Receivables and credit policy - Credit terms, screening, and...

Learning Outcomes

After studying this article, you will be able to explain how to establish and implement effective credit policies for receivables management. You will be able to describe key elements of credit terms, assess the creditworthiness of customers, and outline methods for collecting outstanding debts. You will understand the financial impact of these policies and recognize common issues relevant to the ACCA FM exam.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the principles of managing accounts receivable and the application of credit policy. In this article, focus your revision on:

• The objectives of receivables management and its role in working capital control
• The key components and implications of setting credit terms
• Techniques for assessing creditworthiness, including the sources of customer information
• Management of the credit collection process and handling overdue debts
• The impact of credit policy on liquidity, profitability, and bad debts

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is NOT typically a goal of receivables management?
   1. Maximising sales revenue
   2. Minimising irrecoverable debts
   3. Reducing customer satisfaction
   4. Improving cash flow

2. True or false? Offering longer credit periods to all customers will always increase a company’s profits.

3. What is the main purpose of credit screening?

4. Briefly describe two methods a company can use to recover overdue debts.

Introduction

Establishing and managing receivables and credit policy is essential for balancing business growth with financial discipline. Allowing sales on credit can boost revenue but also increases risks and strains cash flow. A well-defined credit policy sets clear rules for customer credit, ensures consistent decision-making, and minimises financial losses from bad debts.

Financial managers must make informed decisions about: what credit terms to offer, which customers receive credit, and how to ensure timely collection. This article covers all three main areas—credit terms, credit screening, and collection—required by the ACCA FM syllabus.

Key Term: Receivables
Amounts owed to a business by its customers for goods or services sold on credit, shown as current assets on the statement of financial position.

Key Term: Credit Policy
A set of guidelines governing to whom credit will be extended, the terms of such credit, and the measures for collecting overdue accounts.

Key Term: Credit Terms
The agreed conditions under which credit is offered to customers, including length of payment period, any discounts, and penalties for late payment.

Key Term: Credit Screening
The process of assessing a customer’s creditworthiness before granting credit, using relevant information to evaluate risk.

Credit Terms: Setting Effective Rules

Clear credit terms form the basis of the receivables policy and affect both profitability and liquidity. Credit terms determine how much time customers have to pay, any available cash discounts for early payment, and any interest or penalties charged for late payment.

Common Elements of Credit Terms

• Length of credit period (e.g., 30 days from invoice date)
• Early settlement discount (e.g., 2% if paid within 10 days)
• Penalties or interest charges for late payment
• Maximum allowable credit limits per customer

Setting generous credit terms may help win sales but increases exposure to bad debts and can pressure cash flow. Conversely, very restrictive credit can deter valuable customers or reduce competitiveness.

Worked Example 1.1

A company usually offers all customers 30 days to pay, but a large new customer requests 60 days. If annual sales increase by $50,000 but overdue balances rise by $20,000, what is the potential impact?

Answer:
Extending credit may boost sales but ties up more cash in receivables. The company will incur higher financing costs on the $20,000 receivables. There is also higher risk of default. Before agreeing, the financial manager must weigh the sales benefit against these additional costs.

Credit Screening: Assessing Customer Risk

Before granting credit, companies should evaluate the likelihood of being paid on time. Credit screening aims to minimise irrecoverable debts by identifying risky customers.

Common sources of information include:

• References from other suppliers or banks
• Credit agency ratings
• Analysis of published financial statements
• Company’s own sales history with the customer
• Credit scoring models based on payment history, size, and industry sector

The outcome of screening is to approve, reject, or modify the credit application—possibly reducing credit limits or demanding payment in advance for risky customers.

Worked Example 1.2

A small business’s credit controller receives an order from a new client worth $8,000. By reviewing the client’s accounts, she finds overdue debts with other suppliers and county court judgments listed in a credit agency report. What should she recommend?

Answer:
She should recommend not extending credit or requesting payment in advance. The customer’s poor credit record raises the probability of late or non-payment.

Collection: Managing and Recovering Receivables

Having set credit terms and screened customers, the next step is ensuring payments are collected efficiently. Delays in receipt of cash increase financing costs and risk.

Collection procedures should be systematic:

• Issue invoices promptly
• Send reminders as due dates approach
• Telephone or email overdue customers
• Place persistent late payers “on stop”—withhold further supplies
• Engage debt collection agencies if necessary
• Pursue legal action for irrecoverable debts as last resort

Strong collection minimises bad debts and keeps cash flowing. For key clients with temporary difficulties, flexible negotiation might help preserve relationships.

Worked Example 1.3

After 35 days, a customer has not paid a $2,500 invoice despite two reminder letters. The company’s credit policy allows putting accounts on hold after 40 days. What should the credit controller do?

Answer:
The controller should make a direct phone call to the customer, remind them of the overdue status, and warn that no further orders will be processed unless payment is received promptly. If there is no response by day 40, further supplies should be withheld.

Exam Warning

Do not confuse credit screening with collection. Screening is proactive and happens before granting credit, while collection addresses overdue balances after credit has already been provided.

Summary

Effective management of receivables starts with a clear credit policy. Financial managers should define credit terms suited to their industry and risk appetite, screen customers before granting credit, and follow consistent collection procedures to minimise late payments and bad debts. All decisions must balance increased sales potential against the financial risks and cash flow cost of extending credit.

Key Point Checklist

This article has covered the following key knowledge points:

• The objectives and risks of receivables and credit policy
• Key components in setting credit terms, including periods and discounts
• Methods and importance of credit screening
• Collection techniques and procedures for overdue accounts
• The financial impact of credit decisions on the business

Key Terms and Concepts

• Receivables
• Credit Policy
• Credit Terms
• Credit Screening