Describe the components of working capital, and indicate the importance of this calculation.
Describe the components of working capital, and indicate the importance of this calculation.
List four factors that support holding lower inventory levels, and four factors supporting higher inventory levels.
List and briefly discuss the three motives for a business holding cash, according to economic theory.
Case Study: Management of Credit Risk:
The following article addresses the management of credit risk. Read the article and answer the questions that follow. (use other additional references and Australian Accounting Standard)
Reducing credit risk
Maintaining a healthy cash flow is essential to the survival of any business, but its becoming more difficult in this tough economic climate to manage cash flow from debtors. The problem is that each of your debtors poses a different level of credit risk. In order to protect your cash flow, it is vital to understand the various credit risks that customers pose and to manage those risks effectively.
First, you need to understand exactly what credit risk is: an expression of the probability of financial loss after taking into consideration as many influencing factors as possible. Every customer and every transaction carries an element of credit risk. There is the risk that they may not pay at all, or that payment will occur beyond your trading terms. Both of these have a direct impact on cash flow. Non-payment and delayed payment are financial burdens that can be overcome by good credit risk assessment.
A good credit risk assessment involves carrying out the relevant checks and only granting credit to creditworthy customers. It includes an examination of the customers financial strength and trading history in order to evaluate whether they have the financial resources to settle their debts. Delayed payment can occur if a customer has processes, or a track record, that indicates they pay creditors outside trading terms.
Credit risks should not stop a business from transacting with customers, but it becomes doubly important to determine what level of risk your business can bear without restricting your customer base, trade or reducing your income. Each business will have a different risk tolerance and understanding. The right assessments will allow you to reduce risk to an acceptable level that allows the customer relationship to continue.
Credit risk assessment
Evaluating the creditworthiness of a customer is about making an informed decision on the level of credit risk they pose to your business. This decision should be made before the relationship begins with new customers, and should also be carried out periodically for existing customers, or whenever there is a change in the relationship.
The assessment has three basic steps: gathering the information required; analysing, verifying and assessing that information; and making an informed decision. The primary source of information for the assessment is the account application form. You may need to review it to ensure all the relevant details are captured. Credit reporting agencies can provide further information. The minimum information to obtain from a prospective customer includes:
registered name and trading name
ACN or ARBN number
type of entity
registered address and primary business address
trade references
date of birth, or drivers licence number if the applicant is a sole trader, partnership, or individual.
If a customer, or potential customer, seeks higher credit limits, or if the credit risk appears to be high, seek additional information, including:
incorporation date, or length of time in business
number of staff employed
companys or customers verifying financial data
statement of assets and liabilities from sole traders, partners and individuals
trust deeds for trusts.
This list isnt exhaustive, but it provides a base from which to review account application forms. If you are dealing with individuals, the terms and conditions you present should address the privacy obligations under the Privacy Act, and you will need to seek authorisation to carry out credit checks. Even when you have this information, it should be verified then assessed to ensure you are contracting with the correct entity.
Accredited reporting agencies, the Australian Taxation Office and the Australian Securities and Investments Commission can verify the registered name, registered address, ACN or ARBN number, type of entity, and date of incorporation, or the date the business started. If the entity is deregistered, or data unmatched, the application should be held until you can clarify its status. Entities that are under administration or other external control, require special care.
Once the information is gathered, you need to understand which factors potentially make the entity a low or high risk. Indicators of lower risk are that a customer has been in business for a long time, there is a large number of staff and the individuals, or management, have many years of business experience. Warning signs for higher risk include directors having links to failed companies and evidence of court actions or default notices. Trade references and credit bureau reports can indicate higher or lower risk. Trade references are also an effective way to ascertain the entitys payment history and patterns with other credit providers. Of course, be aware that the customer may only provide good references.
The financial data of a business is the best source of its financial strength. In most instances, financial stress is evident long before a business fails. Information such as growth in turnover, profitability, its gearing and asset base are all good indicators of financial strength and can be measured using financial ratios. Its also important to note who provides the information, and whether it has been audited or not. Personal financial information provides an assessment of an individuals financial strength. This information can be gathered from a personal assets and liabilities statement, and some assets, such as real estate, are easily verified by credit reporting agencies who provide access to land titles, other assets, and encumbrances such as mortgages.
With all of this in hand, you should be able to make a good judgement regarding the customers credit risk. When all the information is positive, accept the customer and grant credit. If there are many negative findings, such as court actions against directors, then decline credit and look for another way to transact with the customer. If the information is both positive and negative, assess its impact on the ability of the customer to pay their account, and then decide if it is safe to extend credit, and the amount by which you care to extend it.
You can use credit scoring software to assist in processing and assessing information. This software assigns a numerical value to measure the risk of a number of indicators and factors, based on benchmarks and historical data. The result is usually presented as an overall risk percentage. Credit scoring takes the subjectivity out of assessment and can help you make consistent and sound credit risk decisions.
Where the credit risk is elevated, explore strategies to reduce the risk before turning the customer away. These might include obtaining personal guarantees, reducing credit limits and reducing trading terms. Remember that while credit risk assessments are important, they are not an exact science and commonsense should always prevail.
Source: Malcolm Polinsky, Reducing credit risk, In the Black, CPA Australia, December 2008.
Questions
What do you understand by the term credit risk?
What does a good credit risk assessment involve?
How might you determine your own risk tolerance in a given situation? What factors will influence your choice?
When should a credit risk assessment take place?
What agencies can be used to verify information regarding potential or actual customers?
What factors determine the level of risk? What are the warning signs?
What information is provided by the financial data of a business, and what degree of confidence might you have in it?
What do you understand by credit scoring software?
How might elevated credit risk be alleviated?
