CREDIT MANAGEMENT POLICIES AND PRACTICES

STRATEGIC FOUNDATIONS FOR CREDIT MANAGEMENT

TYPES OF RISK ( COUNTRY / BANK / CORPORATE )

A PORTFOLIO MANAGEMENT APPROACH

Credit Management embraces all the activities designed to manage and protect a company’s investment in receivables.

‘Receivables’ are amounts of money owed to the company (seller) by its customers (buyers) for goods (including raw materials and/or services) supplied to the customers.

It is the role of Credit Management to support the Sales Force in its efforts to maximise sales without endangering the survival of the company.

Sales of goods are the only source of revenue and the main source of funds for future growth for most businesses.

Credit Management has an equally important investment management role.

In many companies the investment in receivables is one of the largest assets appearing on the balance sheet and one which demands a significant commitment of precious working capital resources. An increase or reduction in the amount invested in receivables will usually have a significant (negative or positive) impact on the company’s cash flow and on the company’s cash cycle.

The ‘cash cycle’ is the time required to convert goods into cash; from the date the company pays the costs of acquisition of the goods to the date of receipt of the cash from related sales.

When a company agrees to deliver goods, without receiving immediate payment, it gives "credit" to the buyer.

It has been said that "a sale is a gift until it is paid for" - this maxim emphasises firstly that the seller gives the buyer free use of the goods for a period of time and secondly that often in the sale process a tangible asset (goods) is converted into an intangible asset (receivables).

Competition between sellers is the main motivation behind any offer to provide credit.

In a situation of monopoly supply the seller can demand terms such as "cash in advance" but where competition is the rule credit terms can offer a major source of competitive advantage.

In fact when the ‘product’ offered for sale is a ‘commodity’ (such as a certain type of crude oil) it is often true that, when comparing offers made by competing sellers, delivery dates are not materially different and transport arrangements are similar. In such circumstances offering unique credit terms may be the only way to win a buyer from the competition.

It is therefore correct to remark that Credit Management has become an important 'sales tool'.

In a world of increasingly transparent markets (markets where all relevant information is freely available to buyers and sellers) the importance of the role of credit terms in providing a competitive advantage is growing.

Nonetheless the risk of loss of a receivable and the danger which this presents to the survival of the company is still the compelling force behind the need for Credit Management. The loss of a large amount of working capital in this way would almost inevitably lead to the failure of a company.

However this risk should not be eliminated, it must rather be managed.

Risk is an essential business ingredient hence the belief that "taking risk offers reward".

The reverse is a business truism stated thus; "no risk equals no reward".

Risk is also neutral in that a change in perceived risk may present ‘an opportunity to do more profitable business’ as easily as it may present ‘an increased danger of loss’. It is therefore important to regularly review the risk profile of each customer and potential customer noting new opportunities or new dangers present. Subsequent actions by Sales and Credit personnel should be guided accordingly.

Risk has to be defined relative to both ‘expected rewards’ and ‘company objectives’.

A company should be seeking to maximise the benefits and minimise the dangers; while at the same time creating the greatest possible return (profit) for ‘acceptable’ risk-taking.

The definition of what level of risk is ‘acceptable’ will vary from company to company and from time to time. Each company will have a unique definition of ‘acceptable’ risk. This is exactly why it is possible for credit terms to provide a marketing advantage.

The company which is prepared to accept the highest degree of risk will generally be the competitor most likely to win the sale.

There are many categories of risk associated with doing business but the three which are most readily observed in respect of Credit Management are:

1. Country Risk:

The risk that something may happen in a foreign country which will negatively influence the willingness or ability of customers in that country to pay their debts on time.

In this respect it is usual to think in terms of a State decreed moratorium on foreign payments or a situation where assets are nationalised and ‘old’ debts are not recognised. However it is also probable that a severe decline in the external value of a country’s currency would cause all importers with payments due in foreign currency to face bankruptcy without warning. Similarly a harsh tax introduced with retrospective application could convert many previously solvent companies into bankrupt companies. 

(Refer to the Country Risk Article for more details.)

The risk that a bank which has added its name to a transaction (provided payment risk security in the form of a Guarantee or Documentary Credit, for example) will fail to honour its commitment due to bankruptcy.

In the case where a bank has provided security 'corporate risk' (also known as 'customer risk' - see below) is converted into 'bank risk'. However should the bank fail to honour its commitment the seller still has the right to call upon the buyer to pay direct, in terms of the contract. This is true even if the buyer has already paid the bank and given the bank instructions to transfer such payment to the seller. The bank acts as "an agent for the buyer" in such a case so if the bank goes bankrupt while the payment is in process, the buyer must carry the loss. 

(Refer to the Bank Risk Article for more details.)

3. Corporate Risk:

The risk that a buyer will fail to pay either due to financial constraints (bankruptcy) or due to dishonesty (indefinite payment delays without good reason).

This is the main element of risk which is under the direct and active control of the management of the buyer. The management must be honest. The management must also be capable of operating the business effectively day to day and of dealing with crises effectively. Hence a perceptive assessment of the ability of the management of a customer is as important as a competent assessment of the financial and commercial information presented for analysis. 

(Refer to the Corporate Risk Article for more details.)

A PORTFOLIO MANAGEMENT APPROACH

It is important to keep in mind the concept of investment management when considering the management and protection of receivables.

In terms of this concept receivables should be managed at a macro-level using a portfolio approach, as well as at a micro-level.

The micro-management of receivables involves assessing individual banks, assessing individual customers and controlling individual deliveries.

Macro-management is another simultaneous operation whereby the whole receivable portfolio is assessed and controlled with reference to its proportional composition on a country by country basis and also on an industry by industry or sector by sector basis, where applicable.

The underlying philosophy is to spread risks over various categories and over various layers so that the company cannot be destroyed should one customer or one bank or one sector or one country fail.

Macro receivables management entails the notional sharing out of a portion or a multiple of the company’s equity (own shareholders’ funds) to each sector and country.

This is done on the basis of the perceived risk of failure in each case translated into an overall risk limit for each sector and country. The total exposure by division or segment is monitored day to day, on an ongoing basis. If the company’s exposure exceeds a segment limit at a particular time the excess exposure has to be shifted to another segment.

Thus, for example, if the risk exposure in respect of country A exceeds the company’s country A limit the excess must be shifted to say risk on country B. This could perhaps be done by arranging for a bank in country B to guarantee a payment due from a buyer in country A. This would be done even if the buyer in question is a first class risk because it would be important to limit exposure to country A in order to keep the portfolio of risks in balance.

AN EXAMPLE TO ILLUSTRATE A PORTFOLIO MANAGEMENT APPROACH:

Say the company’s capital (own shareholders’ funds) equals $50 million.

In this example the company has the following LIMITS recorded;

A rated Countries; 10 times own funds (i.e. $500 million per ‘A’ rated Country).
C rated Countries; 0.6 times own funds.
A rated Sectors; 5 times own funds.
D rated Sectors; 0.4 times own funds.
Banks; 7 times own funds.

Switzerland $500 million.
Hungary $30 million.

Refineries $250 million.
Traders $20 million.
Banks $350 million.

Refinery A Hungary $10 million.
Refinery B Hungary $5 million.
Refinery C Hungary $25 million.

Trader A Hungary $1 million.
Trader B Switzerland $20 million.

Bank A Hungary $5 million.
Bank B Switzerland $50 million.

A SCENARIO FOR ILLUSTRATION PURPOSES:

In all cases payment terms are "payment in full 30 days after the date of delivery or the date of the Bill of Lading ".

DAY ONE: Refinery A owes the company $15 million for a crude delivery. The company obtains a $5 million payment guarantee from Bank A to cover the excess over Refinery A’s credit limit.

DAY TWO: Refinery B purchases a crude cargo worth $20 million and provides a Documentary Credit, opened by Bank A, to cover the full amount. The company arranges for Bank B to confirm this Letter of Credit thus covering the excess risk in the name of Bank A and converting this exposure from Hungarian to Swiss risk.

DAY THREE: Refinery C agrees to take delivery of two cargoes of crude worth a total of $25 million. This is acceptable in terms of corporate risk limit but when added to the exposure to Refinery A (a net $10 million) and Bank A ($5 million) causes the Hungarian country limit to be exceeded.

The company decides to ask Bank B to provide silent (not disclosed to Refinery C) payment risk cover for $10 million of its exposure to Refinery C. This converts such $10 million in exposure from Hungarian Refinery risk to Swiss Bank risk.

DAY FOUR: Trader A agrees a contract for differences with a marked to market exposure of $1 million. This contract is agreed on open account.

DAY FIVE: Trader B purchases a cargo of crude worth $20 million. At the micro level this is acceptable on open account but it causes the ‘Trader’ segment limit to be exceeded. Therefore the company takes action to convert at least $1 million of this exposure from Trader risk to Bank risk by obtaining silent payment risk cover from Bank B.

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