Credit Extensions

Investigation

Before you decide, get the facts. Thorough investigation of credit requests protects you from the fraudulent applicant who has no intention of paying as well as the applicant who is extremely slow in paying.

Credit Applications

The basic source of information for decisions on credit extensions is the credit application. There are three major factors to consider in evaluating a credit applicant. The first is the applicant's ability to pay, based upon income and obligations. The second is willingness to pay, which can be determined from the applicant's credit history. The third factor is potential profitability of the account. You stand to lose your cost of the product or service sold to the customer if you cannot collect an account. If your cost is relatively high compared to the selling price, then you have to be particularly careful in assessing credit risks.

Application Evaluation

Your evaluation of any credit application will depend upon a number of factors. In the case of an individual applicant, you will want to consider the following:

• Employment history
• Current position
• Current income
• Time on job
• Job security
• Monthly obligations (rent, loan payments, food, utilities, etc.)
• Bank balances
• Personal assets (house, cars, stocks, bonds, etc.)
• Credit standing
• Amount of credit desired

Information Verification

Information on credit applications must be verified to ensure that it is correct, current, and complete. A good place to begin is the place of employment to verify that the applicant is employed and that income and time on the job have been reported accurately.

Bank references should also be verified. While laws restrict the amount of information that banks can disclose, checking on this information can protect you from obvious fraud and may give you some indication of the applicant's ability to pay. Most banks will confirm the existence of an account and disclose a broad idea of the average balance. The bank may also indicate whether or not the account has been satisfactory.

Credit Bureaus

An important source of information for retail credit is the local credit bureau, which generally provides information on credit applicants to firms that are bureau members. Annual membership fees usually depend upon the size of the business.

Besides the membership fee, there is a nominal charge for each inquiry on a credit applicant. Your local credit bureau will provide you with details about services and costs.

Stability

In situations where the time or cost of a comprehensive credit check is prohibitive, professional credit managers have often found that a quick evaluation can be made based upon the applicant's stability. Stability is determined by the length of continuous employment and residence. This assumes that the person who has been employed for several years on the same job will most likely continue to be employed and therefore will be able to pay. Similarly, continuous residence indicates a desire to maintain standing in the community.

Summary

Commercial accounts should complete an application similar to that used for personal credit. Unlike individual credit applications, it is often difficult to verify information on income and expenses for businesses. It is also more difficult to make estimates of these factors for commercial accounts. There are situations where it may be reasonable to request a financial statement from the commercial account before extending credit, but these situations are not typical. Instead, you must rely more heavily upon references such as banks and suppliers with whom the applicant does business, the applicant's reputation in the industry, identity of officers, and so on.

The application should note the names of individuals who are authorized to purchase for the account so that fraudulent purchases can be detected. There should also be an indication of purchase order requirements so that you will be protected in the event of an unauthorized purchase.

Frequently, the commercial applicant with a marginal credit rating will list only those suppliers with whom a satisfactory relationship has been maintained. However, you can often use your own judgment and knowledge of your industry and locale to determine other suppliers with whom the applicant may have done business. If there is any doubt in your mind as to the credit worthiness of the applicant, it is always a good idea to contact these other sources to find out what their experience has been.

Commercial Credit Services

The average collection period is calculated as follows:

Accounts Receivable
_____________________
Average Daily Credit Sales

Or, viewed another way, the total amount owed by customers is equivalent to 45 days' credit sales, on the average.

For example, if a business had average monthly credit sales of $6,000 and outstanding accounts receivable of $9,000, the collection period would be calculated as follows:

                                     Average Monthly Credit Sales       6,000
Average Daily Credit Sales = _____________________ = ________ = 200
                                                             30                           30

                                           Accounts Receivable           9,000
Average Collection Period = ______________________ = ______= 45 days
                                          Average Daily Credit Sales    $200

The average collection period can be compared with any of the following bases to determine whether or not a problem exists:

The extent of the receivables' excess can be measured by comparing your actual receivables with a target level. For example, assume that your terms of sale specify payment Within 30 days, and your industry average collection period is approximately 30 days: A suitable target for your receivables Would then be 30 days' average credit sales.

If your average daily credit sales are $200, you could then calculate a target for receivables as follows:

Average daily Sales x Collection Period = Receivables

$200 x 30 = $6,000

Analysis of your average collection period will help you identify and measure receivables problems in total. However, immediate corrective action requires identification of individual problem accounts.

Problems in individual accounts can be detected through analysis of your receivables by aging. A receivables aging divides each customer's account into amounts that are 0-30 days old, 31-60 days old, 61-90 days old, etc.

The longer an account is past due, the more serious the problem. These can be identified quickly by aging, and corrective action can be initiated promptly.

For example, examine the receivables aging below. The first account shown, L. Brown, has a total outstanding of $775.02. Of this amount, $317.91 is 0-30 days old, $222.63 is 31-60 days old, $156.32 is 61-90 days old, and $78.16 is over 90 days old. Some prompt action seems required.

 The fundamental rule of sound receivables management is to minimize the time span between the sale and collection. Any delays that lengthen this span cause receivables to build to unnecessarily high levels and increase the risk of uncollectible accounts. This is just as true for delays caused by your billing and collection procedures as it is for delays caused by the customer.

Proper collection procedures begin with invoice preparation. Invoices should be prepared promptly and accurately. Promptness eliminates one possible source of delay. Accuracy prevents those delays that occur when the customer disputes the invoice and returns it for correction, triggering a chain of events that is time-consuming and often costly.

Payment terms normally include discount terms and dating terms. Discount terms describe the discount available, if any, for prompt payment. Dating terms specify the time when payment is due.

Discount terms are usually described as follows: 2/10

The number before the / is the discount percentage, in this case 2%. The number following the / is the number of days within which payment must be made in order to take advantage of the discount. In the example, the customer can take a 2% discount for payment within 10 days.

This leads to the next question, 10 days from when? And, if the customer lets the discount period pass, when is the net amount due? The answers to these questions are specified in the dating terms. Extending our previous example a little further, the terms might be expressed as follows:

2/10 - n30

Large accounts often specify certain requirements for invoice preparation. They may require reference to a purchase order, proof of delivery, or a certain number of copies. Be certain that these conditions are m

To keep customers advised of their account balances, monthly statements should be submitted to all open accounts. The statement should summarize the amount owed and any activity in the account within the month.

Abbreviations are used to specify the beginning of dating periods that are different from the invoice date. Two common abbreviations are "EOM," End of Month, and "ROG," Receipt of Goods. In the first case, EOM, the discount and net periods begin at the end of the month, regardless of the invoice date. In the second case, ROG, the periods begin when the customer receives the goods, regardless of the invoice date.

Assume that an invoice issued on September 15 had the following terms:

2/10 - n30 EOM

The customer would be entitled to a 2% discount for payment by October 10. If the discount is forfeited, the net amount would be due October 30.

In some businesses, a delinquency charge for late payment is used to discourage customers from allowing their accounts to become long past due. The delinquency charge normally involves a finance charge or service charge of 1% to 1.5% per month on all balances more than 30 days past due. For example, if a customer's statement at the end of June indicates a total balance due of $630, of which $417 is more than 30 days past due, the finance charge for June would be calculated as follows (assuming a 1% delinquency charge):

$417 x .01 = $4.17

Many businesses are reluctant to enforce strict collection procedures. The reasons for this are several, and none of them are valid. Some people simply are embarrassed to ask for money even though it is owed to them. Others express concern that they might alienate a "good customer" and perhaps lose an account. The opposite is true. How good is an account if the bills are not paid? Even more important, the customer owing you a large balance may be reluctant to do more business with you until the account is cleared. You have not only lost your money, you have also lost a customer.

When an account becomes approximately 15 days past due, the customer should be sent the first collection letter. Since the account cannot be considered seriously delinquent at this time, the tone of the letter should be moderate. Later letters should establish a firmer tone so that the customer is made aware of the seriousness of the situation.

The 15-day past-due letter should read about as follows:

Dear Mr. Adams:

According to our records, your current balance due is $473.25. Of this amount, $215.38 is more than 30 days past due. As you know, our normal terms require payment within 30 days after the invoice is sent to you.

Since you have established an excellent credit rating with us in the past, we are surprised to see a problem arise at this time. If there is some error, or you are unable to pay the amount due immediately, please contact me so that we can correct the situation or make suitable arrangements for prompt payment of this obligation.

Thank you for your attention to this request.

Very truly yours,

A second letter, 30 days later, might read as follows, if no response has been received from the customer:

Dear Mr. Adams:

We have not received any response from our statements of the last two months nor to our letter of September 15. Your entire account is now 45 days overdue, and you owe us a total of $473.25.

If there is some reason why this payment cannot be made immediately, please contact us so that we can make arrangements that will be mutually agreeable. Perhaps we can work out a payment schedule that would be realistic for your present circumstances.

Naturally, we do not want to endanger your credit rating or destroy the good relationship that we have maintained in the past. Therefore, would you please take care of this obligation immediately so that we will not have to file an unfavorable report with the credit bureau or resort to the use of a collection agency or an attorney.

We have enclosed a self-addressed envelope for your convenience. Please return it as soon as possible with your check for the balance owed.

Very truly yours,

If this is unsuccessful, a stronger letter should be sent in 30 days:

Dear Mr. Adams:

We still have no response from our statements of the past three months nor from the letters that we sent you on September 15 and October 15.

Your entire account is now seriously past due: It is obvious that our efforts to clear the account on a mutually agreeable basis have had no impact. Unless we receive payment from you within seven days, or can work out a mutually agreeable arrangement to discharge this obligation, we will have to report the matter to the retail credit bureau.

Subsequently, the account will be turned over to a collection agency or to our attorneys for further action. Since this is a costly procedure for both of us, and will cause serious damage to your credit rating, I would suggest that you call immediately so that we can clear the matter at once without resorting to such procedures.

Very truly yours,

Jim Madison

Frequently, an even more persuasive approach is through use of the telephone. The ground rules are basically the same. You must become progressively firmer with each call and indicate that stronger measures will be used if necessary to ensure prompt payment.

The telephone has the added advantage of flexibility since you can be more direct with better knowledge of the individual account.

You acquire this knowledge through asking questions such as the following:

• "What seems to be the problem? We never had difficulty with your account in the past."
• "How much would be a reasonable amount for you to pay each month? Perhaps $50, $60?"
• "How soon can we expect payment of this amount?"

Try to avoid questions that can be answered "yes" or "no." If the creditor gives you an answer such as, "I'll mail it today," answer with: "I appreciate that. Then I can expect it in two or three days. If I don't have it by then, I'll call you back."

 If your own collection efforts fail, there are two courses of action that are left to you - the collection agencies and the courts.

Collection agencies are businesses established to collect past-due accounts receivable on behalf of creditors. The primary advantage that collection agencies offer is their superior knowledge of persuasive collection techniques. Additionally, creditors are usually anxious to clear invoices referred to collection agencies rather than further damage their credit ratings.

The collection agency's fee is usually based upon a percentage of each account collected. The percentage ranges from 25% to 50% depending upon the size of the account or the total dollar volume of accounts referred to the agency for collection. This approach, while often effective, can be expensive.

If the collection agency fails, your final recourse is through the courts. The matter may be resolved in a small claims court if the amount owed is small. For larger amounts, you may have to file suit to collect. In either case, you are faced with a costly and time-consuming procedure.

Credit card service is available from your regular commercial bank. Receipts from bank credit card purchases can be deposited daily and are immediately credited to your checking account. The bank assumes all credit risks provided that you follow instructions for approval of credit card purchases. Typically, these instructions require that you check the validity of the card against a master list of canceled cards and contact the credit service before accepting the customer's card for purchase above a certain limit.

Credit card services are particularly vital for businesses with a large number of relatively small accounts. They eliminate the need for credit approval, invoice preparation, record maintenance, and collections. They also minimize your commitment of capital and virtually eliminate the risk of un-collectible accounts. From a marketing standpoint, the availability of instant credit could often encourage a customer to buy immediately, rather than postpone the decision to a later date or bypass it completely.

The establishment and execution of credit and collection policies can minimize problems associated with accounts receivable. As with all policies, they must be reevaluated from time to time in order to determine their effectiveness. If your business already has policies for receivables management, evaluate them according to the check list on the following pages. If you do not presently have credit and collection policies, you can use the check list as a guide in establishing policies.

Your answer to all questions should be "Yes" or "Not Applicable." If you have any "No" answers, you should consider revising your policy or have a strong and valid reason for not doing so. For example, you may have a "No" answer to the question, "Do you offer a cash discount?"