIONS TEAM
3 Summary

Learning Objectives

1. Note the roles of the various employees of the credit and collection
functions. 2. Describe special characteristics and abilities to look for when selecting
personnel.
3. Learn how to build a strong credit team.

1.1 Introduction

Credit and collection activities refer to the granting of credit to customers so that they
can defer payments to the seller, and then collecting those funds at a later date. Ideally, it is
vastly easier to collect payment in advance or on delivery from all customers, but competitive
pressures rarely allow this to be the case. Instead, if a business refuses to grant, as well as the
methods required to collect funds.
In this chapter, we describe the structure of the credit and collection functions, key job
descriptions, goal setting, staff compensation, management reports, and other issues necessary
to the daily operation of credit and collection.

1.2 Overview of Credit and Collection Management

In this section, we describe the problems faced by the credit and collection functions, as
well as how these areas can be organized. Both functions impact the performance of other parts
of a company, which can result in some political maneuvering to see who controls them

The Credit Conundrum

 The credit department is arguably the most unpopular department in a company. The
reason is that customers want unlimited credit in order to delay cash payments, while the credit
manager must exercise some prudence in only granting credit where invoices are likely to be
paid. The result is two types of risk:

 The risk of granting too much credit to a customer that cannot pay.
 The risk of denying credit to a customer who can pay.

It is extremely difficult to maneuver between these two risks and grant just the right
amount of credit, so the credit manager is likely to be abused from all directions. The sales
department believes that the credit manager is stifling sales, while the chief financial officer
believes that the extension of too much credit is resulting in outsized bad debt losses.
Further, because of the confidential nature of some of the information used to reach
credit decisions, the credit staff may not be able to fully explain the reasons for its decisions to
the sales department. The result is ongoing frustration on all sides, which can result in the credit
manager losing all power and eventually just “rubber stamping” all requests for credit. This
scenario can only be avoided through the ongoing support of senior management, which most
understand the key role that the credit department plays.

1.3 Organizing Credit and Collection Department

The nature of a business and its size will determine the structure and staffing of the
credit and collection department. Unlike most other company operations, the credit department
tends to remain fairly constant in size and scope of activities during periods of changing
business conditions. This is due to increased support needed for full volume sales in good times
and for increasing delinquencies when economic times are difficult. A credit department may
face a greater number of collection problems in a depressed economy when inflation is rising
and the money supply is tighter. During prosperous times, new account volumes create more
upfront work for the credit department.

The collections team can be considered the janitor and sweeps up after the other parts
of a business have completed their work. The analogy is an apt one, for any number of
problems may have been caused by other parts of the business, such as incorrect billings,
flawed product designs, or damaged goods, which the collections team must work around
during its efforts to collect cash from customers. This means that the collection effort may seem
inefficient, due to problems that are outside of the control of the collections group. Only by
giving feedback to the rest of the company can the collection manager achieve reasonable
collection results. Thus, collection management requires expertise in dealing with other
departments, as well as collection skill.

The organization of the department is particularly important; a measure of permanence

and stability must be achieved that will ensure that the department functions under all
conditions. Although the organization should not remain static, it is highly desirable to have
experienced and capable employees available within the department. The credit manager
should strive to achieve a balance of newly trained entry-level staff and experienced credit
professionals. Alternatives exist to accommodate extra heavy workloads. Cross-training of
personnel can lead to more flexibility. Accounting department personnel can be trained to
perform routine tasks and called upon as necessary and temporary staff hired or tasks can be
outsourced to companies specializing in credit-related functions such as cash application and
dispute resolution.

1.3.1 Organizational Structure

The credit and collection functions may be separately located within different
departments. The credit function is essentially issuing short-term loans to customers, which is a
financing function, and so it may report to the treasurer or chief financial officer. The collections
function is an extension of the billing function, and so is more likely to report to the controller.
Since this means the two areas are organized separately, interactions between the two
departments can prolong the time required to resolve issues with customers. To keep this from
happening, we recommend that the two functions be combined into a single department. In
addition, consider folding the order entry function (which normally reports to the sales manager)
into this group. By doing so, a large part of customer interactions is combined under common
management, which can shorten the time required to resolve customer problems. It is rarely a
good idea to have this merged group report to the sales manager, since doing so gives sales
too much control over the granting of credit, which will likely be expanded to accommodate all
customer orders.

Centralization vs. Decentralization

Although there may be variations among companies, the control and administration
functions can usually be classified into two types of operations: centralization and
decentralization. The question of whether to centralize or decentralize the credit function is
faced by companies with geographically and culturally diverse operating units. It remains
important as corporations continue to reengineer their business processes to leverage their
technology. In a centralized structure, the credit function is controlled and administered from a
principal or central location. In a decentralized structure, the credit function may report to a
principal location (headquarters) with credit personnel located at remote offices.

A. Centralized—Credit Controlled and Administered at a Headquarters

Office

A centralized department services credit operations that are based entirely at a

company’s main headquarters. It is the responsibility of the credit manager and staff to approve
credit terms on most orders. Credit professionals may find themselves questioned by sales staff
or even upper management if they decline an application to grant terms on an important or
significant order. An increasing number of credit departments are using automated options that
approve credit lines for perceived low-risk customers or low-amount credit requests as long as
they meet certain pre-established criteria. This, in theory, allows credit managers and staff to
focus on the most important customers and situations.

A centralized credit system may be modified in certain respects. In some companies, for
example, most of the credit functions are carried on at headquarters, but collections offices are
located in the field to work directly with customers, secure payments and make adjustments.

Figure 3-1 illustrates a credit department that is administered and controlled from a
headquarters office. The senior ranking credit professional (e.g., director of credit, credit
manager, etc.) is charged with ensuring department responsibilities are met and policies
followed. That person is responsible for reporting to upper management staff, such as the
treasurer or chief financial officer, as it is important for the credit function to maintain close and
open communication with those responsible for the greater financial functions of a company.
 B. Decentralized—Credit Controlled at Headquarters but Administered from
Decentralized Location(s)

A mid-management level credit manager reports functionally to an executive-level credit

manager at headquarters and also reports to the division head (the principle is the same for
subsidiary or branch operations). While authority in credit and collection is provided by the
executive-level credit manager, in all other respects middle management establishes the
procedures to which the credit professional must conform. Figure 3-2 illustrates a decentralized
operation under which the middle-level credit manager has a dual reporting role requiring close
cooperation between the top-level credit executive and the division general manager.

Authority of the Mid-Level Credit Manager

The mid-level credit manager is normally empowered by the division general manager to
take care of personnel problems, operating expenses and all other nonfunctional matters within
the scope of local policy. The mid-level credit manager has authority to give final credit approval
on all orders not exceeding a stipulated amount. Orders in larger amounts are referred to
headquarters for processing and approval, usually with local recommendation. The mid-level
credit manager may be authorized to give preliminary credit approval so the order can be
processed. Another method is to designate certain customers as “headquarters accounts”
because of special circumstances. When this procedure is followed, the mid-level credit
manager ordinarily has final approval authority for all other orders, and can recommend credit
limits for accounts with sound financial resources whose orders normally exceed local
authorization.

Authority Retained by the Top-Level Credit Executive

The top-level credit executive establishes credit policy for the divisions, considers
approvals in cases that exceed the limits set for mid-level credit executives and is completely
responsible for all headquarters accounts. The top-level credit executive, in conjunction with the
accounting and systems departments, also determines the procedures, techniques and
practices to be followed by the divisions in their credit and collections operations. Training of
credit personnel and the assignment of employees to the divisions, with the agreement of the
division manager, are also primary responsibilities of the top-level credit executive.

Decentralized—Credit Controlled and Administered from Decentralized

Location(s) with a Staff Office at Headquarters

In this type of organization, the top-level credit executive is responsible for collecting
information and preparing reports for management, providing advice and counsel to the field
credit executives, and participating in major problem-risk analysis. Figure 3-3 illustrates a
decentralized operation with a staff office maintained at headquarters. This arrangement
requires the top-level credit executives to be responsible for order approvals and collections and
to control their own unit credit departments.

The top-level credit executive usually establishes the overall credit policies. Divisions
coordinate their activities based on industry best practices and select the best alternative action
in the light of prevailing conditions. Compliance with the overall policies is especially important,
so telephone calls, video conferences or field trips are key to monitoring the activities of credit
personnel in the field. In cases where control is completely decentralized, the midlevel credit
manager reports only to the division general manager and has complete authority in all credit
and collection matters without reference to headquarters. The division is required to carry out
the general credit policies of the company, but the operation within those policies is the
responsibility of the division. Consequently, the division credit executive is responsible to the
division general manager both for the performance of the function and for the operation of the
division.

Benefits of Centralization

• Economies of Scale. When separate divisions serve common customers, a centralized credit
office can mean a reduction in operating costs and a more efficient income stream, along with
enhanced customer service.

• Consistency and Control. Adherence to standardization of policies, procedures and

protocols is more manageable in a centralized environment. This has the advantage of
providing consistent credit decisions across all business units which minimizes risk of satellite
departments having undue influence. When information about a common customer is
centralized, the credit function has more risk control over bad debt exposure and perhaps
increased leverage in collection efforts. Closer proximity tends to encourage communication
between staff members and management. Likewise, updates to policies, procedures and
protocols can be disseminated more quickly.

Benefits of Decentralization

• Internal and External Relationships. Close proximity to customers can enhance a credit
professional’s relationship with marginal customers and lead to developing a better rapport with
customers having a sizable dollar exposure. Being on site with other business functions
promotes a better understanding of business goals and fosters the exchange of information
about market and customer needs. It also enhances communication among departments and
reduces the number of interdepartmental conflicts.
• Involvement in Setting Strategic Priorities. Credit can integrate its objectives with those of
sales and marketing into divisional goals. Also, decisions made at a local level can be
implemented immediately without going through additional levels of review.

1.4 The Credit and Collections Team

Who works in the credit and collection areas? There is manager of each function, as well
as highly specialized clerical staff. In this section, we describe the job descriptions of the credit
manager, credit clerk, collections manager, collector and skip tracer. We also note the
importance of using of a probationary period when hiring employees into any of these positions,
since this type of work does not appeal to everyone.

Credit Manager Job Description

The credit manager position is responsible for the entire credit granting process,
including the consistent application of a credit policy, periodic credit reviews of existing
customers, and the assessment of the credit worthiness of potential customers, with the goal of
optimizing the mix of company sales and the bad debt losses. The position generally reports to
the treasurer or chief financial officer. The credit manager should not report to any position in
the sales department, since the credit function should act as a counterbalance to that
department.

The key elements of the credit manager position are as follows, broken down by tasks
related to management and to credit operations:

Management Tasks

 Maintain a department organizational structure sufficient to meet all goals and

objectives.
 Properly motivate the credit staff
 Measure department performance
 Provide for ongoing training of the credit staff
 Manage relations with credit reporting agencies
 Manage relations with credit insurance providers
 Manage relations with the sales department

Credit Operations Tasks

 Maintain the corporate credit policy

 Monitor industry trends
 Recommend changes in the credit policy to senior management
 Create a credit scoring model
 Update customer credit files
 Monitor the credit granting and updating process
 Accept or reject credit recommendations forwarded by the credit staff
 Conduct on-site visits with the largest customers
 Monitor periodic credit reviews
 Monitor deductions taken from payments by customers
 Monitor the application of late fees to customers
 Monitor the corporate leasing program
 The credit manager should have considerable experience in the credit granting field,
probably having moved up from a credit clerk position. The position can require a college
degree, though it is not necessary. Of more importance than a college degree is an excellent
knowledge of credit scoring systems, financial analysis, and how credit-related laws may apply
to the business. The position may periodically require travel to investigate or build relations with
larger customers.

Credit Clerk Job Descriptions

The credit clerk is responsible for not only reviewing credit applications from new
customers, but also monitoring current customers to see if their credit levels should be re-
examined. The key elements of this position are:

 Process credit applications from new customers

 Conduct trade and bank reference checks
 Establish credit limits based on credit criteria
 Maintain records of credit reviews and document reasons for credit limits granted
 Monitor credit usage by existing customers
 Monitor financial and credit condition of customers
 Review existing credit limits at regular intervals
 Provide credit information to third parties upon request

It is not necessary for a credit clerk to have a college degree, though it is necessary to
have a thorough understanding of financial statement analysis and how it relates to the granting
of credit.

Collections Manager Job Description

The collections manager position is responsible for all collection activities, including all
collection interactions with customers and the management of collection agencies and collection
attorneys. This manager is also responsible for accumulating information about the reasons for
collection problems and passing the information back to the rest of the company for resolution.
The position usually reports to the controller.

The key elements of the collection manager position are as follows, broken down by
tasks related to management and departmental interactions:

Management Tasks

 Maintain a department organizational structure that can meet all goal and objectives
 Monitor the use of collection techniques
 Monitor payment deductions taken by customers
 Properly motivate the collections staff
 Measure department performance
 Conduct staff training as needed
 Review and approve negotiated settlements with customers

Third Party Interaction

 Provide feedback to other departments regarding collection issues originating internally

 Manage relations with collection agencies
 Manage relations with collection attorneys
 Manage relations with outside skip tracers

A key aspect of this position is to standardize the process used for contacting
customers. This does not necessarily mean a highly regimented process, but rather one in
which boundaries for acceptable collection behavior are firmly enforced. Also, the collections
manager must ensure that customers are uniformly dealt with in a manner that abides by all
applicable laws.

One of the more useful aspects of the collections manager position is monitoring the
general trend of collections to see if there is a pattern that may require a change in credit policy.
The collections manager is in the unique position of being able to monitor all collection activities,
which makes it easier to discern subtle increases in days’ sales outstanding across the entire
customer base, or within specific customer concentrations. It can be difficult to allocate time for
this analysis in the midst of day-to-day department operations, but it can lead to credit changes
that can ultimately save a company from incurring inordinately large bad debts.

Collector Job Description

The collector position is responsible for collecting the maximum amount of overdue
funds form customers, which may include a variety of collection techniques, legal claims, and
the selective use of outside collection services. The position is not strictly that of a clerk, since
the best collector should operate with a more independent orientation than a procedure-bound
clerk, taking those steps needed to collect funds. The key elements of the collector position are
as follows:

 Stratify collection activities to maximize cash receipts

 Issue drumming letters to overdue accounts
 Use skip tracing techniques to locate customers
 Contact customers regarding overdue accounts and determine reasons for non-payment
 Issue payment commitment letters
 Negotiate the return of unpaid merchandise
 Repossess merchandise when payment is unlikely
 Monitor cash on deliver payments
 Issue credit hold notifications
 Recommend that accounts be shifted to a collection agency
 Process small claims court complaints

It is not necessary for a collector to have any type of college degree. Instead, it is much
more important for a collector to have dogged persistence in contacting customers at regular
intervals and the negotiation skills necessary to extract payments from customers. If the
company uses computerized collection monitoring software and auto-dialers, a collector should
be comfortable with the use of this technology.

A productive collector who enjoys the work is a rare find indeed. These individuals
commonly achieve much higher collection rates than normal. The collections manager would be
well advised to create a special environment for such employees, including especially quiet
work environments, some measure of privacy, bonus pay, and any other inducements
necessary to retain their services.

Skip Tracer Job Description

A skip tracer is essentially a private investigator who locates people who do not
necessarily want to be found. The orientation of this position is toward research into a variety of
databases, so computer skills are paramount. Work hours can be long, and are likely to be self-
directed, especially if the skip tracer works from home.

A skip tracer is more likely to be an introvert, given the amount of research involved.
However, there is also a need for sufficient social skills to extract location information from the
associates of a person who is missing. Obtaining information in this manner requires that a skip
tracer be good at posting the correct questions, listening carefully to answers, and interpreting
this information “on the fly” to obtain additional information with just the right questions.
 In short, a skip tracer is a unique individual, whose personality is inquisitive and
research-oriented, and self-directed. It is quite difficult to find a qualified skip tracer, which is
why this position is so frequently outsourced.

Probationary Period

When hiring a person into any of the preceding positions, be aware that credit and
collections activities are not for everyone, so a certain proportion of new hires will not work out.
Accordingly, this is an area in which a mandatory probationary period is useful for deciding
whether someone can be an effective part of credit and collections. If not, it is best for the
company and for them if they are terminated by the end of the probationary period. Otherwise,
the rest of the department will be consumed by the ongoing training requirements, errors, and
morale problems of these employees. The result should be a more cohesive group that is entire
comprised of the types of people who thrive in the high-pressure credit and collections
environment.

SUMMARY

This chapter discusses the role of the credit department from an organizational point of
view. Proper structuring of the credit department—from a one-person operation to a multi-tiered,
multifunctional entity—ensures that the role of credit contributes to the overall success of any
company regardless of size. The role and responsibilities of each member of the team for the
proper functioning of the department and the different types of operations; Centralized and
Decentralized structure.

Centralized credit departments are entirely based in the company’s main headquarters.
Decentralized credit departments are not housed in the headquarters, but report to the
headquarters from a remote office or offices. The role of the mid-level credit manager and the
top-level credit executive play similar roles over decentralized and centralized organization
structure. However, their authority and duties may differ depending on the credit policies
enacted by the credit department. The benefits of a centralized credit department include: –
Economies of scale – Consistency and control. The benefits of a decentralized credit
department include: – Internal and external relationships – Involvement in setting strategic
priorities.
 CHAPTER 3

CREDIT PROCEDURES AND CONTROLS

Chapter Outline

1 Learning Objectives
2 Topics
1.1 INTRODUCTION
1.2 CREDIT APPROVAL PROCESS
1.3 SEGMENTATION OF CREDIT APPROVAL PROCESSES
1.4 IMPORTANT FACTORS FOR CREDIT APPROVAL
1.5 CREDIT APPROVAL PROCESS
1.6 ESSENTIAL AND BEST PRACTICES IN MANAGING CREDIT RISK
1.7 COMMON CREDIT MANAGEMENT STRATEGIES
1.8 CREDIT CONTROL TIMELINE: KEY STEPS
3 Summary

Learning Objectives

1. Identify the key procedures and forms needed to operate the credit
function.
2. Cite the key controls needed for the credit function, and note what they are
intended to accomplish.
3. Evaluate the creditworthiness of customers

1.1 Introduction

There is an old adage in credit that says a sale is not a sale until the invoice is paid. Until
that point, it is a gift. It is the primary responsibility of the credit department to make sure that
the company converts all those gifts into sales. It is also the job of the credit department to
make sure that sales are made to companies that have both the ability and the willingness to
pay for the goods.
The individual steps in the process and their implementation have a considerable impact
on the risks associated with credit approval. Therefore, this chapter presents these steps and
shows examples of the shapes they can take. However, this cannot mean the presentation of a
final model credit approval process, as the characteristics which have to be taken into
consideration in planning credit approval processes and which usually stem from the
heterogeneity of the products concerned are simply too diverse. That said, it is possible to
single out individual process components and show their basic design within a credit approval
process optimized in terms of risk and efficiency. Thus, the risk drivers in carrying out a lending
and rating process essentially shape the structure of this chapter.

1.2 Credit Approval Process

First of all, we need to ask what possible sources of error the credit approval process
must be designed to avoid. The errors encountered in practice most often can be put down to
these two sources:

— Substantive errors: These comprise the erroneous assessment of a credit exposure despite
comprehensive and transparent presentation.
— Procedural errors: Procedural errors may take one of two forms: On the one hand, the
procedural-structural design of the credit approval process itself may be marked by procedural
errors. These errors lead to an incomplete or wrong presentation of the credit exposure. On the
other hand, procedural errors can result from an incorrect performance of the credit approval
process. These are caused by negligent or intentional misconduct by the persons in charge of
executing the credit approval process.

In the various instances describing individual steps in the process, this chapter refers to
the fundamental logic of error avoidance by adjusting the risk drivers; in doing so, however, it
does not always reiterate the explanation as to what sources of error can be reduced or
eliminated depending on the way in which they are set up. While credit review, for example,
aims to create transparency concerning the risk level of a potential exposure (and thus helps
avoid substantive errors), the design of the other process components laid down in the internal
guidelines is intended to avoid procedural errors in the credit approval process.

Still, both substantive and procedural errors are usually determined by the same risk
drivers. Thus, these risk drivers are the starting point to find the optimal design of credit
approval processes in terms of risk. Chart 1 shows how banks can apply a variety of measures
to minimize their risks.
 Chart 1

1.3 Segmentation of Credit Approval Processes

In order to assess the credit risk, it is necessary to take a close look at the borrowers
economic and legal situation as well as the relevant environment (e.g. industry, economic
growth). The quality of credit approval processes depends on two factors, i.e. a transparent and
comprehensive presentation of the risks when granting the loan on the one hand, and an
adequate assessment of these risks on the other. Furthermore, the level of efficiency of the
credit approval processes is an important rating element. Due to the considerable differences in
the nature of various borrowers (e.g. private persons, listed companies, sovereigns, etc.) and
the assets to be financed (e.g. residential real estate, production plants, machinery, etc.) as well
the large number of products and their complexity, there cannot be a uniform process to assess
credit risks. Therefore, it is necessary to differentiate, and this section describes the essential
criteria which have to be taken into account in defining this differentiation in terms of risk and
efficiency.

1.3.1 Basic Situation

The vast majority of credit institutions serve a number of different customer segments.
This segmentation is mostly used to differentiate the services offered and to individualize the
respective marketing efforts. As a result, this segmentation is based on customer demands in
most cases. Based on its policy, a bank tries to meet the demands of its customers in terms of
accessibility and availability, product range and expertise, as well as personal customer service.
In practice, linking sales with the risk analysis units is not an issue in many cases at first. The
sales organization often determines the process design in the risk analysis units. Thus, the
existing variety of segments on the sales side is often reflected in the structure and process
design of the credit analysis units. While classifications in terms of customer segments are, for
example, complemented by product-specific segments, there appears to be no uniform model.
Given the different sizes of the banks, the lack of volume of comparable claims in small banks
renders such a model inadequate also for reasons of complexity, efficiency, and customer
orientation. Irrespective of a bank’s size, however, it is essential to ensure a transparent and
comprehensive presentation as well as an objective and subjective assessment of the risks
involved in lending in all cases. Therefore, the criteria that have to be taken into account in
presenting and assessing credit risks determine the design of the credit approval processes.

If the respective criteria result in different forms of segmentation for sales and analysis,
this will cause friction when credit exposures are passed on from sales to processing. A risk
analysis or credit approval processing unit assigned to a specific sales segment may not be
able to handle all products offered in that sales segment properly in terms of risk (e.g.
processing residential real estate finance in the risk analysis unit dealing with corporate clients).
Such a situation can be prevented by making the interface between sales and processing more
flexible, with internal guidelines dealing with the problems mentioned here. Making this interface
more flexible to ease potential tension can make sense in terms of risk as well as efficiency.

1.3.2 Accounting for Risk Aspects

The quality of the credit approval process from a risk perspective is determined by the
best possible identification and evaluation of the credit risk resulting from a possible exposure.
The credit risk can be distributed among four risk components which have found their way into
the new Basel Capital Accord (in the following referred to as Basel II).
a. Probability of default (PD)
b. Loss given default (LGD)
c. Exposure at default (EAD)
d. Maturity (M)

The most important components in credit approval processes are PD, LGD, and EAD.
While maturity (M) is required to calculate the required capital, it plays a minor role in exposure
review.
The significance of PD, LGD, and EAD is described in more detail below.

a. Probability of Default - Reviewing a borrower’s probability of default is basically

done by evaluating the borrower’s current and future ability to fulfill its interest and principal
repayment obligations. This evaluation has to take into account various characteristics of the
borrower (natural or legal person), which should lead to a differentiation of the credit approval
processes in accordance with the borrowers served by the bank. Furthermore, it has to be taken
into account that — for certain finance transactions — interest and principal repayments should
be financed exclusively from the cash flow of the object to be financed without the possibility for
recourse to further assets of the borrower. In this case, the credit review must address the
viability of the underlying business model, which means that the source of the cash flows
required to meet interest and principal repayment obligations has to be included in the review

b. Loss Given Default - The loss given default is affected by the collateralized portion
as well as the cost of selling the collateral. Therefore, the calculated value and type of collateral
also have to be taken into account in designing the credit approval processes.

c. Exposure at Default (EAD) - In the vast majority of the cases described here, the
exposure at default corresponds to the amount owed to the bank. Thus, besides the type of
claim, the amount of the claim is another important element in the credit approval process.

Thus, four factors should be taken into account in the segmentation of credit approval
processes:

1. type of borrower
2. source of cash flows
3. value and type of collateral
4. amount and type of claim

1.4 Important Factors for Credit Approval

 1. The purpose of credit and sources of repayment.
2. The current risk profile (including the nature and aggregate amounts of risks) of
the borrower or counterparty and collateral and its sensitivity to economic and market
developments;
3. The borrower’s repayment history and current capacity to repay, based on
historical financial trends and future cash flow projections, under various scenarios;
4. For commercial credits, the borrower’s business expertise and the status of
borrower’s economic sector and its position within the sector.
5. The proposed terms and conditions of the credit, including covenants designed to
limit changes in the future risk profile of the borrower; and
6. Where applicable, the adequacy and enforceability of collateral or guarantees,
including under various scenarios.

Integrity and reputation of the borrower or counterparty as well as their legal

capacity to assume liability.

1.5 Credit Approval Process

To make prudent credit decision, bank and other financial institution essentially should
know the borrower well. Without these information bank cannot judge the loan application.
Credit worthiness of the applicants is evaluated to ensure that the borrower conform to the
standards prescribed by the bank. It can be said that a loan properly made is half-collected. So,
a bank should make proper analysis before making any credit decision. With increasing credit
risks, banks have to ensure that loans are sanctioned to “safe” and “profitable” projects. For this
they need to fine tune their appraisal criteria. A mix of both formal and non-formal credit
appraisal techniques will go a long way to ensure perfection in credit appraisal.

The credit evaluation process involves three steps:

1. Gathering Credit information

2. Credit Analysis (credit worthiness of applicants)
3. Credit Decision

1. Gathering credit information: The credit department of a bank collects various important
information regarding borrower from different sources to evaluate the customer. A number of
sources would available for gathering information which depends upon the nature of the
business, form of loan, amount of loan etc. these sources are:

a. Interview: Interview with the borrower enables the banks to secure the detail
information about the borrower’s business which can help in credit decision process. If the
applicant does not satisfy the credit norms, the lending officer may stop further procedure. In
case of the success of preliminary investigation, as up to the standards, borrower may be asked
to submit various financial reports.
b. Financial statements: Financial statements include the balance sheet and the profit
and loss account. The financial statements of the last few years should be obtained. This
analysis would provide an insight into the borrower’s financial position, funds management
capacity, liquidity, profitability and repaying capacity of the borrower.
c. Report of credit rating agencies: The move is in line with the Credit Information
System Act (CISA) or Republic Act No. 9510, and Securities and Exchange Commission (SEC)
Memorandum Circular No. 7, which laid down the rules for the accreditation of these firms. The
SEC memorandum said entities seeking to establish credit bureaus in the country should have a
minimum paid-up capital stock of P50 million and has the ability to operate a successful credit
bureau. The applicant should likewise use updated technology, have a good governance
structure and risk management framework, among others. CIC President and CEO Jaime P.
Garchitorena earlier said that the firm is looking to accredit credit bureaus by yearend. He
earlier noted that CIC had been conducting orientations and technical trainings the past two
years on setting up credit bureaus “to assist lending institutions in their compliance with the
law.” Under the CISA, lending institutions need to forward both the positive and negative credit
information of their borrowers to CIC. These “submitting entities” will similarly be able to access
the credit database or get the services of credit bureaus to establish the creditworthiness of their
borrowers.
d. Bank’s own records: If the applicant is the existing customer of the bank, the banker
can study the previous records, which provides an insight into the past dealings with the bank.
Every bank maintains a record of all depositors and borrowers. The transactions of borrower
can give depth idea to banker.
e. Bazaar report: Report regarding applicant can also be obtained from various markets.
The strengths and weaknesses of the borrowers are monitored by the markets continuously.
Market opinion can also predict the future of the business. Market intelligence can also be
gathered through borrower’s competitors. It should be a continuous process on existing current
account holders and other prominent businessmen.
f. Report from other banks: Bank credit department may ask to other banks in which
the applicant has dealings.
g. Other non-formal methods: There are other ways also which can give many clues
and make the judgment more accurate. The most popular non-traditional method is to
understand the personality, motive and the capabilities of the borrowers, based on non-verbal
clues as trying to predict the results of a human mind.

2. Credit analysis (credit worthiness of applicants): After gathering the credit information,
banker analyses it to evaluate the creditworthiness of the borrower. This is known as Credit
Analysis. It involves the credit investigation of a potential customer to determine the degree of
risk in the loan. The creditworthiness of the applicant calls for a detailed investigation of the 5
“C” of credit – Character, Capacity, Capital, Collateral and Conditions.

a. Character: The “character” means the reputation of the prospective borrower. This
includes certain moral and mental qualities of integrity, fairness, responsibility, trust worthiness,
industry, etc. The honesty and integrity of the borrowers is of primary importance. So, credit
character should be judged on the basis of applicant’s performance in bad times.
b. Capacity: It is the management ability factor. It indicates the ability of the potential
borrower to repay the debt. It also shows the borrower’s ability to utilize the loan effectively and
profitably.
c. Capital: Capital refers to the general financial position of the potential borrower’s firm.
It indicates the ability to generate funds continuously over time. Capital means investment
represents the faith in the concern, its product and nature. Bank should also determine the
amount of immediate liabilities that are due. For the true estimate, market value of assets
should be considered rather than book value.
d. Collateral: Collateral means assets offered as a pledge against the loan. It serves as
cushion at the time of insufficiency of giving a reasonable assurance of repayment of the loan.
e. Conditions: It refers to the economic and business conditions of the country and
position of particular business cycle, which affect the borrower’s ability to earn and repay the
debt. This is beyond the control of the borrower. Sometimes borrower may have a high credit
character, potential ability to produce income but the condition may not be in favor. For the
proper evaluation, bank should have eyesight on the economic condition too.

For this, they have to rate the borrowers in different categories like excellent, well and
poor. Both the formal and non-formal tools combined would lead to perfection in credit appraisal
and ward of increasing default tendency in credit. There are number of tools and techniques
developed to evaluate the creditworthiness of the borrower like, ratio analysis, cash flow
projections, fund flow statement, credit scoring etc.
3. Credit decision: After passing through whole this process, the banker has to take decision
about sanctioning of credit facility. The creditworthiness should be matched against the credit
standards of loan policy. The banker should be very conscious about this, for taking right
decision to avoid the possible credit risks to arise in future.

1.6 Essential and Best Practices in Managing Credit Risk

a. KNOW YOUR CUSTOMER. Knowing your Customer is an essential best practice
because it is the foundation for all succeeding steps in the credit risk management process. To
be successful, you must operate on pertinent, accurate, and timely information. The information
you gather and the relationships you establish are critical to positioning yourself as a valued
financial consultant and provider of financial products and services. Establishing a good
relationship can bring a long stream of equity to your institution.
 A poorly planned and executed initial call could limit your opportunity for future business.
One of the best ways to get to know the customer’s needs and establish yourself as a valued
financial consultant is through face-to-face meetings to discuss the customer’s history and
future plans. Prior to meeting with the customer, you should find out as much as you can about
the company and its industry. This up-front exploration will allow you to make the most of the
time that you have with the customer and help you set up an effective calling plan to guide you
through the interview process. You should make sure that you elicit all key information, keeping
in mind that the most important techniques you can demonstrate are the ability to listen
effectively and to respond to a customer’s needs. Listen for verbal cues and watch for non-
verbal cues to help establish a customer’s needs.

During the initial interview, establish your credibility as a professional, knowledgeable,

and friendly businessperson. Ask questions and gather information about the company’s
products and services, customers, suppliers, facilities, management, ownership, and history.
This is when you can develop your initial observations about management’s behavior and start
to evaluate their qualifications and abilities to carry out the company’s business strategy.

On subsequent calls, investigate competition, market share, and the probable impact of
economic conditions on the business. And identify the company’s business strategy and what
the company must do to succeed.

b. ANALYZE NON-FINANCIAL RISKS. Understand your customer’s business by

analyzing nonfinancial risks. Information gathered in this step is critical to positioning yourself as
a financial consultant to your customer and a valued member of your financial institution’s
lending team.
The concept of risk management can apply to a single loan or customer relationship
(micro) or to an entire loan portfolio (macro). The whole concept of institutional risk
management is to ensure that a particular issue has been identified as a risk. At the micro level,
a loan is a risk. At the macro level, a portfolio of loans is a risk. Your credit policy department
will identify risk factors and query the entire loan portfolio (macro) to judge whether the
particular risk is relevant to other customers of your institution. The key question is, “How does
this identified risk affect a company’s ability to repay debt?”

Risk Management is a continuous process (not a static exercise) of identifying risks that
are sometimes subject to quick and volatile changes. The identification of risks may result in
opportunities for portfolio growth or may aid in avoiding unacceptable exposures for the
institution.
There is risk to every line item on the balance sheet and income statement and you must learn
how to evaluate those risks, which fall into the broad categories of:
 Industry
 Business
 Management  

The integration of the analysis of risks associated with the industry, business, and
management of a company is a critical piece in the overall credit underwriting process. From
your institution’s perspective, senior credit policy management wants to know:    
 Is there enough capital available on the institution’s balance sheet to support the risk
being taken?  
 Is the institution being adequately compensated for the risk?
 Are there adequate controls in place at the institution to assure the proper tracking of the
risk and minimize the element of surprise?  

Evaluating industry, business, and management risks enables you to ask questions of
customers and prospects in order to fully identify, quantify, and if possible mitigate key risks. As
a result, you develop critical thinking skills and techniques that integrate economic, political, and
market issues into the overall underwriting process. Assuming the loan meets underwriting and
credit approval criteria, properly analyzing these risks gives you the information to help structure
the loan in a fashion that will ensure the highest probability of repayment. 

Analysis of the industry, business, and management risks precedes or is concurrent with
financial analysis of an individual company. If the financial institution has, or wants to gain, a
significant exposure to a particular industry, it usually has industry experts on both the lending
and credit analyst teams. Industry experts provide an intimate knowledge of an industry and will,
 Identify, understand, evaluate, and mitigate risk.
 Provide expertise in the event of a loan workout situation with a customer.
 Provide efficient marketing strategies in acquiring creditworthy and profitable clients
within a particular industry. 

An understanding of the economic and industry factors that influence a company’s

financial stability and financing requirements is necessary before valuating the numbers.
Because you can’t analyze a company in a vacuum, it must be analyzed within the larger
context of its industry and the world economy. 

Industry, business, and management risks are inherently an important part of the overall
credit underwriting process. A company’s financial statements are a   
reflection of a company’s management decisions as that company interacts with the outside
world. Industry, business, and management risks (nonfinancial risks) describe that outside
world.

c. UNDERSTAND THE NUMBERS. There are many benefits and risks associated with
establishing a banking relationship with any entity or individual. As a lender, you should know:
 How the requested funds are going to be used and how they are anticipated to be
repaid.
 Techniques to identify, categorize, and prioritize all of the risks inherent with the
customer that are known at the time of the analysis as well as those that are anticipated
to be in existence over the period of the relationship.

To understand the numbers, you should focus on the financial capacity of the company
as evidenced by the information provided and examine the accuracy of the information as well
as the quality and sustainability of financial performance. Before beginning any financial
analysis, it is important to understand why companies and individuals borrow money.  

When dealing with new clients, it is doubly important to probe into how and why the loan
request originated. When loaning to established relationships, your assessment of the loan will
be guided by your knowledge of the changes in your customer’s asset structure as it goes
through its business cycle.

The reason for borrowing provides you with insights into the company’s ability to repay.
A complete understanding of the historical and projected financial performance of your customer
is key to your analysis and overall credit risk management.

The loan request is generally the most scrutinized part of a credit write-up. Once you are
comfortable with the nature of the loan request, the process of understanding the numbers can
begin. The process includes:

 Knowing the Auditor – Analyze the competency and reputation of the firm or individual
preparing your customer’s financial reports.
 Accounting Fundamentals – Review the auditor’s Engagement Letter, Financial
Statements, and Management Letter, as well as accounting fundamentals and generally
accepted auditing principles (GAAP).
 Balance Sheet Quality Analysis –Analyze the balance sheet along with relevant liquidity
and leverage ratios.
 Income Statement Quality Analysis – Analyze revenues and costs along with income
statement ratio analysis.
 Cash Flow Statement Analysis – Analyze operating cash flow, investing cash flow,
financing cash flow, and cash flow ratios.
 Analyzing Financial Efficiency Cash Flow Drivers – Use profitability ratios and turnover
ratios to analyze a company’s cash flow drivers.
 Developing Projections – Determine the reasonableness of assumptions behind
business fundamentals and swing factors.
 Personal Financial Statement Analysis – Analyze the personal financial statement and
tax return in the event that you are lending directly to or seeking additional credit support
from an individual.
  Company Financial Statements – Analyze the company’s financial statements and
provide an overview. Obviously, a small company will have a simpler chart of accounts,
while a large domestic or international corporation will be more complex.

d. STRUCTURE THE DEAL. The first step is to understand the business. Before
completing a financial analysis on the organization, you identify the characteristics that influence
a company’s success by studying:
1. The nature of the business.
2. The nature of the industry.
3. The impact of economic conditions.
4. Its business strategy.
5. The competencies or deficiencies of management.

Learn what the company does and how it operates. Then examine how it fits into its
industry and how it is affected by economic conditions. That information shows you what the
company’s business strategy should be and how easy or difficult it will be to carry out that
strategy. Finally, you can evaluate how competent the company’s management is to accomplish
the activities you have identified as crucial to the company’s success.

Having completed the analysis of the business, you can then move to analyzing the
financial reports, historical and forecasted. Understanding profitability and cash flow, liquidity,
and leverage are key to structuring the facility.

You cannot determine what product(s) fit the customer’s profile until these steps have
been completed. Once this process has been completed, applying the appropriate structure
becomes a simple procedure. By taking the time to understand the personal, financial, and
business strategies of the owners, you will have an easier time getting to “yes,” with a risk
profile acceptable to your financial institution.

Once you have identified the underlying borrowing cause(s) and understand both
primary and secondary repayment sources available, the next step is to structure the loan. 

Loan structure is important because your customer needs to clearly understand the
boundaries within which it can operate and continue to depend upon your institution for its
financial service needs. The structure of the deal appropriately establishes your customer’s
expectations for how your institution will perform during the term of the relationship. Your
customer needs this assurance in order to run the business efficiently, i.e., if they operate in
accordance with the terms and conditions of the loan agreement, your customer can expect
funding from your institution.

By having an appropriate structure to the relationship, agreeable to both parties, you

have established a mechanism for monitoring individual transactions within a relationship. This
monitoring process can be accomplished in two ways:
 Have a loan covenant checklist that routinely tracks your customer’s adherence to
covenants.
 Require that an officer of the company regularly (quarterly, for example) certify as to the
company’s compliance with all of its outstanding agreements.

Failing to notify your customer of a covenant default may make your institution’s future
enforcement of the covenant difficult. 

e. PRICE THE DEAL. Determining the appropriate pricing is a critical credit risk
management technique. It ensures that your financial institution will be adequately compensated
for the risk of the deal.

In the late 1970s, nearly 90% of all floating rate loans were linked to the prime rate and
used as a benchmark for loan pricing. Adjustments to the incremental spread over/under the
prime rate generally signaled the softening or hardening of loan conditions. These adjustments
were not always closely synchronized with changes in short-term money market rates, such as
the Fed Funds rate or other cost of funds indices.
 However, over the past 20 years, increasing competition from foreign financial
institutions seeking business in the U. S. through offshore branches and agencies and the
expansion of the commercial paper market have caused a movement from prime-based loans to
pricing based on money market base rates. As U.S. banks’ access to overseas sources of funds
has increased, London Interbank Offering Rate (LIBOR) has become an increasingly popular
base rate index among customers of regional and even small banks. LIBOR is the rate that the
most credit-worthy international banks dealing in Eurodollars (U.S. currency held in banks
outside the United States, mainly in Europe) charge each other for loans.

With money market rates of interest fluctuating dramatically over the past 20 years,
banks’ loan pricing systems have become largely based on floating rates. This pricing tactic ties
the loan rate to a base rate that responds to movements of money market rates. Financial
institutions painfully learned their lessons with respect to managing interest rate risk in the early
1980s. Institutions with large portfolios of low fixed-rate loans found they were exposed to
considerable interest rate risk when variable funding costs rose sharply. Today, banks have
created increasingly complex strategies for managing interest rate risk through the use of
financial futures and options. Interest rate risk management and loan pricing are now highly
interrelated through the use of pricing models.

Traditionally, banks have used pricing models that parallel the format of their income
statement. As the major source of profitability for many banks, loan interest income has played
an important role in the banks’ return to shareholders. As the market for loans has become
more competitive, banks have had to change the way that they look at profitability.
Many complex factors determine the final rate a bank charges its commercial clients. In addition
to company-specific variables, factors that affect pricing include the 
following:
 Marketplace in which the bank operates.
 General economic conditions.
 Matching of the pricing and maturity of the bank’s assets and liabilities, i.e., Asset
Liability Committee (ALCO) policies.

f. PRESENT THE DEAL. Communicating your findings in a cogent and professional

manner is a critical practice in getting your proposal approved. Credit decisions should not be
made on financial statement analysis alone. A credit review would not be complete without an
equally significant emphasis on the qualitative issues such as the ability of management, the
competitive business environment, and the economic issues relating to the business.

Whether you write the credit presentation or hold a credit discussion, the following
format will be equally applicable.

The five key sections that are integral to any effective credit recommendation report or
presentation are:
1. Summary and Recommendations – A one-page summary of all the information that has
been gathered in the analysis that supports the credit recommendations.
2. Economic and Competitive Environments – Analyses of the company’s current and
evolving position in the industry and how susceptible it has been, and may be, to
changes in the general economy.
3. Management Assessment – Evaluations of the company’s operations and
management’s capabilities.
4. Financial Analysis and Projections – Analysis of the financial position of the company
and evaluation of the projected performance of the company.
5. Sources of Repayment – Identification of all projected sources of repayment and the
appropriate loan structure. 

g. CLOSE THE DEAL. Closing the Deal takes place after the analysis, structuring, and
pricing have been completed. Do the following and it is more likely that your loan closing will be
successful:
1. Prepare a closing memorandum or detailed loan documentation checklist.
2. Provide sufficient time for the borrower and any other parties involved in the transaction
to gather documents.
 3. Provide the borrower and any other parties with instructions on how to complete your
standard documents and ensure that they return the forms to you for review prior to the
closing.
4. Prepare drafts of loan documents and deliver them to the borrower or other involved
parties prior to the closing with sufficient time for the recipients to have the documents
reviewed by their own legal counsel. 

h. MONITOR THE RELATIONSHIP. In today’s competitive environment, you cannot

afford to wait for your loans to be repaid and expect your clients to call you for other products
and services. To have a competitive advantage in today’s market, you must continue to monitor
the risk profile of your client and, at the same time, pursue opportunities to develop and expand
the relationship.

A profitable relationship can quickly turn into an unprofitable one. Loan payments may
be timely, but deteriorating collateral, idle equipment, or unpaid taxes can create serious risk for
you. Periodic reviews, ratings, and audits can ensure that the client is one that will create long-
term profitability for your bank.

Asset quality is one of the key success factors of a financial institution. Although every
bank is subject to scrutiny from state and federal regulatory agencies, most banks supplement
these functions with internal monitoring.

In a recent survey of banks conducted by RMA, the following were determined to be

critical to a successful risk management strategy:
 A quantitative risk-rating system with a wide range of grades, which includes subjective
factors, such as management quality. A wider range of grades allows the bank to assign
credit costs more precisely.
 An effective management information system to track credit exposure.
 Risk pricing based on required rates of return that are then used in customer sourcing.
 A business strategy that reflects a proactive role in guiding relationship managers on
credit exposures in the portfolio. 

1.7 Common Credit Management Strategies

As much as businesses wish there was, there is no silver bullet or panacea when it
comes to credit management. Different customers and sectors will respond better to some
strategies than others, while some simply won’t pay on time regardless of your credit controllers’
efforts. What businesses can do, however, is have a clear picture about the different strategies
that could be used based on different eventualities. This not only provides the best chance of
getting paid, but also reduces the impact of late payment on the business’s all-important cash
flow. Here, we look at some of the most common tactics employed by British businesses.

1. Constant reminding. Whether by phone, email, letter or in person, there are always
ways to contact your customers to remind them of the invoice. The secret is to contact them at
the most opportune moments.

2. Suspending work/services. This is quite an extreme step to take, but it can prove
extremely effective. By refusing to trade with a particular customer – usually one which has a
track record of paying late – you’re forcing their hand to either clean up their act or go
elsewhere. Though the latter option seems counterproductive, you have to ask yourself how
valuable a customer they are if they don’t pay on time.

3. Credit reports. Credit reports are an excellent tool to gain a picture of a prospective
or existing customer’s creditworthiness prior to offering them credit terms. The outcome of the
report can be used to determine the length of terms to supply, whether a deposit should be
taken up-front or whether you should trade with them at all.

4. Suspending customer credit facilities. By refusing to extend credit terms to a

customer, you remove the risk of them not paying at all. This decision can be based on your
previous experiences with that customer, or perhaps an unfavorable credit report being
obtained.
However, it can lead to your business being less competitive and lead to that customer looking
elsewhere.

5. Court Judgments. Although it can be an expensive process, legal proceedings are

available to businesses wishing to take a strong stand against a late paying customer. The
threat of court can sometimes be enough to encourage payment, but it can prove to be a
stressful, drawn-out and costly method.

6. Visiting debtors in person. Unfortunately, it can be quite easy for a customer to

ignore phone calls, emails and letters requesting payment. Sometimes it can therefore be worth
knocking on their door to request payment and have a face-to-face conversation to demonstrate
how valuable their prompt payment is for your business.

7. Applying statutory late payment interest. Businesses have a legal right to charge
their customers statutory interest and late payment compensation should they miss a payment
deadline. This can compensate your business for the impact late payment has on your cash
flow and additionally cover the cost of employing a debt collection agency to recover the full
amount.

8. Written credit policy. More commonly used by larger businesses, a written credit
policy can be a great way to ensure your team goes about its credit management in a
structured, effective and consistent way.

9. Early settlement discounts. In many cases it can be more beneficial financially to be

paid a smaller-than quoted sum if it means payment is received after seven days instead of 30.
Any customer taking advantage of the offer also means that’s one less account your credit
control team has to worry about.

10. Invoice finance. The nature of trading on credit terms means there will always be a
cash flow gap between providing a service and getting paid. Invoice finance enables businesses
to access up to 90% of their invoice value within 24 hours of an invoice being raised, while
facilities can also incorporate a sales ledger management service and bad debt protection.

11. Credit insurance (bad debt protection). Bad debt protection can also be provided
on a standalone basis. By safeguarding your cash flow against late payment or protracted
default, if affords you peace of mind when trading on credit – particularly for larger contracts.

12. Outsourcing. Chasing customers for payment can be an arduous task. As a result,
some businesses choose to instruct a debt collection agency to recover unpaid invoices which
are proving difficult and time-consuming to chase. Other businesses choose to outsource all or
part of their credit control function so that they can concentrate on running their company.

1.8 Credit Control Timeline: Key Steps

One of the most important but frequently overlooked elements of the credit control
process is the process itself. By clearly setting out a day-by-day strategy from the moment the
order is placed until the invoice is paid, your accounts receivables team can adopt a coordinated
and professional credit control procedure.

Once you have agreed the timetable with all the relevant people in your company, the
next task is to ensure that the necessary levels of training are provided so that all stages are
adequately completed and meticulously stuck to at all times.

Stages can include invoicing the day the order is fulfilled and courtesy calls or letters that
politely, but firmly, remind the customer of their obligation to pay. Should the invoice not be paid
after a certain time, it may be beneficial to pass the debt over to a specialist commercial debt
collection agency. Below is an example timetable based on credit terms of 30 days, but it should
be adapted to your business’s experiences and needs:

SUMMARY

In this chapter the decision making processes used to assess individuals when they
apply for credit have been explored. Lenders attempt to forecast the likelihood that a potential
customer will be a ‘good’ or ‘bad’ risk and make lending decisions based on this prediction, with
good and bad acting as approximations to profitable and non-profitable respectively. Every
lender has different overheads and operates at a different level of profitability. Therefore, a
customer who is deemed creditworthy by one lender, may be not be considered creditworthy by
another.

There are no hard and fast rules that can tell you who is a good credit risk and who is
not. There are cases where the poorest of people pay their bills promptly, while the wealthy
ignore them. As the owner of a small business, you must combine facts about the applicant with
common sense to determine those risks that appear reasonable.
 CHAPTER 4

CREDIT POLICY AND CREDIT APPLICATION

Chapter Outline

1 Learning Objectives
2 Topics
1.1 INTRODUCTION
1.2
3 Summary

Learning Objectives

1. Identify the main elements of a credit policy, and note the situations in
which the policy may be changed.
2. Cite the contents and handling of a credit application, and note why this
process is used.

1.1 Introduction

Finding the right credit policy is a mixture of art and science. Many issues affect the
policy. Corporate culture, the company’s margins, competition, existing inventory, and
seasonality are just a few of the matters to be considered, in addition to the obvious financial
analysis. When credit is extended to a company that cannot or will not pay, the impact directly
impacts the seller’s bottom line. More insidious, when the seller pays late, there is a bottom line
impact as well, although it is not as apparent. Similarly, when a buyer takes unauthorized
deductions the action impacts the bottom line—sometimes to the point of making the sale
unprofitable.

A credit policy is simply a set of rules and procedures that you need to apply to all
customers in every foreseeable situation. In a credit policy, you normally need to decide on the
following major credit aspects: the maximum amount of credit you are willing to extend to a
customer, the terms of payment (whether 30 days, 60 days, 90 days, or longer), the down
payment required, and the credit evaluation criteria for new customers. You also need to include
in the policy how to go about notifying customers who have past due accounts, and how to write
off account receivables that you have already considered as bad debts or un-collectibles. When
planning your credit policy, it is advisable to consult your accountant or business advisor for
insights and advice on how to best reduce your company’s credit exposure.

1.2 Factors Influencing Credit Policy

1. Competition:
Credit practices within an industry influence the formal credit policy of any individual
company. Competitive conditions place a high degree of importance on credit availability. The
credit policy of a company is important for maintaining or improving its competitive position.
Even where credit is not generally a competitive tool, an individual company can use it in this
manner if it is willing to do so.

2. Customer Type:
 The type of customer has a direct limiting influence on the credit policies of all
companies in an industry. Where the buyers’ line of business is characteristically short of
capital, it is unrealistic for credit policy to be unduly restrictive. A company that operates on that
basis will not maintain its market.

3. Merchandise:
The type of merchandise affects the credit policy of the seller in a number of ways.
There is a tendency to sell on a more liberal basis if the merchandise has a relatively high profit
margin or high price. Also, terms may be somewhat more liberal if the merchandise can be
repossessed or returned inward in the same condition as it was sold. On the other hand if the
shelf life is shorter of the merchandise then most probably the credit terms will provide shorter
credit period. For example, those that can spoil will require shorter terms, so terms are usually
net 10 in the food industry.
4. Profit Margin:
Markup is important. When profit margins are slim, the credit department may be more
careful in the selection of its accounts. High-markup goods should, at least in thoery, encourage
credit professionals to approve sales to marginal credit risk accounts. In other words, the higher
the gross profit margin, the more tolerant of credit risk the credit manager should be. This is a
general statement and not always true.

5. Unit Price:
It is easier to establish a uniform liberal policy that applies to all customers when the unit
price of merchandise is relatively low. Even on a wrong decision, the dollar amount of risk is low
credit exposure is greater. A more detailed analysis is usually conducted before a customer
order is approved.

6. Geographical Distributions:
The geographical distribution of customers determines credit policy to some degree.
Widely separated markets require particular modifications in credit analysis and in collection
efforts. A highly concentrated selling and buying area, on the other hand, involves a special type
of price competition and service requirements.

7. Government Regulations:
In the case of particular commodities, such as spirits and liquors, government
regulations specify credit policies or procedures which must be followed by the seller. There, the
overall policy must take the regulations into consideration. In a very general way, expected long-
range trends in the economy also influence credit policy.

8. Economic Conditions:
Economic or business conditions are of much greater significance, however, in
determining how policy is to be applied over a shorter period of time. When times are
prosperous, ability of debtors to pay their bills is somewhat improved; however, there is a
danger that they may tend to overbuy. During slack business periods, debtors tend to delay
payment of their bills and credit requirements may tend to be stricter. Concurrently, as sales
drop, the company is faced with the problem of maintaining volume in the face of decreasing
sales and more demanding selection of credit customers.

1.3 The Importance of a Written Credit Policy

1. A written policy provides a structured approach to risk management and the debt
collection process.
2. A written credit policy provides a certain amount of consistency which is important to
the department’s reputation.
3. It helps ensure a consistent approach among customers, reducing the chance of
personal bias affecting the decision making process.
4. A written policy can be reviewed by senior management and either accepted or
modified – helping ensure that the credit department focuses on what the company considers
vital.

1.4 Formulation of Loan/Credit Policy

 A bank or any financial institution has the social obligation to meet the credit needs of
different sectors of the community. But it cannot afford to incur losses. They have to manage
lending business in safe manner by that the loan portfolio of a business institution remains
balanced from the point of view of size, type, maturity and security that promises for reasonable
and steady earnings. This is called clear cut and definite credit policy. A credit policy includes
detailed guidelines for the size of the loan portfolio, the maturity periods of the loan, security
against loan, the credit worthiness of the borrower, the liquidation of loans, the limits of lending
authority, the loan territory etc. Credit policy provides some directions for the use of funds, to
control the size of loans and influences the credit decision of the bank. So, the loan policy is a
necessity for a bank.

Formulating and implementing loan policies is the most important responsibilities of bank
directors and management. In this activity, the Board of Directors take the services and co-
operation of the bank’s credit officers, who are well experienced and expert in the techniques of
lending and are also familiar with external and internal factors that affect to the lending activities
of the bank. In formulating the loan policies, the policy formulators must be very cautious
because the lending activity of the bank affects both the bank and the public at large. All the
influencing factors should be considered.

1.5 Contents of Loan Policy

1. Size of loan account:

The total amount of the total advances that a bank would sanction should be clearly
mentioned in loan policy. There is no iron-clad formula for fixing the size of the loan. The only
rule is that bank should continue to lend till the bank has funds for lending. The basic social and
business excuse for the bank is the ability to supply credit to the community. A bank should
determine the optimum size of loan portfolio. In this decision, management must foresee the
economic situation of the economy and region also. The size of the loan account may be fixed
at a higher limit in case of good capital position in relation to its total deposit liabilities.

2. Credit for infrastructure:

The operational guidelines on financing infrastructural projects have been issued to

commercial banks. According to that, banks would be free to sanction term loans for technically
feasible, financially viable and bankable projects undertaken by both public and private sector.

3. Types of loan portfolio:

Decision on the type of loan must also be taken. Different types of loans carry different
degrees of risks which are depended upon the adequacy of its capital fund and the structure
and stability of bank deposits. In the loan policy, various forms of loans and the proportion of
each form should be clearly spelled out. Policy statement should also mention the maximum
amount of the loan that might be granted to a particular borrower.

4. Acceptable security:

The Government policy and credit policy should also be kept in view while granting any
credit. Bank should observe the rules and regulation time to time for maintaining liquidity and
profitability. Otherwise if security aspect is not considered, bank will have to suffer from any loss
which may occur from any unsecure loan.

5. Maturity:

A loan may be called back in times of need to satisfy the liquidity needs of the bank.
Short term loans are more liquid and less risky. The minimum period of loans and spread over
various maturities subject to roll-over would now be decided by banks and banks could invest
short-term /temporary surplus of borrowers in money market instruments.

6. Compensating balance:
 Compensating balance is a protective device to save the bank from the risk of default.
The compensating requirement may not be common for all the customers. The way in which the
compensating requirement is applied seems to vary from bank to bank.

7. Lending criteria:

To minimize the risks in lending, a bank should grant loans only to deserving parties
whose credit character, capacity and integrity are good. The criteria of evaluating credit
character and capacity to generate income should be set forth in the policy statement.

8. Loan territory:

The loan policy statement of the bank must include the regions to be served by the
banks. This will save the time and efforts of the credit department in respect to receive a loan
application.

9. Limitations of lending authority:

Large-scale commercial banks consist a number of loan officers. The loan authority of
different officers should determine to avoid overlapping and duplication of efforts and wastage.
The management must set forth the lending limits of each officer in the policy statement.

1.6 Points Covered by Policy

When establishing an international credit policy, take into account the following general
considerations:

• The longer time period for delivery, fund transfer (payment), and the credit
extension period
• The need for terms that provide for security for the risks of time and distance
• The competition created by credit terms from the domestic market and
other foreign competitors
• The competition from other countries having different costs and governmental
policies
• The correct use of international terminology such as shipping and payment
terms, especially the use of INCOTERMs
• The assessment of political transfer and event risk, including:
identifying sources of information, establishing procedures for assessing and
spreading the risk, and evaluating and verifying the sources and reliability of
information obtained
• The assessment of customer risk

1.7 International Credit Policy Tips

Based on conversations with hundreds of international credit professionals, here are the
techniques that work best.

1. Produce a coherent credit policy for selling international accounts and make sure the
sales force and sales reps, if they are used, understand it.

2. Begin accepting corporate procurement cards for international sales. Be aware,

however, of the fees charged by most service providers and make sure prices cover these fees.
Otherwise, you may be giving away all your profits. Procurement cards are a particularly
attractive option for smaller sales and allow companies to sell to customers who might not meet
ordinary credit standards. Most salespeople love this option.

3. Develop a simple, but complete, credit application that can be faxed. Leave adequate
space for the customer to fill in needed information. Then accept signed applications that are
faxed back. Doing so will make you a hero with the sales department.
 4. For smaller accounts, use a scoring system to determine which method of account to
use for each sale: letters of credit, open account, documentary collections, and so on. Some
report success using this technique on larger sales as well. However, you may want to review
large sales individually.

5. Document your policies and procedures in a manual. Doing so will help the credit staff
implement them. Give a copy to the sales department, if that is appropriate.

6. Require letters of credit only when absolutely necessary. Companies that have
demanded all customers provide letters of credit are beginning to rethink that requirement. Such
requirements often lose sales as letters of credit are expensive for customers and a hassle for
everyone involved. While proper in many cases, they are not always needed. By eliminating this
requirement on small orders, some companies have garnered additional business with little
additional risk.

7. Within limits, let the selling unit closest to the market set terms. After all, these are the
individuals in the best position to know what is typical for that country. The companies that have
had the best success with this approach are those requiring these same units to follow up on
late
payments and those that pay commissions only after the company collects its money.
Salespeople who have to wait for their money are going to think very carefully about extended
terms.

8. Limit export credit to companies with ties in the continental United States. While not
everyone will agree with this approach, the few companies that do use it report they have better
control over marketing conflicts. This might work for those firms that are just starting to export.

9. Have the international credit policy formalized and approved by senior management.
While this may take a bit of time in the beginning, it will save time and aggravation in the long
run. More than one salesperson has tried to make an end run around credit by going straight to
senior
management about a credit decision. Doing so is more difficult if the credit policy has been
preapproved. If your sales force is apt to try such a maneuver, make sure they understand the
formal credit policy.

10. Ship goods to a bonded warehouse for release to distributors in countries where
international sales are to be made. (Only if the distributor’s account is current, of course.) This
approach offers freight payment savings as well.

11. Upgrade credit policies when key personnel turn over. Several firms have reported
stumbling blocks in the form of employees (some of them quite senior) who insist on doing
things “the way we always have.” Strike while the iron is hot and before newcomers get too
entrenched in the old way.

12. Rewrite the credit policy as simply as possible. One flexible credit pro reports that he
“broke down rules of thumb, which confused everyone, into a few simple categories and then
educated everyone involved.” The old KISS (Keep It Simple, Stupid) approach really works.

13. Get sales involved in the establishment of the new credit policy. Find out what gives
them difficulty and see if they can be accommodated. Sometimes a simple adjustment in the
credit policy can make their lives much easier. Often what is needed becomes clear if the credit
manager
goes on some sales calls with the sales force. The old aphorism about “walking a mile in
someone else’s shoes” certainly fits in this case. Many international credit managers who have
done this come back with a new respect for sales.

14. Hire agents who will get paid only after the company is paid. This will prevent reps
from selling to companies that they know either will not pay or will pay only after a good deal of
follow-up and trouble. No one wants to waste his or her time.

15. Use a matrix that employs third-party credit reports to evaluate international
customers’ credit risk.
 16. Ship to new accounts only on cash-in-advance or letter-of-credit terms.
17. Standardize guidelines regarding which companies you will sell to on open account.
This will stop the ongoing conflict between sales and credit.

18. Use letters of credit designed to meet established seller criteria.

19. Incorporate into every international sales contract the letter-of-credit requirements,
terms, and conditions of sale. Doing so saves both time and money at the negotiation stage.

20. Begin using international accounts receivable insurance. Doing so generally permits
companies to offer their customers longer terms and larger credit limits.
21. Use credit insurance for marginal customers and those in high-risk countries. Doing
so allows sales expansion when selling under standard credit terms would not.

22. Begin to communicate consistently and on a timely basis with international

customers when payments are late. By doing this with the consensus and agreement of the
sales department, you will reduce conflicts and customers will begin to realize that they cannot
play one
department against the other.

23. Develop a comprehensive handbook for the sales force that contains all necessary
information, so they can quote accurately. Include matters such as letter-of-credit terms, lists of
customers they may sell to on open-account terms, INCOTERMs to use, wire transfer
information, and credit card use.

24. Rewrite any old, staid policies so they are more user friendly. This does not
necessarily mean loosening terms but rather rewriting the policy in a manner that is easy for the
end user to understand.

25. Do not let the sales force establish terms of sale. The credit department or someone
who fully understands and appreciates the ramifications of such policies should handle this. One
company that implemented such a policy was able to reduce its Days Sales Outstanding (DSO)
by 20 days.

26. Create a credit risk model to score customers’ audited financial statement figures.
Use this to ascertain whether specific customers can be offered open-account terms.
Customers who do not meet the open account standards can be offered secured terms.

27. In order to give operating units more latitude in the decision-making process, involve
the unit heads in determining whether to accept or reject “unusual” terms and conditions of sale.

28. Develop innovative international financing programs to help the sales force meet
goals without increasing credit risk. Some credit managers have used receivables discounting in
order to offer extended terms. Doing so is especially important to those selling in the Far East.

29. Identify customers who also work with other units of the company. Involve upper
management in developing a unified approach to establishing credit limits for such entities so
that reasonable amounts of credit are extended in total. The goal is not to overextend without
realizing it.

SUMMARY

Creating Credit Policy should have careful consideration. Credit Control must not
become a sales prevention department; imposing a credit policy so strict that bad debt is
reduced by virtue of doing no business. Conversely, a policy that is too loose will have sales
romping away doing business with anyone and everyone regardless of their ability to pay.

For new customers, there should be a defined process for account opening, including
some form of credit checking. There are several online services that can provide data to help
assess a customer’s creditworthiness. Based upon this, a credit limit should be set to minimize
trading risk. The account opening process should ensure that all required information is
collected regarding new customers. It’s amazing how often credit is provided without knowing
the legal entity to which it is actually being provided.

Once a customer is on-board, ongoing credit checks should take place at regular
intervals, dependent on the level of risk with the account. You’ll probably wish to increase credit
limits for regular clients with a proven history. The health of your customers will vary with time; it
is important that early warning signs are spotted to reduce the exposure to company failure.
Credit-checking services are now available that integrate seamlessly with your accounts system
to provide real-time risk indicators relating to your customers and the level of credit provided to
them.