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title: "Introduction to Customer Credit."
canonical: "https://kb.myframeworks.com.au/space/PROSTIXV48DOC/31101229/Introduction%20to%20Customer%20Credit."
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What is credit? Credit is the selling of a product or service based on payment at a later date. It is a lubricant of commerce that allows for the expanded movement of products and services. It is a sales support function. Sales support is why credit exists and that must be the vision that drives the credit and collection area of business. Companies extending credit terms often have more money tied up in Accounts Receivable than any other asset. Next to cash on hand, A/R is the most liquid asset available being but one step removed from money in the bank. Yet, the credit and collection function responsible for creating and managing Accounts Receivable may be the most misunderstood, under-utilised and under-valued area of a business. Why offer credit? Because there are customers who require that suppliers provide their product and then give them time to determine if they received what was ordered and to process the bill for payment. And there are other customers who must sell to their downlink customers and collect from them before they can pay their own creditors. And then, there are competitors who offer credit terms. What are the major components involved with the credit function of a business? What are the costs and risks involved with offering credit? What are benefits of a sales and profit driven credit functions of a business? What are the roles of the Credit Manager? This course covers all of the given functions under the following topics: Establish and Maintain Credit Terms No system of credit evaluation is fool proof and a large degree of experience and skill is required by the person assigned to manage credit control. There are established guidelines that should be adhered to in evaluating new accounts and in taking up credit references. It is equally important to point out penalty charges and deductions at this stage so that any disputes be resolved before the account gets to the collection cycle. Credit Application Who are we dealing with, a Company, a Partnership or an Individual? You must obtain full names of owners, partners or officers and all business addresses. A review of the local service directory and a request to the Australian Securities Commission may help with determining the full picture. How long has the applicant been in business? Statistics show that 50% of businesses fail in their first year and 75% fail in their first five years. If your are experiencing problems in collecting debt from companies that are in the risk groups, alarm bells should be ringing and a review of their application is in order.  What bank does the applicant do business with? Typically the supplier of the goods/services asks the purchaser to supply details of his bank account to allow the seller to contact the bank and seek a report on the credit worthiness of the purchaser. These references are useful and should be sought for every new account opened to establish both credit worthiness and the amount of credit that may be given. However, it should be borne in mind that the bank has its customers, as well as its own interests to maintain, whilst being careful not to mislead the seller.  Experience leads a credit controller to read between the lines of a bank reply and to evaluate credit worthiness, taking into account both clear signals from the bank and also unclear signals. Who are some of the businesses that the applicant is currently dealing with? It is useful to have the customer supply names of its major suppliers but again, it must be realised that any contact name given by a purchaser is going to be one that will provide the best reference for the customer. Ensure that any response is properly evaluated. In the event of dealing with a major customer, a reliable credit rating agency may provide useful information. Very often a seller knows other companies selling to the purchaser and it is useful to discuss in general terms the credit worthiness of the purchaser. Again this has to be treated with caution and information of this nature should form only part of the decision-making process. Factual information such as the date an account with the business was opened, the $ amount for the average monthly purchases of the customer from the referee and the number of days in which the customer paid their account held with the referee should help in assessing the reference. Seek a Copy of Last Audited Accounts This is probably one of the best indicators of credit worthiness particularly if the accounts are up-to-date. It is important however that the credit controller is able to read and understand a set of financial statements and, if possible, calculate a number of key working capital ratios to assist in the evaluation process. A number of key ratios and application are given below. In the case of a limited liability company, it may be helpful to carry out a search of the company to ascertain further information on the shareholders, directors and details of any debentures or charges registered Visit the Customer It is likely in the event of opening a new account that the sales rep responsible for the new account has visited the purchaser to secure the sale. In that situation, the sales rep should be trained to observe the general operation of the business to see if everything appears normal or if there are signs that the account may be a problem. Things to look for could include:  In the situation where the account is potentially a major one, the managing director or sales director should visit the purchaser as part of the evaluation process. Credit Terms The terms of credit are the conditions upon which a seller supplies to a purchaser. For example 'Account Due Strictly 30 days'. In setting the terms of credit, the following should be considered: Set standard terms:  varying credit terms generally makes it more difficult to achieve a systematic approach to credit control. Do not give credit unless necessary:  where possible, sales should be cash on delivery. However, where credit is expected, supply on industry standard terms. Suppliers should not be persuaded into giving extended terms to win a sale unless the implications of this have been carefully thought out. Ensure that the terms are clearly stated:  define the terms of trade to all new customers and seek their agreement to those terms. Remind customers who over-step the terms of the conditions of sale. Maintain discipline on the terms:  having established the terms at the outset, work at ensuring that customers adhere to those terms. Purchasers may attempt to extend the terms and it is part of good credit control management that the system polices the credit situation with the terms as the reference point and gives rise to action where the credit terms are breached. Suppliers should be firm but fair in applying the terms laid down. Credit Limit All credit evaluations should be stated as an amount which a customer is allowed to purchase. In setting that amount it is necessary to consider:  Terms of credit Likely anticipated purchase Assuming that credit terms are 30 days and that the supplier expects to purchase $2,000 per month, it is pointless setting the credit limit at $2,000. It would be more appropriate to set the limit at perhaps $2,500 to allow for possible likely increases in sales and allow the debtor to trade while a payment may be in limbo. This may be further reduced by the trade reference reports or some other information that suggests the account should be no higher than $1,000 and less than the standard 30 days with an agreement to build up to 30 days after satisfactory performance of the account for a period of six months. Credit Grace This facility allows for the delay between the payment due date and the actual receipting of the monies (grace days). To take the guesswork out of nominating a credit grace amount, extend the credit limit by a proportion based upon the limit:  EgGrace = (Credit Limit / trading terms) * Grace days = (2000 / 30) * 5 = 333 Create a Credit Account Consider the credit terms as the point at which you should expect payment and after which point, your customer has breached the conditions of sale. Good credit control does not give rise to punitive action but rather to persuading the customer to remain within and to adhere to terms laid down. When a customer application for credit has been approved, there are certain fields in the customer setup that will allow the Credit Manager to monitor the terms that have been negotiated for the account. Please refer to  Customer Credit Terminology  for more information. The vetting process should be reviewed regularly on the basis of experience in dealing with the account and the credit rating updated accordingly. The key is to be professional and consistent in the evaluation of credit worthiness. In that regard, potentially large accounts should be treated exactly the same as small accounts. Just because your business is dealing with a large reputable company, this should not necessarily give better payment expectation - indeed it may well be that the larger customer expects more credit and takes longer to pay. It may well be that the large customer requires 90 days to pay and this can cause difficulties with cash flow if the amount supplied forms a high proportion of total sales in any one month. Settlement Discount Settlement discount is a mechanism whereby, for prompt or immediate payment the customer is able to deduct an agreed percentage of the total invoice. Generally this approach requires particular attention as:  Settlement discount percentages are defined in the System Control File and the flag is set at the customer account level. Interest and Accounting Charges Many businesses attempt to levy interest and/or accounting charges on accounts not paid within the standard terms. This may be worthwhile if it ensures that customers pay within the agreed terms but, it can give rise to a loss of client goodwill. It is important that the possibility of incurring penalties is explained as part of the credit application process and penalty details be printed on the appropriate sales documentation so that the customer cannot use these charges as basis for disputing an account. To add interest charges and accounting charges:  Collecting Debtors Accounts Speed is the key to collecting accounts. In planning and carrying out credit policy, the credit manager should recognise that time is the safest refuge of any debtor. The more time they are given, the less likely they are to pay. If an account is late, incomplete, inaccurate or difficult to understand, the debtor has reasons not to pay. The goal of collecting debtors accounts is simple – to facilitate payment. Sales documents should be explicit about payment terms, return privileges, interest charges on overdue accounts, product guarantees and service costs. Consideration may be given to sending invoices out as they are produced rather than holding them until end of month and, more regular statements may be the key for a certain range of customers. Invoices There are fields in the customer set up that regulate the printing of invoices and the amount of details on an invoice for that customer: Statements The issuing of statements should be an organised and consistent request for payment. It is essential to educate customers and to establish regular, on time collections. If you falter with the accuracy of the information on the statement or are slow in issuing statements, the customer can use either as an excuse not to pay or to delay payment of the account. Before statements are printed, it is advisable to print a Debtors Trial Balance and take note of any stray or untidy balances, that is, small amounts or credit amounts spread across various periods. These accounts should be investigated and tidied up before the statement print. Even with a statement, the first visual impression is important. After the first statement goes unheeded, start the credit collection process, noting that procedures for handling slow paying accounts should emphasise speed in contacting the delinquent debtor. The creditor who moves first is the most likely to recover money when a debtor is in serious difficulty. Issuing further statements before the first collection step is taken is likely to lower the recovery ratio.  Diary Notes A diary note is a short message about the customer that can function as a reminder to take some action in relation to that customer. For example, a customer may have promised to pay an account by a certain date. If that commitment is recorded in a diary note with the promised date set as a follow up date, the Credit Department can be alerted to the account on the given date. Diary Notes is an option on the Customer Maintenance screen and entries can be added by pressing/clicking <F6> once the Customer Diary is displayed. Diary Follow Up This option prints a list of all the customer diary notes for a selected follow-up date. The report can be run on a daily basis and forwarded to the Credit Manager to follow-up any expected payments by customers with overdue accounts. Select Diary Follow-Up from the Reporting menu and key the range of customers to include in the listing. Danger Signs Inevitably there are situations where customers take credit greater than that allowed and it is a highlight of a good credit control management system that the customer is returned to standard terms as soon as possible. If the supplier does not force compliance, it is unlikely that the purchaser feels any necessity to comply with terms. It is important to look for danger signals that might arise when accounts break standard terms. Some of the most common signals are: Payments on Account Where a customer was paying total invoices promptly, there may be pending problems if they suddenly start to make partial payments on account. This could suggest cash flow problems and should alert the credit manager to take action. Pay special attention if they are in a risk group. Use the risk code (0-9) or the customer group code to flag these type of customers. Cheque in the Post Where a customer delays the payment by continually promising to pay, the credit manager should be aware that problems may be developing. Use your diary system to ensure prompt follow up on the promises made and that the follow up is made as arranged. Failure to Return Calls Where a customer refuses to take or return calls there is obviously something wrong. Where personal contact cannot be made, an appropriate letter must be sent and the decision should be made whether or not this customer is wanted. Cheques not Honoured This is a danger signal and it is a clear indication that a business is suffering cash problems when its bank refuses to honour cheques. After drawing the distinction between cash flow reasons and technical reasons, get your money and get out. Reports   The following Credit Reports eliminate the need to flip through lengthy ageing reports in order to direct the workflow of the Accounts Receivable Department towards customers that have become high maintenance: Stop Credit List This report prints all customer accounts that fall outside trading terms to the extent that further credit has been denied. This is a good opportunity to contact such customers before they are caused embarrassment at the counter. Customer Balances by Sales Rep This report lists customer details, sorted by Sales Rep and will give the following summarised information for each customer:  The report can then be handed to the appropriate Sales Rep to take action. Stopped Debtors Invoice Register This report lists all invoices and back orders for customers that have exceeded their trading limits and have a credit status of HOLD. The report will include information such as the customer number and name, the date that the account was put on HOLD, the customer home branch, the invoice or back order reference number and date, the amount, the Account Supervisor and the current status of the account. Overdue Accounts This report prints the account details for all customers within the selection criteria with an overdue account. It displays the balance due by the customer, with this balance being aged according to your reporting selections. The date of the most recent payment is displayed and this information can be used when following up outstanding payments. You may specify a minimum overdue amount and a minimum age period in order to concentrate on the more critical accounts. It is suggested that this report be used to check for outstanding COD accounts as well. Customers by Balance Due This report may be used: The printed report lists basic customer details, the aged balance and the account status. Debtor Letters The automation of traditionally labour-intensive collections and credit activity is not easy. Debtor Letters Extraction is one tool available through ProStix that can make this task easier. Contacting a customer say, five days after payment is due and not received lets a customer know that they are expected to adhere to the credit terms agreed upon. While debtors letters should be worded according to the severity of the request for payment, they should be designed to make payment easier for the customer rather than isolate the customer. By not isolating the customer, there is more chance that they communicate  why  they are not paying, giving the credit department valuable feedback for management. It is important to keep track of any communication to a customer regarding breach of their credit terms. When Debtors Letters are extracted, there is an option to make a record in the Diary Notes. When a Customer Enquiry is performed, the Diary Notes for the customer display any entries that have been recorded. Debtors Letters Extraction allows the user to determine the criteria for selecting customers, for example: Suspended or held accounts, for processing in a third party mail merge package.   Internal Controls There are a number of control mechanisms within ProStix that not only identify customers in excess of their credit arrangements but also allow you to direct the workflow rather than concentrating on accounts that are easy, avoiding the more difficult ones. Credit Status There are a three status conditions that are recorded on the customer file: The Stop Credit List lists all accounts that have a credit status of Held or Suspended and details the account balance and ageing details. The Over Credit Limit Report lists all customers who have exceeded their permitted credit limit. The details displayed will include the customer name and number, the balance due and aging details, the credit limit value and the customer credit status, that is, Suspended or Held. Aged Trial Balance The Debtors Ledger must be constantly up-to-date in order to establish who owes, how much is owed and, for how long. Good management information is called for, typically in the form of a Debtors Ledger analysed by customer, amount and the age of the debt. The analysis of debtors balances by age groups: This report allows you to investigate ageing and payment pattern, providing information on a selected range of customers, showing their balance, ageing and credit history. It should always show the correct ledger balance. Reconcile the Aged Trial Balance The total of the Aged Trial Balance represents the total of all the debtors amounts outstanding. If this total does not equal the Debtors Control account, the ATB does not balance. If this situation occurs, some hints on reconciling the ATB are: Credit Notes and Refunds It is suggested that the Credit Notes and Refunds Report be printed at least monthly so that the Credit Manager can monitor unusual credit or refund activity. The report details the type and reason for the credit or refund. Performance Measurements & Reports Historically, credit departments had little opportunity to see what was causing problems and find solutions to them. With the wealth of information available through ProStix, payment collections have become more efficient, the workflow is more fluid and the credit department is much better informed as to the impact of the customer on the company. By prioritising collection activities with the aim of achieving the collection results that you want, customers are segmented in terms of size, risk and other criteria. These criteria become the reporting tools that give management an overview of what is happening; whether present controls are achieving results and can be a basis for taking action. The following reports provide the information that enables the credit department to determine if areas of the company's credit policy are not meeting the needs of the customers: Settlement Discount Highlight This report enables you to report on the difference between the settlement discount allowed and the actual discount that was taken when payment was made, that is, the actual settlement discount taken. By monitoring this figure, management can monitor the effectiveness of offering settlement discounting as a form of marketing and as a collection tool. New Account Checklist This report lists all new customer accounts that have been created between a specified date range, allowing management to monitor any increase in customer base. The information included on the report include:  Bad Debts This report lists the customers who have been flagged as Bad Debts and lists the customers account number and name, the date and amount of the last payment and the total outstanding. If there has been significant movement in this report, the reasons why need to be looked at, for example: Has the number of bad debts increased? Are there any payments being recovered? Receipts for Stopped Accounts This report lists all monies that have been received by customers that have exceeded their trading terms and have had their credit stopped. The report lists the customer number, name and branch, the date that the money was receipted, the amount that was paid and the location of the till that processed the payment, the credit status of the customer and the customer group. Outstanding Deposits This report lists customers who have outstanding deposits on their accounts. Detail included in the report includes:  This report also lists any pre-paid delivery deposits that have been processed through POS.   Enquiries Payment History The easiest way to explain the number of days in the payment history enquiry might be by way of an example: Account Balance = 100,000 Current= 20,000 30 Days= 60,000 60 Days= 20,000 90 Days= 0 120 Days= 0  Sales History Current= 20,000 30 Days= 60,000 60 Days= 40,000 90 Days= 10,000 120 Days= 15,000 The program firstly works out the total sales that are overdue by subtracting the 'Current' due from the 'Balance Due', that is, 100,000 - 20,000 = 80,000. It then searches through the customer's Sales History (starting with last month's sales and working back) until it has accumulated sales for the total amount overdue that is, 60,000 from 30 Days + 20,000 from 60 Days. It then takes the amount that is overdue for each period (above) and multiplies it by the period days overdue that is, 60,000 x 30 and 20,000 x 60 The results for each period are added together and divided by the total amount overdue that is,  1,800,000 + 1,200,000  = 37.5 80,000 The result of this calculation is displayed in the  'Days'  field on completion of the Month End close. There is also a change which is currently going through for open item accounts. Once in place, the number of 'Days' in the payment history for open item accounts are calculated as follows: The program firstly works out which invoices were paid over the month. It then works out which ones were paid on time and which ones were overdue. An invoice is declared overdue if it is not paid within 30 days of the invoice statement date. The 'Days' paid overdue is then calculated for each invoice and averaged (by dividing the number of days overdue by the number of invoices paid for the month). The number of payment days overdue is calculated as follows: For example, Inv 123 Dated 23.05.95 was paid on 15.07.97. Therefore the payment days overdue for this invoice would be 15. If there were 2 other invoices for the month that were paid on time (that is, days overdue = 0), then the payment days overdue for the month would be 5 that is, (15 + 0 + 0)/3 = 5. Current Key Working Capital Ratio Current Assets / Current Liabilities This ratio is an indication of the ability of a business to meet its debts as they fall due, that is, Are the current assets sufficient to cover day to day liabilities? Typically speaking, a ratio of 1.5:1 is reasonable. Quick Ratio (Debtors + Cash at Bank) / Current Liabilities This is a better indication of the ability of a business to pay debts as they fall due. If the company has sufficient funds in debtors and cash to meet its creditors and bank overdraft, then it should be able to pay debts on time. A ratio of 1:1 is acceptable. Creditors Days Average Trade Creditors /Annual Purchases * 365 days This ratio gives an indication of whether a prospective customer appears to be settling accounts on time. For example, if the ratio was: $60,000 / $400,000 * 365 = 55 days then, on average, it would appear that the customer takes 55 days to pay. It must then be considered whether the customer adheres to stated terms or whether terms offered reflect an average of 55 days. Debtor Days Average Trade Debtors / Annual Sales * 365 days This is an indication of your debtors credit control and might give indications as to what the debtors expectations are in terms of being paid.