Page 290 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 13: Receivables Management

13.2.2 Credit Analysis Notes

Besides establishing credit standards, a firm should develop procedures for evaluating credit
applicants. Two basic steps are involved in the credit investigation process – obtaining credit
information and analysis of credit information.

Did u know? On the basis of credit analysis the decision to grant credit to a customer as
well as the quantum of credit is taken.
Sources of credit information are internal and external. Internal means various forms filled in
by the customers giving details of financial operation, trade references of firms with whom the
customer has business, behaviour of the customer in terms of historical payment pattern in
respect of existing credit customer. External sources include copy of the published financial
statements, trade references and bank references. Finally, specialist credit bureau reports from
organizations specializing in supplying credit information can also be utilized.
Once the credit information has been collected from different sources, the next step is to determine
credit worthiness of the applicant. There are no established procedures to analyze the information.
The analysis should cover two aspects – quantitative and qualitative.

The assessment of the quantitative aspect is based on factual information available from the
financial statements, the past records of the firm and so on. Another step may be through a ratio
analysis of the liquidity, profitability and financial capacity of the applicant and comparison
with the industry average. Again trend analysis over a period of time will reveal the financial
strength of the customer. Another approach may be to prepare an ageing schedule of the accounts
payable of the applicant. This will give an insight into the past payment pattern of the customer.
The quantitative assessment should be supplemented by qualitative interpretation of the
applicants credit worthiness. For example, quality of management, references from other
suppliers, bank references and specialist bureau reports.

13.2.3 Credit Terms

Credit terms have three components:

1. Credit period in terms of time for which credit is extended, during this period the overdue
amount must be paid by the customer;
2. Cash discount, if any, which the customer can take advantage of i.e., overdue amount will
be reduced by this amount; and
3. Cash discount period, which refers to the duration during which the discount can be
availed of.
These terms are usually written as 2/10 net 30. The abbreviation 2/10 net 30 means that the
customer is entitled to 2% cash discount if he pays within 10 days (discount period) after the
beginning of the credit period of 30 days. If, however, he does not want to take advantage of the
discount he may pay within 30 days. If not made within a maximum period of 30 days, the
customer would be deemed to have defaulted.
The credit terms such as the credit standards, affect the profitability as well as the cost of this
firm. The three components of credit terms, namely, the rate of discount, period of discount and
the credit period affect the trade-off. Here the analysis is restricted from the point of suppliers of
trade credit.

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