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. 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.

Page 1 of 5

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 Low High Short-term High Low Long-term

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 companys finance is going to be relatively high cost (that is sacrificing low cost finance) but low risk; this will make the companys 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 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. More short-term source of finance, less long- Low cost, high risk leading to high Aggressive approach term source of finance profitability but low liquidity Uses short-term source of finance for Balance between cost and risk, leading to a Matching approach fluctuating current assets and long-term balance between profitability and liquidity source of finance for permanent current assets More long-term source of finance, less less- High cost, low risk leading to low Conservative approach term source of finance profitability but high liquidity

Page 2 of 5

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 shortterm 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 companys request for funds we are more interested in the men behind the company their ability. 9. Miscellaneous Sources: There are many more sources from which can secure funds for short period. They arefriend 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 weeks or months 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

Page 3 of 5

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 owners 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 creditors 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 to the wholesaler, who may also facilitate the retailers 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 sellers 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.

Page 4 of 5

 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 dont 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 st anding and thats 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 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 cant 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.

Page 5 of 5