The Role of Credit and

Collection Management

BA FINC 34
Credit Risk and Collection Management
 DEFINITION OF CREDIT
• Credit is a contractual agreement in which a
borrower receives something of value now
and agrees to repay the lender at some date
in the future, generally with interest.

• Credit also refers to an accounting entry that

either decreases assets or
increases liabilities and equity on the
company's balance sheet.
 IMPORTANCE OF CREDIT
• Credit leads to an increase in spending, thus
increasing income levels in the economy. This
in turn leads to higher GDP (gross domestic
product) and thereby faster productivity
growth.
• Credit is used to purchase productive
resources. It helps in economic growth and
adds to income.
• Credit further leads to the creation of debt
cycles.
 IMPORTANCE OF CREDIT
• Good credit standing plays an important role
in the financial life of an individual like
qualifying for a loan.

• It helps an individual get the things needed

for personal or business use.
 THEORIES OF CREDIT
• Henry Dunning Macleod

- In The Theory of Credit (1889) he says:

"Money and Credit are essentially of the same
nature: Money being only the highest and most
general form of Credit" (p. 82).
 THEORIES OF CREDIT
• Alfred Mitchell-Innes

- The Credit Theory of Money (1914)

The Credit Theory is this : that a sale and
purchase is the exchange of a commodity for
credit.
 THEORIES OF CREDIT
• Alfred Mitchell-Innes

- From this main theory springs the sub-theory that the

value of credit or money does not depend on the value of
any metal or metals, but on the right which the creditor
acquires to "payment," that is to say, to satisfaction for the
credit, and on the obligation of the debtor to "pay" his debt
and conversely on the right of the debtor to release
himself from his debt by the tender of an equivalent debt
owed by the creditor, and the obligation of the creditor to
accept this tender in satisfaction of his credit.
 THEORIES OF CREDIT
• Joseph Schumpeter

- Schumpeter argued that the institution

enabling the entrepreneur to buy the resources
needed to realize his or her vision was a well-
developed capitalist financial system, including
a whole range of institutions for granting credit.
 ROLE OF CREDIT
• Credit can provide a smoother flow of money
through an economy to ensure that periodic
starts and stops are not affected by variations
in the cash flow.
• Credit is used for large capital expenditure
that would otherwise be impossible to obtain.
• Credit provides equilibrium pertaining the
money flow between the demand and supply
segments.
 SCOPE OF CREDIT
1. Customer attraction (Sales and Marketing)
Many organizations use credit as a way of
attracting new customers by giving them
attractive terms for repayment of purchases. In
that case the credit decision is actually a
marketing decision.
 SCOPE OF CREDIT
2. Liquidity decision (Management)
Credit policy directly affects the liquidity of an
organization since itmeans the goods advanced
on credit represent a financing gap which the
organization has to fill. If an organization has a
lot of its working capital tied in accounts
receivable is likely to face liquidity challenges
hence the credit decision is a financing
decision.
 SCOPE OF CREDIT
3. Competitive strategy (Strategic Management)

The credit decision is also used by organizations

to compete inthe market place with
organizations positioning themselves in the
market by formulating attractive credit policies.
 SCOPE OF CREDIT
4. Effect on the balance sheet (Financial
Management)
Credit management affects the quality of the
accounts receivable as relates to their
collectability and since they are presented as
part of the working capital the credit decision
affects the value of the accounts receivable
depending on how sound the credit policy
are.
 SCOPE OF CREDIT
5. Exposure to credit risk (Financial
Management)
This refers to the risk that accounts receivable
will not be collected as expected or that the
clients with contractual obligations with the
company will not be able to settle their
accounts as they become due. This is a risk to
the organization.
 SCOPE OF CREDIT
Important Note:
The credit management department should
hold a compromise position between the
optimism of the sales department and the
rigidity of the finance department so as to have
credit policies that enable the organization to
compete in the market while at the same time
avoiding the risks of bad debts.
 FUNCTIONS OF CREDIT
1. Economy in the use of money
The credit system economizes the use of metallic
money and paper notes. The credit instruments
like promissory notes, bills of exchange, letter of
credits, checks, credit cards, etc. are used in the
modern society as money-substitutes, and so they
have reduced the cost of issuing metallic money
and paper notes. Likewise they have minimized or
eliminated the risks and inconveniences involved
in cash transactions.
 FUNCTIONS OF CREDIT
2. Easy exchange and remittance
The credit instruments minimize the cash
transactions and thereby make the scope of
exchange wider and the remittance of funds
easier. They permit wealth to be transferred to
places where more economic use can be made
of it.
 FUNCTIONS OF CREDIT
3. Helpful to production
The credit system facilitates large- scale pro-
duction. It stimulates and finances production in
anticipation of demand.
The credit system lubricates the production
processes and keeps the wheels of production
constantly moving. There is a steady flow of
goods from the wholesaler to the retailer and
from the latter to the consumer with the help of
credit.
 FUNCTIONS OF CREDIT
4. Promotion of trade especially foreign trade
The bills of exchange have increased the scope
of both internal and external trade as the trade-
payments can now be made without the
transfer of funds or gold. The commercial credit
enables the buyers to make payments for the
value received at convenient times. So, the
credit system enables the traders to tide over
periods of difficulty.
 FUNCTIONS OF CREDIT
5. Expansion of bank credit
The credit system enables the banks to create
a large amount of credit out of a small amount
of deposit. This has resulted in the vast
expansion of bank deposits.
 FUNCTIONS OF CREDIT
6. Financial accommodation to industries
Industries get short-term credit from
commercial banks and the long-term credit from
the development banks. This enables them not
only to tide over the temporary financial
stringency but also to maintain continuity in
their activities.
 FUNCTIONS OF CREDIT
7. Benefits the consumers
Bank credit to the consumers enables them to
buy durable consumer goods, especially
household goods on installment basis.
 FUNCTIONS OF CREDIT
8. Credit to the government sector
The credit to the government also helps them to
meet both temporary necessities and growth
requirements.
 FUNCTIONS OF CREDIT
9. Provides stability
If the issue of credit is properly regulated, it
tends to stabilize trade and reduce fluctuations
in prices.