The Credit Period And Standards

A firm’s regular credit terms, which include the credit period and discount, might call for sales on a 2/10. net 30 basis to all “acceptable” customers. Here customers who pay within 10 days would be given a 2 percent discount, and others would be required to pay within 30 days. its credit standards would be applied to determine which customers qualify for the regular credit terms, and the amount of credit available to each customer.

Credit Standards

Credit standards refer to the financial strength and creditworthiness a customer must exhibit in order to qualify for credit. If a customer does not qualify for the regular credit terms, it can still purchase from the firm, but under more restrictive terms. For example, a firm’s regular credit terms might call for payment after 30 days, and these terms might be extended to all qualified customers. The firm’s credit standards would be applied to determine which customers qualified for the regular credit terms and how much credit each should receive. The major factors considers when setting credit standards relate to the likelihood that a given customer will pay slowly or perhaps end up as a bad debt loss.

Setting credit standards requires a measurement of credit quality, which is defined in terms of the probability of a customer’s default. The probability estimate for a given customer is, for the most part, a subjective judgment. Nevertheless, credit evaluation is a well-established practice, and a good credit manager can make reasonably accurate judgments of the probability of default by different classes of customers.

Managing a credit department requires fast, accurate, and up-to-date information. To help get such information, the National Association of Credit Management (a group with 43,000 member firms) persuaded TRW, a large credit reporting agency, to develop a computer-based telecommunications network for the collection, storage, retrieval, and distribution of credit information. A typical business credit report would include the following pieces of information:

1. A summary balance sheet and income statement.
2. A number of key rations, with trend information.
3. Information obtained from the firm’s suppliers telling whether it pays promptly or slowly, and whether it has recently failed to make any payments.
4. A verbal description of the physical condition of the firm’s operations.
5. A verbal description of the backgrounds of the firm’s owners, including any previous bankruptcies, lawsuits divorce settlement problems, and the like.
6. A summary rating, ranging from A for the best credit risks down to F for those that are deemed likely to default.

Although a great deal of credit information is available, it must still be processed in a judgmental manner. Computerized information systems can assist in making better credit decisions, but in the final analysis, most credit decisions are really exercises in information judgment.