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CREDIT MANAGEMENT AND COLLECTION

When companies sell their products, they sometimes demand cash on delivery, but in most cases they allow a delay in payment. The customers` promises to pay for their purchases constitute a valuable asset; therefore, the accountant enters these promises in the balance sheet as accounts receivable. If you turn back to the balance sheet in Table 2.1, you can see that accounts receivable constitute on the average more than one-third of a firm`s current assets. These receivables include both trade credit to other firms and consumer credit to retail customers. The former is by far the larger and will therefore be the main focus of this material.

Customers may be attracted by the opportunity to buy goods on credit, but there is a cost to the seller who provides the credit. Take PepsiCo, for example. We saw that in 1998 PepsiCo had sales of $22,300 million, or about $61 million a day. Receivables during the year averaged $2,300 million.1 Thus PepsiCo`s customers were taking an average of 2,300/61 = 37.7 days to pay their bills. Suppose that PepsiCo could collect this cash 1 day earlier without affecting sales. In that case receivables would decline by $61 million, and PepsiCo would have an extra $61 million of cash in the bank, which it could either hand back to shareholders or invest to earn interest.

Credit management involves the following steps, which we will discuss in turn. First, you must establish the terms of sale on which you propose to sell your goods. How long are you going to give customers to pay their bills? Are you prepared to offer a cash discount for prompt payment?

Second, you must decide what evidence you need that the customer owes you money. Do you just ask the buyer to sign a receipt, or do you insist on a more formal IOU? Third, you must consider which customers are likely to pay their bills. This is called credit analysis. Do you judge this from the customer`s past payment record or past financial statements? Do you also rely on bank references?

Fourth, you must decide on credit policy. How much credit are you prepared to extend to each customer? Do you play safe by turning down any doubtful prospects? Or do you accept the risk of a few bad debts as part of the cost of building up a large regular clientele?

Fifth, after you have granted credit, you have the problem of collecting the money when it becomes due. This is called collection policy. How do you keep track of payments and pursue slow payers? If all goes well, this is the end of the matter. But sometimes you will find that the customer is bankrupt and cannot pay. In this case you need to understand how bankruptcy works.

After studying this material you should be able to

_ Measure the implicit interest rate on credit.

_ Understand when it makes sense to ask the customer for a formal IOU.

_Explain how firms can assess the probability that a customer will pay.

_ Decide whether it makes sense to grant credit to that customer.

_ Summarize the bankruptcy procedures when firms cannot pay their creditors