Influence of Trade Credit on Commercial Ratings

Accounts Receivable

Why is the practice of managing Accounts Receivables significant?

Much of the commercial world revolves around credit -- trade credit or accounts receivable and accounts payable. The management of accounts receivables encompasses a variety of substantive activities essential to the fiscal solvency of a company. Firms that offer sales on credit must establish policies, procedures, and practices that guide their transactions and comply with official regulations. Managing accounts receivables includes the establishment of terms and conditions for sales and the granting of credit, including processes for evaluating credit worthiness of potential customers and the associated risk assessment and any resulting receivables collections.

The importance of accounts receivable to the fiscal status of a company is reflected in the inclusion of accounts receivable on a firm's balance sheet as a short-term asset (Cotell, 2010). The value of accounts receivable is the potential for converting the credit accounts into cash flow (Cotell, 2010). Indeed, the liquidity of a company can be impacted by the conversion of accounts receivable into cash, an activity that is pivotal to maintaining a reasonable corpus of working capital, and avoiding operational constraints due to an absence of a comfortable cash margin (Cotell, 2010). But there is a flip side to accounts receivable in that trade credit activity will increase bad debt costs, management costs and opportunity costs (Song, 2013). It is apparent that successful management of trade credit is necessary if the investment income of accounts receivable is to be maximized (Song, 2013). Song refers to this dynamic as the unity of opposites, or the unity of production and marketing (2013).

The benefits of trade credit extend to both the company and the consumers who purchase goods or services from the company. Access to credit can enable a company to increase or move their inventory, increase sales over the short-term, and establish a basis for stable operating cycles (Cotell, 2010). Customers are able to use credit to purchase from a company while deferring their payments for access to the goods or services (Cotell, 2010). The use of credit can open up opportunities for the customers in their own enterprises such that they are better able to manage their cash flow and have more control over their business operational cycle (Cotell, 2010). Although trade credit is not commonly thought of as a tool to gain competitive edge, credit sales are a viable mechanism for increasing sales, right along with advertising, customer service, product quality, and price. It is generally held that credit sales will exceed cash sales when other conditions, such as the level of quality of the products and services, are the same (Song, 2013).

What is the influence of the management of Accounts Receivables on shareholder value, credit policy decisions, credit rating sources for potential clients, credit scoring models, and credit terms with analysis?

The assessment of risk analysis is a necessary stage that proceeds the granting of credit to a customer or client through the establishment of a credit agreement. A comprehensive evaluation of credit worthiness and short-term liquidity of a potential client or customer includes an examination of financial statements, general economic conditions and payment history. A central factor of the risk analysis is the ability of the customer or client to meet debt obligations, a factor that is gauged by the short-term and long-term liabilities (Cotell, 2010). As desired, the risk analysis can be outsourced or credit-risk analysis reports can be purchased from third parties serving the credit industry, such as Business Credit USA, Dun and Bradstreet, Equifax Business, and Experian Business.

The design of sales and credit terms is an integral aspect of accounts receivables management. The outcome of the evaluation of client or customer creditworthiness and the resultant credit risk profile is the primary driver for the terms of the sales that are offered on credit. Sales and credit terms typically include discounts for payment in full within a specified amount of time, and/or allowances for paying the net purchase amount after a specified number of days following the date of the billing invoice. Favorable terms for customers or clients typically mean that lengthier terms for payment are offered as part of the sales and credit agreement. Enterprises must carefully establish a balance between the cash flow and working capital needs of their companies with the ability to attract customers or clients by extending favorable credit terms. Longer repayment terms result in delayed cash receipts and the tying of receivables to those terms, which translate into opportunity costs and increased risk since receivables tend to become less collectable the longer they are outstanding. The accounts receivables personnel in an enterprise maintain the documentation, bookkeeping, and communication related to collecting payments. Journal entries are recorded to reflect a credit (reduction) to Receivables accounts and a debit (increase) to the Cash account. As a practical matter, specific accounts are created to address delinquent accounts. These accounts might be labeled Allowances for Doubtful Accounts or Bad Debt Accounts, which are contra-accounts of Accounts Receivables. As a strategic measure to realistically manage sales and receivables, forecasts for uncollectable debts as a percentage of sales are established based on historical delinquent account patterns and the current economic situation.

Credit ratings and stock values are impacted by the performance of accounts receivables management. Several measures, which are reported as financial ratios, are routinely calculated to assess how well personnel in accounts receivable achieve the best practices expected of their management. Variables that can potentially be impacted by accounts receivables management practices include the generation of cash flow and revenue, current and quick ratio, liquidity, working capital, and stable operating cycles. These financial ratios include the following: Aging receivables, cash conversion cycle, days in sales outstanding, net working capital, and receivables turnover ratio.