Management of Debtors
When a prospective customer asks for trade credit from a seller, he is careful how to put his request, but if he had to be honest and speak his mind, he would possibly actually ask the seller something like this:
â€œIâ€™d like to borrow some money from your company. Iâ€™d like the loan for at least 90 days, but I will probably take longer to repay you, if I repay you at all. There is, in fact a chance that I will not actually repay you and, if I do, it will be after you have spent a considerable amount of time, effort and money chasing me. I do not intend to pay any interest on the amount borrowed and, incidentally, Iâ€™m not giving you any say in whether to give me the loan or not: Iâ€™ve simply taken it.â€
Giving loans is not something that only banks do. Most businesses loan money to their customers in the way stated above, such customers being known as debtors, and this is standard business practice. The only real difference between bank loans and debtors is that banks get paid interest on the money they have lent.
The following, again, is a debtor who is actually speaking his mind:
â€œThe one contribution that debt collectors do make is that every time they telephone me, I have to think up an even more imaginative reason for further delaying the payment: none of the directors are here to sign the cheque, I have run out of cheques and the bank has run out of chequebooks, Maltapost is becoming more inefficient by the day, somebody has set fire to the post office boxâ€¦â€
Though this may seem a rather light-hearted approach, the problem is very real, very costly, and has resulted in the failure of many organisations, particularly in the last few years. It is often not the lack of profit flow that has caused these failures, but the lack of cash flow caused by poor and slow payments by customers.
If you think that this is exaggerated, consider the following example. A companyâ€™s annual sales revenue is Lm1 million and the gross margin on sales (gross profit/sales) is 20 per cent i.e. Lm200,000. After deducting operating and other expenses, and assuming that the companyâ€™s sales had all been for cash, the company would have made a net profit before tax of, say, Lm80,000.
However, the companyâ€™s sales are all on credit and customers take, on average, 90 days to settle their invoices. At any one time, therefore, Lm250,000 worth of debtors is outstanding. Let us assume that cash availability is not a problem â€“ the company either has a positive cash flow or a particularly friendly bank manager. The company still has to fund the outstanding amount. Even in these times of low interest rates, the rate would not be lower than 6 per cent per annum, meaning an annual interest charge of (Lm250,000 @ 6%) = Lm15,000. Moreover, there is the cost of chasing the debt: credit department salaries, legal fees, telephone and postage costs. Let us say that these also amount to Lm15,000 per annum. To cap it all, there are 1 per cent of customers, equivalent to Lm10,000 â€“ this is not a high figure, it is often higher â€“ who prove to be bad debts. These add up to Lm40,000 per annum, which means that net profit will be cut by 50 per cent from Lm80,000 to only Lm40,000.
Agreed, you may say. It is true that our customers take 90 days to pay us, but we also take 90 days to pay our suppliers and our other expenses, so it all comes out okay in the end. To some extent this may be so, and it will go some way to offering a compensatory saving; but staff will not wait 3 months for their salary, neither will the VAT department or the Inland Revenue or the Social Security departments, or Enemalta or Maltacomâ€¦
And do not think that it is only the smaller firms which are the culprits. Selling to the big and well-known names may look good for Public Relations purposes, but they are often the worst offenders, and because of their larger purchase volumes, they would often have squeezed the sales manager on price to such an extent that the gross profit margin is much less than normal. So, you may often find that the 5 per cent gross margin you make on sales to them disappears when they take one year to pay you and you are borrowing from the bank at 6 per cent. Remember also that such big companies often have smart lawyers who can usually find the loophole in your sales contract if they want to!
So, with all this risk and hassle, why sell on credit at all? The reason is to facilitate the sales process, and as an inducement or aid in the marketing of the goods or services of the seller. Because all other sellers give credit, you would find it impossible to sell if you do not do likewise.
One of my favourite sayings is that â€˜if you do not manage debtors, debtors will manage you.â€™ Another is that, in spite of what accountants say,â€™ a sale is not made until you get paid.â€™ It is not enough for a business to induce the customer to choose its product or service over that of its competitor, but it must ensure that it actually receives the cash and receives it in proper time. This objective can only be achieved if we have in place a proper credit policy.
The following are the essential elements of a proper credit policy:
1. Who sets the Credit Policy
Research indicates clearly that most organisations in Malta have no formal or even clear credit policy, and fewer still have any sort of policy set out in writing. This often sets the stage for problems for these organisations.
In a properly set-up organisation there is usually a credit manager, (in Malta it is often the Accountant) whose function it is to monitor and chase trade debtors. However, the setting of the firmâ€™s credit policy should not be his prerogative. Top management should set this. Why?
The reason is that credit policy should not be viewed in isolation, but must support the firmâ€™s objectives. Only top management should decide what these objectives should be. Once such objectives are determined, top management, in consultation with the credit manager, will devise a credit management policy that will complement and support corporate objectives. In this way one eliminates from the start those conflicts that often arise between the sales and credit departments: the sales department wants to increase sales at all costs, irrespective of the creditworthiness of the customer, while the credit department does not want to run any risk of bad debts. This gives rise to conflict. However, when the policy is clear, sales do not over-reach, while credit policy is not so strict that it seeks to avoid total risk to the detriment of sales.
2. The Clientâ€™s Creditworthiness
The customer who applies for credit should be required to produce proof of his ability to settle within an agreed period the amount he owes. This is the time to make sure that the customer is creditworthy. Most debtors (customers) fully intend to pay their debts, but many executives tend to be too optimistic about their financial condition and future prospects, and thus find themselves short of funds.
The initial credit application, which should be done in writing, is intended to provide the credit manager with certain information that can be readily verified. Greater detail can be sought later, if necessary, in the form of financial statements. The information included in the initial application should enable the seller, however, to avoid considering doing business with those customers who have little prospect of success or whose past performance indicates that they are unable to meet their obligations when due. The seller should not deal with customers who ask for credit but who refuse to supply the information requested.
What facts are important, and why?
First, who owns the business? Who runs it? Beyond the simple requirement of getting the signatures of those executives who can bind the company (normally the directors and managers), this question is intended to find out something about the character of the owner and the senior executives. The reputation of the companyâ€™s Chief Executive Officer carries great weight when it comes to such decisions, and is not difficult to discover, especially in a small country like Malta where everyone knows everyone else.
Again, the owner of a business may have large personal resources and be willing to pledge them to support his business. Such a factor would be carefully considered by the credit manager, and weigh heavily in the customerâ€™s favour. An unwillingness to do so is also an important pointer, but in the opposite direction.
The credit manager would also want to know something about the history of the business. How old is it? How has it developed? How does it meet its obligations? The answer to these and other questions are obtained from trade references, credit rating agencies, banks (to a limited extent), and financial statements.
Banks can be sources of useful information about customers, though in many countries nowadays laws dealing with privacy have restricted the information which banks can supply. Banks also tend to be reluctant to commit themselves formally to recommending a customer lest they be held responsible if that customer should default. However, the credit manager may often obtain useful information by talking to the customerâ€™s bank manager, especially if the client has given permission to do so. In addition, the credit manager may ask his own banker for indications he may have of the clientâ€™s creditworthiness, as bankers hear a lot of things. Information can be passed on by the banker in general terms without violating any confidentiality.
In Malta, one good source of information is your companyâ€™s lawyer. Because of their presence in Court, lawyers tend to hear about businesses which have been, or are currently in trouble.
Professional credit rating agencies, such as Dun and Bradstreet, can also be consulted. Their information is useful as an indicator of performance for an established business, but they can usually report little or nothing about one just getting started. In Malta there are nowadays other such agencies, including Creditinfo Malta Ltd, offering information about customers, suppliers and other business partners. Following some recent bankruptcies in the retail sector, the MACM (Malta Association of Credit Management) was set up in 2001, with the aim of providing a central national organisation for the promotion of all credit interests to local businesses.
A customer can also be asked to provide trade references from suppliers he is already dealing with. Keep in mind, however, that no customer is going to list a reference on a credit application if he has ever failed to pay that supplier in time. The credit manager should therefore try to check with other suppliers in the same line and find out if the applicant has ever done business with them and what the results were. (In Malta, this cross checking is done regularly among insurance companies when they have doubts about a customer).
The general economic situation, and the industry conditions, will certainly have a bearing on the credit decision, though most credit managers give more importance to character and past performance. Some companies always manage to survive bad economic conditions and succeed even when times are bad. However, if credit has already been given and suddenly conditions get bad, then credit managers should watch over their accounts more carefully, check the outstanding balances (especially the bigger ones) more frequently, and revise the credit limits more often.
The purpose of all this checking before giving credit is to ensure as much as possible the creditworthiness of the customer. Creditworthiness, however, is rarely assessable in absolute terms, and it will be a matter of judging the risk in each case and categorizing the customer accordingly. Some risk is inevitable when business is done on credit, and this must be balanced against the expected returns from the additional sales. Initially, a new customerâ€™s credit limit should be set at a low level and increased only if his payment record justifies it. Even in the case of old customers, the credit limit and period should be periodically revived, and should be raised only at request of the customer and if his credit performance has been good.
3. Credit Limits and Credit Periods
These should be established when the initial request for credit is being considered.
In a computerised setting this is a simple matter. The customer is assigned an account number and all payments and charges enter the computer system before an invoice is issued. The credit limit is programmed into the computer for each account, and any new sale which will lead to exceeding the limit is automatically rejected. Rejections would then normally be brought to the attention of the credit manager for a decision. He may approve a small excess and â€˜overrideâ€™ the system, but any large excess should call for an investigation and perhaps a demand on the customer to prove that he can settle the amount soon.
In most cases the period of credit is set by the convention of the trade, and very little flexibility is available to the individual business. It is usual to find credit periods of 30, 60, or 90 days i.e. payment has to be made within that interval following the date of the invoice.
It is useless demanding cash with orders if oneâ€™s competitors are giving, say, 30 days credit. Only a very marked price or quality advantage would make this possible. On the other hand, there is usually little point in offering more credit than your competitors. This would tie up more of your funds, and although it will possibly attract more customers (research carried out in Malta indicates this), there is a risk that many of these will be less creditworthy, leading to higher bad debts.
However, if a firm is considering extending credit to attract more customers, it is first
necessary to determine:
1 The expected additional sales volume;
2 The profitability of the extra sales;
3 The extra length of the average debt-collection period;
4 The return on the investment in additional debtors.
Kreditsails Ltd. is considering a change of credit policy which will result in a slowing down of the average collection period from one to two months. This policy is expected to produce an increase in sales amounting to 25 per cent of the current sales volume.
You have been given the following information:
Sales price per unit Lm10.00
Variable costs per unit Lm8.50
Current sales per annum Lm2.4 million
As a result of the expected additional sales, the average stock level would have to increase by Lm100,000, and creditors by Lm20,000.
The company has a cost of capital of 24% per annum. Should it extend the credit period as proposed, if this is to apply to both its existing and new customers? Answer: the change in credit policy will only be justifiable if the return on the additional capital employed exceeds the cost of this capital.
1 The extra profit is calculated as follows: Increase in sales: Lm2,400,000 x 25% Lm600,000 Contribution/Sales ratio (Lm1.50/Lm10,00) 15% Increase in contribution: Lm600,000 x 15% = Lm90,000
2 The extra working capital required is calculated as follows: Average debtors (Lm3,000,000 x 2/12) Lm500,000
Less: Previous average debtors (Lm2,400,000 x 1/12) 200,000
Increase in debtors 300,000
Add: Increase in stocks 100,000
Less: Increase in creditors (20,000)
Net increase in working capital 380,000
Increase in financing costs: Lm380,000 x 24% 91,200
Less: Increase in sales contribution (90,000) Net increase in costs 1,200
Conclusion: the credit period should not be increased, as the costs will outweigh the benefits.
4. Offers of Cash Discounts
Many firms offer a cash discount for the quick settlement of accounts. A typical invoice might state: â€œTerms 2.5% cash discount within 7 days, otherwise 30 days net.â€ This means that the debtor is allowed up to 30 days to settle his bill at the stated amount, but if he pays it within the first 7 days of this period he may deduct 2.5% from the total. If the debtor takes up the discount offer, the effect would be to reduce the average level of trade debtors; so one would expect that the amount of cash discount would be related to the firmâ€™s cost of capital.
In practice, however, the discount is usually more generous than this. This is because early payment not only reduces capital requirements for the seller, but also saves him administration costs in pursuing outstanding debtors, and also reduces the risk of bad debts. There may also be a hidden element of price reduction in the cash discount. It is a concealed way of offering lower prices to a sector of the market which might otherwise go to competitors. Research has shown this to be the case in Malta.
5. Collection Procedures and Credit Control
A customer who has been paying regularly suddenly starts slowing down his payments. This is always a danger single, and if you are the credit controller you must try and discover immediately the reason for this, either perhaps by asking the salesman to call on the customer, or by phoning the customer, or asking around for information. The worst thing to do is to sit and wait for developments. In any case discovering, hopefully, that there is nothing to really worry about will set your mind at rest.
One danger signal that should not be ignored is the sudden unavailability of any of the people that you usually contact. This often starts to happen after collection efforts have been started but with no success. The firmâ€™s managers and directors, at a loss what to do and embarrassed by constant demands for payment, are â€˜abroadâ€™, â€˜sickâ€™, or in a meetingâ€™.
When a debtor starts acting suspiciously, the best method of enforcing payment is to stop any further supplies to him while you investigate. This will show him that you really mean business, and in any case will ensure that your problem does not grow any bigger. If the customer finally pays up, you should still not relax and go back to the old arrangements before you are fully satisfied that he has no long-term underlying problem. In fact you would be strongly advised to start all over again the whole process of assessing his creditworthiness.
If your efforts to collect do not give results, you must decide on your next step. If you believe that the customer is in deep trouble, you should not hesitate to take strong measures. How?
Collection letters are rapidly losing popularity among modern credit managers. The telephone, they say, is a better way to get results. Some still use letters which may begin as polite reminders and go on to threats of court action. Here again, credibility plays an important role. A firm that sends out half a dozen pre-printed or computer-generated letters, each threatening something worse than the last, loses credibility. If you threaten to sue unless payment is effected within a week, make sure that you if payment is not effected within the week. Of course, this will probably mean the end of your relationship with the customer, who will probably go to your competitor. Let him do so, he will be doing you a favour in helping to ruin him! You certainly do not need such customers.
One final but important thing; Maltese legislation for combating late payment was introduced in 2001. The Business promotion Act, section 45 (1) states that if payment is due to an undertaking which is a micro-enterprise, and such payment is due by a medium-sized or large enterprise, government departments, local councils, or a government-owned or controlled entity, it shall carry legal interest as stipulated in the Act. Very few businesses seem to be aware of this provision, and nobody seems to make use of it.
Maltaâ€™s entry into the EU on May 1, 2004 will also mean the automatic adoption of the EU late payment Directive 2000/35/EC, aimed at curbing late settlement of debts by charging interest at a substantial rate on overdue accounts. The Directive defines a fixed reference period of 30 days commencing from the date of receipt of invoice or receipt of goods. It also recognizes that the seller retains title to goods until payment is effected. Unless the debtor is not responsible for the delay, the creditor can claim compensation for all costs incurred in recovering the debt.