I.

Importance of Credit Management

What is credit management?

Credit management refers to the process of granting credit to your customers, setting
payment terms and conditions to enable them to pay their bills on time and in full,
recovering payments, and ensuring customers (and employees) comply with your
company’s credit policy.

It is also important for businesses as it improves cash flow, reduces late payments,
guards against defaults, optimizes performance, mitigates risks, and enhances
reputation. It is a crucial aspect of financial management that helps businesses maintain
financial stability and success.

What are the risks of poor credit management?

Cash is the lifeblood of every business. If you're spending money on resources but not
receiving payments from customers, sooner or later you'll hit a bump in the road - and
that bump may be a threat as significant as liquidation.

Keeping your business afloat may require a large overdraft or loan, that you wouldn't
otherwise need if customers paid on time. You will be charged interest on any credit
extended from a bank, which eventually becomes an additional expense. As a result, it
may become difficult to pay suppliers if there’s no liquid cash flowing through the
organization. These negative outcomes can be minimized simply by employing some
effective credit management procedures.

Benefits of Effective Credit Management

● Minimize risks

Having a clear picture of your company's finances is one of the most beneficial
aspects of credit management. With clarity you can avoid unnecessary credit risk
and take advantage of previously unseen opportunities.

● Improve cash flow

 By continuously assessing income and expenditure, it’s easier to take actions
that ensure the incomings are exceeding the outgoings. As a result, it’s far more
likely that payments such as bills and salaries can be paid on time.

● Avoid late payments

Bad debts can be prevented, and the number of late payments made by
customers can be reduced by detecting them earlier. This also reduces the
likelihood of your company experiencing adverse effects as a result of a default.

● Increase liquidity

An asset's liquidity refers to its ability to be converted into cash simply. Stable
and consistent income from customers is one of the main sources of healthy
liquidity for businesses.

● Better debt recovery

Debt recovery can be completed in a much smoother manner, at a much faster

rate, and with as little effort as possible, while also ensuring none of the debt is
missed. There’s also less tension between the payer and payee.

● Enhanced reputation among lenders

Lenders are more likely to look fondly on businesses that have efficient methods
for retrieving the credit they are owed. And these lenders will be more willing to
provide credit to those that can demonstrate healthy cash flow.

II. Credit Investigation and Appraisal

‌Credit appraisal refers to assessing and investigating a particular loan application or

proposal thoroughly to gauge the repayment ability of the loan applicant. A lender

conducts a credit appraisal chiefly to make certain that the bank gets back the money

that it lends to its customers. Whether one applies individually or as a corporate entity, a

lender always conducts a detailed and systematic credit appraisal process. The credit

appraisal process before giving a loan to entities is comprehensive as it appraises or

evaluates management, market, technical, and financial elements.

No lender approves and sanctions anybody's loan application instantly without an

evaluation. A lender needs to carry out a credit appraisal process to ensure that the

borrower can repay the entire loan amount on time without missing any payment

deadlines. This is very crucial for a bank as this determines the interest income and the

capital of the bank. The repayment behavior of a borrower directly affects the

performance of the bank.

Both banks and non-banking financial corporations (NBFCs) utilize credit appraisal

procedures before approving a personal loan application or any other loan application.

Each lender will have its techniques for performing credit appraisal processes. A lender

will have certain norms, rules, and standards to assess the creditworthiness of a

particular loan applicant. If a borrower has high creditworthiness, there is a high

probability that his or her loan application will be accepted by the bank. A credit

appraisal is done to avoid the risk of default on loans.

Factors Evaluated During a Credit Appraisal Process

● Income

● Age

● Repayment ability

● Work experience

● Present and former loans

● Nature of employment

● Other monthly expenses

● Future liabilities

● Previous loan records

● Tax history

● Financing pattern
 ● Assets owned

A lender typically compares your loan amount, income, EMIs, repayment capacity, and

your overall expenses in order to determine if you are eligible or not to get a personal

loan or any other loan. These are some of the ratios that are useful in the credit

appraisal process:

Fixed obligation to income ratio (FOIR): This ratio refers to how one deals with his or
her debts and how often they repay their debts. It refers to the ratio of the loan
obligations and other expenses to the income that they earn on a monthly basis.

Installment to income ratio (IIR): This ratio considers the equated monthly
installments (EMIs) of your loan to the income that you earn.

Loan to cost ratio: This ratio indicates the maximum amount that a particular borrower
is eligible to take.

III. Scope of Credit Investigation

The purpose of a credit investigation should be to obtain information to make a specific
decision about granting credit to a company. The goal of the investigation is to obtain
factual and accurate information that will lead to an appropriate credit decision

FACTORS

1. Purpose and types of investigation

2. Company credit policy
3. Client classification
4. Amount involved
5. Time and resource constraint

Credit Investigation covers the following:

I. Company’s Background/History
II. Financial Conditions
III. Dealings with Government lending agencies
IV. Bank’s experience with the subject
V. Court Cases

I. Company’s Background/History

Type of business:
1. Sole proprietorship
The investigator sees to it that:
- Owner has the capacity to enter into a contract.
- Civil Status
If she is a married woman she must possess the legal right to
transact business under Civil Code of the Phils.

2. Partnership
1. General or specific partnership
All members are general partners.
They are liable to the whole extent of their separate properties.

One or more members aside from the general partner shall not be
bound by the obligations of the partnership.

2. If the contract is registered or not with the Securities and

Exchange Commission.

3. Corporation
Credit investigators consider the ff. (Articles of Incorporation) :

1. Name of the corporation

2. Its purpose, objectives, nature and powers
3. Location or place of the business
4. Term duration of corporate existence (do not exceed 50 years)
5. Names and residences of the Incorporators - to know that the
majority of the Incorporators are residents of the Phils.
6. Names of the incorporating officers
7. The # of stock and the # of share into which it is divided
 8. Names and citizenship of the stockholders and the amount of
shares they are subscribed to and amount paid on subscription. (at
least 20%)
9. Acknowledgment of the duly executed Articles of Incorporation
before a notary public.

Company's history also covers the ff.

Complete record of the men who comprise the operating management of
the business
● Age
● Status
● If they have children
-Number of children
-Age
-Sex
Educational attainment
● Previous employment (if any)
-experience in their field

II. Financial Conditions

-It is represented in a summary form a breakdown of the financial statements of
the company reflecting its latest financial condition and results of operation for
the past 3 - 5 years.
- schedules
- explanations or extraordinary items
- breakdown of merchandise and receivables
- full explanations of all inter-company loans and merchandise transactions.

III. Dealings with Government lending agencies

a. With the lending agencies of the government.
- CI concentrates on the size and degree of fluctuations on borrowings as well as
the nature of security pledges to secure the loan.

b. Multitude of facts that could be obtained from merchandise suppliers.

- incidence of credit
- amount owing
 - amount past due (if any)
- terms and payments performance of the subject of inquiry.

c. Other banking institutions

1. Nature of the credit accommodation.
2. Whether borrowings are on a secured or clean basis.
3. If secured, consists of
- real estate mortgage, shares if stock, warehouse receipts and etc

IV. Bank’s experience with the subject

V. Court Cases
a. Importance of the subject in its particular line of business, general reputation,
ability of the management and quality of the products.
b. General outlook as to the conditions in the subject’s line of business.
c. Whether the subject resorts to unfair methods of competition.
d. Names of other concerns to whom the subjects may be known.

IV. Bank Appraisal Report

A comprehensive report that estimates the value of a property based on various

factors. It is typically required when a mortgage is involved in buying, refinancing, or
selling property.

The purpose of a bank appraisal report is to provide an unbiased professional opinion of

a property's value. It helps lenders determine the loan amount they are willing to provide
based on the property's assessed value.

Bank appraisal reports are important for both buyers and lenders as they help ensure
that the property's value aligns with the loan amount and provide an objective
assessment of the property's worth
V. Credit Policy

A credit policy is a set of rules and standards that directs how companies can grant
credit to customers and the collection method. It also describes who in the company is
in charge of allotting credit. The main objective of this policy is to set certain guidelines
that help handle credit risk.

Credit policy variables help in understanding the outstanding credit balance of

customers. Businesses can easily set up credit terms and limit certain customers. Also,
businesses can use it to shield against unknown credit risks. It also helps in keeping a
consistent approach toward customers. However, a tight policy can lead to inventory
issues.
Types of Credit Policy Prevailing in Credit Management

1. Liberal or Lenient dit PolicyCre

According to this, businesses and companies try to be liberal or put very few restrictions
on credit terms. As a result, there is an increase in sales, and it attracts new customers.
However, a lenient credit policy can lead to bad debts and liquidity issues.

2. Restrictive or Tight Policy

Here, the terms are very strict for any client or customer. As a result, firms are very
selective in extending credit terms and duration. However, it can lead to a loss of
customers and consistent cash flow for the firm.

6 Elements of Credit Policy

1. Credit Terms
- It refers to the certain terms and conditions regarding credit policy which
also includes the payment duration for every customer.
2. Credit Worthiness of The Customer
- It is a crucial element of the policy. Old customers often have a positive
credit score or history. However, there are high chances of default by the
new ones. Businesses must assess and evaluate the creditworthiness of
customers.
3. Cash Discounts
- Credit policies include cash discounts as a vital component. A higher
discount attracts more customers and reduces DSO.
4. Credit Limits
- Credit limits are the extended period given to customers based on the
credit policy.
5. Collection Policy
 - Credit policies have a different collection term for every customer.
Companies must provide them with all information on collection policies
like late fees, interest payable, and others.
6. Customer Information
- It is necessary from the lender’s side to have all information and
documents regarding the deal. Some include sales documents, bill
invoices, contracts, and others. Also, it benefits in assessing and
reviewing clients’ data.

Difference Between Credit Policy And Monetary Policy

Credit and monetary policy have similar characteristics, they differ slightly.

Basis Credit Policy Monetary Policy

Meaning It refers to the rules the company sets for managing To set and determine the
the credit period and terms of the customers. interest rates for banks
Monetary policies are the regulations for controlling in the country.
the country’s interest rates. Purpose Manage,
handle, and control the credit risk arising from
unknown circumstances.

Types Lenient and restrictive policy. Contractionary and

expansionary monetary
policy.

The issuer Companies, financial institutions, and governments. The central bank of the
of the country. For example,
policy RBI (Reserve Bank of
India) and Federal
Reserve.
 Exception Some nations might refer to credit and monetary None
policy as the same.

VI. Credit Analysis

Credit analysis is the method by which one calculates the creditworthiness of a

business or organization. In other words, It is the evaluation of the ability of a company
to honor its financial obligations. The audited financial statements of a large company
might be analyzed when it issues or has issued bonds. Or, a bank may analyze the
financial statements of a small business before making or renewing a commercial loan.
The term refers to either case, whether the business is large or small. A credit analyst is
the finance professional undertaking this role. Credit Analysis evaluates the riskiness of
debt instruments issued by companies or entities to measure the entity's ability to meet
its obligations. The credit analysis seeks to identify the appropriate level of default risk
associated with investing in that particular entity.

The Five C's of Credit

The five-Cs-of-credit method of evaluating a borrower incorporates both qualitative and
quantitative measures. Lenders may look at a borrower’s credit reports, credit scores,
income statements, and other documents relevant to each lender has its own method
for analyzing a borrower’s creditworthiness. Most lenders use the five Cs—character,
capacity, capital, collateral, and conditions—when analyzing an individual or business
credit application borrower’s financial situation. They also consider information about
the loan itself.

1. Character
- Character, the first C, more specifically refers to credit history, which is a
borrower’s reputation or track record for repaying debts. This information
appears on the borrower’s credit reports, which contain detailed
 information about how much an applicant has borrowed in the past and
whether they have repaid loans on time.
2. Capacity
- Capacity measures the borrower’s ability to repay a loan by comparing
income against recurring debts and assessing the borrower’s debt-to-
income (DTI) ratio.
3. Capital
- Lenders also consider any capital that the borrower puts toward a
potential investment. A large capital contribution by the borrower
decreases the chance of default. Capital contributions indicate the
borrower’s level of investment, which can make lenders more comfortable
about extending credit.
4. Collateral
- Collateral can help a borrower secure a loan. It gives the lender the
assurance that if the borrower defaults on the loan, the lender can get
something back by repossessing the collateral. The collateral is often the
object for which one is borrowing the money: Auto loans, for instance, are
secured by cars, and mortgages are secured by homes.
5. Conditions
- In addition to examining income, lenders look at the general conditions
relating to the loan. This may include the length of time that an applicant
has been employed at their current job, how their industry is performing,
and future job stability. The conditions of the loan, such as the interest rate
and the amount of principal, influence the lender’s desire to finance the
borrower. Conditions can refer to how a borrower intends to use the
money.