FACTORS INFLUENCING CREDIT POLICY

Competition:
Credit practices within an industry influence the formal credit policy of any individual company. Competitive
conditions place a high degree of importance on credit availability. The credit policy of a company is important
for maintaining or improving its competitive position. Even where credit is not generally a competitive tool, an
individual company can use it in this manner if it is willing to do so.
Customer Type:
The type of customer has a direct limiting influence on the credit policies of all companies in an industry. Where
the buyers’ line of business is characteristically short of capital, it is unrealistic for credit policy to be unduly
restrictive. A company that operates on that basis will not maintain its market.
Merchandise:
The type of merchandise affects the credit policy of the seller in a number of ways. There is a tendency to sell on
a more liberal basis if the merchandise has a relatively high profit margin or high price. Also, terms may be
somewhat more liberal if the merchandise can be repossessed or returned inward in the same condition as it was
sold. On the other hand if the shelf life is shorter of the merchandise then most probably the credit terms will
provide shorter credit period. For example, those that can spoil will require shorter terms, so terms are usually net
10 in the food industry.
Profit Margin:
Markup is important. When profit margins are slim, the credit department may be more careful in the selection of
its accounts. High-markup goods should, at least in thoery, encourage credit professionals to approve sales to
marginal credit risk accounts. In other words, the higher the gross profit margin, the more tolerant of credit risk
the credit manager should be. This is a general statement and not always true.
Unit Price:
It is easier to establish a uniform liberal policy that applies to all customers when the unit price of merchandise is
relatively low. Even on a wrong decision, the dollar amount of risk is low credit exposure is greater. A more
detailed analysis is usually conducted before a customer order is approved.
Geographical Distributions:
The geographical distribution of customers determines credit policy to some degree. Widely separated markets
require particular modifications in credit analysis and in collection efforts. A highly concentrated selling and
buying area, on the other hand, involves a special type of price competition and service requirements.
Government Regulations:
In the case of particular commodities, such as spirits and liquors, government regulations specify credit policies
or procedures which must be followed by the seller. There, the overall policy must take the regulations into
consideration. In a very general way, expected long-range trends in the economy also influence credit policy.
Economic Conditions:
Economic or business conditions are of much greater significance, however, in determining how policy is to be
applied over a shorter period of time. When times are prosperous, ability of debtors to pay their bills is somewhat
improved; however, there is a danger that they may tend to overbuy. During slack business periods, debtors tend
to delay payment of their bills and credit requirements may tend to be stricter. Concurrently, as sales drop, the
company is faced with the problem of maintaining volume in the face of decreasing sales and more demanding
selection of credit customers.

ALTERNATIVE POLICIES FOR FINANCING CURRENT ASSETS/WORKING CAPITAL:

To understand the financing policies of current assets it is essential to understand the two levels of current
assets/working capital and the sources of finance available to them.
Permanent current assets
Permanent current assets are often the minimum current assets held by companies at any given time. Example of
which may include minimum inventory held by a company at any given time for precautionary purpose, others
may include the minimum trade receivable that are almost always outstanding, another permanent current asset
could be the minimum cash balance that company always wish to hold for precautionary and speculative purpose.
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Even though these minimum current assets a still recorded as current assets, it exhibits characteristics similar to
that of non-current assets.
Fluctuating current assets
Fluctuating current assets are therefore the current assets that are used continuously by the company in its
operating activities, such that before it reaches the minimum it takes action to replenish such current assets, such
as inventory, cash etc. with fluctuating current assets, just as it is being used, it is always replenished by the
company anytime such assets reaches re-order levels, or return points etc, to avoid such assets going out of stocks.

SOURCES OF FINANCE FOR CURRENT ASSETS:

Company may use short-term sources of finance to finance the fluctuating levels of current assets and long-term
source of finance for its capital investments in permanent current assets as well as non-current assets. The choice
of which source of finance a company uses to finance its working capital and other activities depend on several
factors such as: availability of fund, the length of time such funds may be required for, the purpose for which the
funds is required, the size of the company, the rate of interest but for the discussion of the financing of the
working capital, the two main factors that needs to be considered are the risk of the finance used and the cost of
finance; either by financing working capital using short or long-term source of finance. The risk and cost factors
are inversely related, in that if a company goes for a low risk source of finance, it is related to a high cost source
of finance and vice versa.
Assuming a normal yield curve where the interest rate curve is upward sloping, a short-term loan will be cheaper
than a long-term source of finance. This means that based on cost, a company may rather choose to use short-term
source of finance than a long-term source of finance.
Based on risk, short-term source of finance (e.g. bank overdraft) is assumed to be more risky than a long-term
source of finance (e.g. long-term bank loans).
In summary: Source of finance Cost Risk
Short-term Low High
Long-term High Low

THREE APPROACHES TO FINANCING WORKING CAPITAL

1. Aggressive approach to financing working capital
The aggressive method is where a company predominantly finances all its fluctuating current assets and most of
its permanent current assets using short-term source of finance and it is only a small proportion of its permanent
current assets that is financed using long-term source of finance.
A company that uses more short-term source of finance and less long-term source of finance will incur less cost
but with a corresponding high risk. This has the effect of increasing its profitability but with a potential risk of
facing liquidity problem should such short-term source of finance be withdrawn or renewed on unfavorable terms.
2. Conservative approach to financing working capital
The other extreme method of financing working capital is where a company decides to use mainly long-term
source of finance and very little short-term source of finance to finance its working capital. This option means
that the company’s finance is going to be relatively high cost (that is sacrificing low cost finance) but low risk;
this will make the company’s profit to be low but does not run the risk of being faced with liquidity problem as a
result of withdrawal of its source of finance.
The conservative method is where a company predominantly finances all its permanent current assets and most of
its fluctuation current assets using long-term source of finance and it is only a small proportion of its fluctuating
current assets that is financed using short-term source of finance.
3. Moderate approach to financing working capital
Between the two extreme approaches to financing working capital is the moderate (or the matching or balancing)
approach. This approach makes distinction between fluctuating current assets and permanent current assets
with the suggestion that to finance working capital; short-term source of finance should be used to finance
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fluctuating current assets, whiles long-term source of finance should be used to finance permanent current assets.
This matches the source of finance with the character of the current assets.
Aggressive approach More short-term source of finance, less Low cost, high risk leading to high
long-term source of finance profitability but low liquidity
Matching approach Uses short-term source of finance for Balance between cost and risk, leading
fluctuating current assets and long-term to a balance between profitability and
source of finance for permanent current liquidity
assets
Conservative More long-term source of finance, less High cost, low risk leading to low
approach less-term source of finance profitability but high liquidity

In short, the financing of working capital approach adopted by a company is very important since it will have an
impact on its profitability and liquidity. It is also important for companies to consider other factors apart from cost
and risk in making such financing decisions with regards to its working capital financing.

SHORT TERM FINANCING:

MEANING AND DEFINITION
“It is the activity of providing fund to the business for the period of one year or less”.
Short Term financing is that from of financing which embraces borrowing or lending of funds for a short period
of time. It refers to the finance obtained on short term basis, usually one year or less in duration. Short term
finance is secured for financing the current assets, for example, inventories.
SOURCES OF SHORT TERM FINANCING:
Following are the sources of short funds available to all business.
1. Trade Creditors: Trade creditors are probably the most important single source of short term credit. Trade
creditors are those business organizations which sell good to others on credit. That is, they do not require payment on
the spot; rather they are to be paid after some days from the date of sale.
2. Customers Advances: Customers often finance the seller through advance payment for the goods. The prices of the
goods to be purchased are paid in advance, i.e. before the receipt of the goods. This practice is prevalent where the seller
does not wish to sell goods without prepayment and the buyer also cannot purchase goods from other sources. The seller
might require advance payment if the quantity of goods ordered is so large that he cannot afford to tie up more fund in
raw materials or in good-in-process. Special type machine manufactures often demand advance payment in order to
protect them from the loss caused by cancellation of contract at a time when the machine has been built up or is in work
in process.
3. Commercial Banks: The commercial banks of a country generally supply funds to the business concerns on a
short-term basis, either with security or without security if the customer is financially established. The banks, collecting
scattered savings of the people, invest a portion of the deposits in the business for a short period of time.
4. Finance Companies: Finance companies usually lend money to business. They are specialized financial institutions
and their primary function is to advance funds to the business
5. Commercial Paper House: They are specialized financial agencies and they are created to purchase promissory
notes and to sell them, in turn, to other investors who desire to have some sort of short-term liquid assets. The firm
having high credit standing can use this source for obtaining short-term funds.
6. Personal Loan Companies: These companies make small loans to individual generally for consumption purposes.
The small business undertakings can procure fund form such companies.
7. Governmental Institutions: There are some governmental and semi-governmental corporations which are
authorized to advance short term funds to business concerns. Their importance is of course not so much less than other
sources.
8. Factors or Brokers: Factoring is a financial transaction whereby a business sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount. In one basic respect, factoring is different from other forms of
financing. In other forms funds are granted to one individual largely on the basis of his property. Factoring is based on a
different philosophy. In considering a company’s request for funds we are more interested in the men behind the
company their ability.

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9. Miscellaneous Sources: There are many more sources from which can secure funds for short period. They are—
friend and relatives, public deposits, loan from officer and the company directors and foreign exchange banks.

ADVANTAGES OF SHORT-TERM FINANCING :

1. Easier to Obtain: Short –term credit can be more easily obtained than long term credit. A firm which has poor
credit rating may be unable to obtain long term funds but it can get, at least some trade credit from sellers who are anxious
to increase their sales. The short-term creditors, by granting loans, assume less risk than long term creditors because there
is less chance of substantial change in the financial soundness of the creditor within a few week’s or month’s time.
2. Lower cost: Short term credit may be obtained with lower cost than the long term finance because of priority of
creditors in general. Because of the prior position given creditors in the matter of claim to income and to assets in
dissolution they generally will accept a relatively low interest.
3. Flexibility: Due to seasonal nature of business many firms have a temporary demand for short-term funds to carry
heavier inventories. Most enterprises are in constant need of short term funds. Short-term financing is flexible in the sense
that the firm is able to secure funds as they are needed and repay then as soon as the need vanishes. Funds may be needed
to meet the daily, weekly or monthly requirements. Such funds can be advantageously supplied by short term credit. It
long term credit is secured to finance the daily or weekly or seasonal variations, it would become inflexible because long
term funds cannot be repaid as soon as the need for funds vanishes.
4. No Sharing of control: Obtaining funds form short term creditors prevents the inclusion of more owners through
the procurement of owner’s funds. This results in maintaining the position of control by the existing owners. Because the
creditors have no voice in the operations of the business.
5. Availability: In many cases, particularly for small enterprises short term credit is the only source available. It may
not be possible for a small firm to obtain long term funds because of poor credit standing. Long-term credit is not
generally granted without adequate margin of protection which the small firms may not be able to provide with. The small
business has then recourse to short term funds.
6. Tax Savings: The cost of short term funds are deductible for income tax purposes while the dividend paid to the
owners is not deductible. Thus a substantial tax-savings may result from the use of short-term funds.
7. Convenience: Short Term credit can be more conveniently secured than the other types of funds. It is more
convenient to pay labour weekly or employees monthly than every day.
8. Extension of credit: Many enterprises purchase equipments, supplies and good by ordering from a supplier with
the intent of paying after delivery has been made. If subsequently the bills are met promptly, the firm acquires a good
credit standing. Then, if any emergency arises for the purchase of any goods the firm.

Disadvantages of Short-Term Financing:

1. Frequent Maturity: Short-Term credit is disadvantageous in the sense that it matures frequently. The principal must be
repaid when due, otherwise the creditors may close the business. The use of such credit is also a risk to the owners’
investment from the inability to meet the creditor’s claims when due. There may be danger of either meeting the
principal payment at maturity of the loan or meeting the principal payment at maturity of the loan or meeting any
periodic interest payment or both. The shorter the credits the greater the potential risk to the owners because of the
problem of prompter repayment.
2. High Cost: The rate of interest paid on short-term financing is usually subject to change with changing interest rates.
The rate of interest usually depends on the risk involved, size of loan, collateral protection, etc. The lenders may demand
a high interest if the credit involves large amount and the potential credit risk is also high or the debtor may not give
suitable security. A high interest may also be demanded when the firm cannot procure funds from other sources on
suitable terms and conditions.

TRADE CREDIT (ACCOUNTS RECEIVABLES )

Definition and Meaning:
Trade credit is a kind of business credit which is extended by the seller of goods to the buyer of the same at all levels of
production and distribution process down to the retailer. Before the goods and services have reached the ultimate users or
consumers, they pass through many hands starting from the producers down to the retailer. Trade credit is used by various
agencies operating in the trade channel between the producer and the retailer. For example, the producer may extend credit

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to the wholesaler, who may also facilitate the retailer’s trade by extending credit to him. Such credits extended by the
wholesaler to the retailer or producer to the wholesaler are known as trade credit.
Trade credit has been defined as the short-term credit by a supplier to a buyer in connection with purchase of goods for
ultimate resale. Trade credit is a credit extended for the purchase of goods with the ultimate purpose of resale. The credit
accepted for the purchase of goods which are consumed by the purchaser is not trade credit—it becomes consumer credit.
So a credit, in order to be designated as trade credit, must be extended in connection with the purchase of goods which must
be resold.
Terms of Trade Credit
Terms of credit vary considerably from industry to industry. Theoretically, four main factors determine the length of credit
allowed.
 The economic nature of the product: products with a high sales turnover are sold on short credit terms. If the seller is
relying on a low profit margin and a high sales turnover, he cannot afford to offer customers a long time to pay.
 The financial circumstances of the seller: if the seller’s liquidity position is weak he will find it difficult to allow very
much credit and will prefer an early cash settlement. If the credit term is used as part of sales promotion then, he may
allow more credit days and use other means for improving liquidity position.
 The financial position of the buyer: If the buyer is in weak liquidity position he may take long time to settle the balance.
The seller may not be willing to trade with such customers, but where competition is stiff there is no choice other than
accepting such risk and improve on sales levels.
 Cash discounts: when cash discounts are taken into account, the cost of capital can be surprisingly high. The higher the
cash discount being offered the smaller is the period of trade discount likely to be taken.

Components of Trade Credit

Free Trade Credit: Credit received during the discount period. When a company buys something from a supplier
they typically will not pay for it immediately. They will be given an invoice and it will have terms that look like "
2/7 n/30". This means that you can receive a 2% discount if the bill is paid within 7 days, or the payment of the
bill in full is due in 30 days.

It provides a very short term financing arrangement for the purchaser because instead of having to pay cash
upfront they can use that cash elsewhere for 30 days at no cost. Of course, there is an opportunity cost involved if
the purchaser wants to wait the whole 30 days before paying bill that is the 2% discount.

Costly Trade Credit: Credit taken in excess of free trade credit, whose cost is equal to the discount lost.

Advantages /Reasons for use Trade Credit:

Low Cost: One of the most important reasons for the use of trade credit is its cheapness. Trade credit, in most
cases, is cheaper than other sources of credit, obtaining funds form finance companies or banks gives rise to many
complications. The lender may impose restrictions on the action of the management. The rate of interest to be
paid on the funds is also determined in advance. In trade credit no specific rate of interest is to be paid.
Convenience of Informality: Trade credit is also used as a matter of convenience. It is convenient to obtain,
because the purchaser receives the goods from the seller when the latter sends the goods on receipt of the order
form the former. The purchaser is to make payment on a stipulated date. But obtaining finance from the financial
institutions is not so easy. Many formalities are to be performed to obtain funds from such institutions.
Less Risk: Trade credit has also got widespread use because of the fact that it is less risky than other sources of
funds. If the credit cannot be repaid by the end of the credit period, the trade creditors usually don’t proceed to
liquidate the firm. If the default is only for a few weeks or a month and does not occur frequently, the creditor
may not even be heard from.
Availability: When other sources of obtaining funds are closed to a business organization trade credit may be
obtained easily. This is especially true of small concerns. Such enterprises do not usually possess a good credit
standing and that’s why, they cannot approach big lending intuitions for loans. The banks, insurance companies
and other finance companies hesitate to lend funds to the business enterprises that are small in size and financially

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weak. They fear that these enterprises would not be able to repay the debt on maturity. As such, the small
business concerns rely mostly on trade credit.

Disadvantages of Trade Credit:

1. Cost of Trade Credit: Trade credit may cause the purchase price to be higher than the list price of the
merchandise because the supplier may demand compensation for the risk transferred to him through accounts
receivables.
2. Frequent Maturity: Usually goods are sold on credit for short term for which a cash discount may be
provided if amount returned before the due date of payment but keeping all this aside, the downside is that this
source of finance can’t be used for longer term and it give a headache to the business to take care of its
accounts payable to prevent from bad credit reputation.
3. Insolvency: When an individual or organization can no longer meet its financial obligations with its lender or
lenders as debts become due, it is considered insolvent. Insolvency can lead to insolvency proceedings, in
which legal action will be taken against the insolvent entity, and assets may be liquidated to pay off
outstanding debts. Businesses with deficit cash budgets for longer periods are more likely to taste these
conditions.

Who Bears the Cost of Funds for Trade Credit?

1. Suppliers -- when trade costs cannot be passed on to buyers because of price competition and demand.
2. Buyers -- when costs can be fully passed on through higher prices to the buyer by the seller.
3. Both -- when costs can partially be passed on to buyers by sellers.

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