Creditors

A- Suppliers and other creditors

1) Credit and collection departments

Companies evaluate the creditworthiness of customers on open account (i.e. those who are given "terms", that is time to pay), on the basis of their ability to pay for their purchases. Vendors who serve a restricted number of large clients conduct a very thorough investigation of each client, which can be, at the extreme, as involved as that of a merger because the very existence of a vendor may depend on the health of its only purchaser (such as in the case of automobile parts subcontractors for a given car manufacturer). At the other extreme, retailers rely on credit card companies, only a few large department stores have their own credit and collection department, and large tag items (e.g. automobile) outlets rely on credit reporting agencies. In between, most of the other firms that have clients that buy in large quantity repeatedly, usually have in their accounting department a credit and collections section that sends out requests for credit information and conducts some credit rating.

Such evaluation is usually of two types. When there is a large number of potential open account customers, they are reviewed in a screening process often relying on a single or on a combination of ratios. Past history of the ability to pay on time is the criteria and ratios (often current, quick and turnover ratios) give each customer a score or grade. Thus the technique is called credit scoring. Using that single statistic is referred to as discriminant analysis. It is a fast and convenient review of hundreds or thousands of prospects.

The second phase of the evaluation is an in-depth analysis of the prospects chosen in screening. Sometimes, customers are asked to fill out an application and to submit financial statements. In the in-depth analysis the overall standing of the firm and potential for paying on time in the future is studied by looking at its present ability to generate revenues and its cushion of safety to cover its liabilities. Obtaining outside references on potential clients from other suppliers and banks is the most common approach. Often, sales representatives are asked to assist in this evaluation when they visit their clients.

When clients are very important to a supplier, an investigation can be commissioned from a credit evaluation service such as Dun & Bradstreet which will investigate companies of any size, and charge depending on volume and depth of requested information, with a minimum of a few hundreds of dollar. Sometimes companies choose themselves to be investigated by a credit evaluation service in order for the information to be on file when they will need to buy from a supplier on credit. There are also several credit reporting agencies, such as TRW or Equifax, which will supply information of payment record of individuals with credit cards, accounts in stores and with banks; this information is inexpensive.

One may note that in the financial analysis conducted by creditors (as well as factors discussed below), the payment is expected in such a short period of time that it is not necessary to discount payments. Nevertheless, there is a time value to this payment as well. Suppliers embed this in cash discounts given for prompt payment, as well as in an interest charge for late payment. Sometimes this cost is already built into the price paid by the customer regardless of when the payment is actually collected. In such a case, the increase in price also serves as a source of revenue that can be set aside as a reserve for bad debt. As any wise analyst would notice, such practice penalizes good customers and makes the supplier less price competitive.

An even less desirable approach of some suppliers is to sell to anyone on open account a first time, but refuse any subsequent order from any client who was late paying a previous order. Here, obviously no prior analysis is conducted, nor objective information sought. The method is only used for small purchases where the cost of analysis and information would exceed the benefit from it. One must remember that the purpose of selling on open account is to increase sales, not to substitute for banks. Setting up a credit department for a large customer base is a costly and lengthy process which a company wants to avoid. But, not allowing any sale on credit would jeopardize sale expansion. Thus, the crude strategy.

Yet, vendor credit becomes sometimes a substitute for bank credit when a tight monetary policy is enforced by a central bank. Large vendors with easy access to borrowing can use this strategy to increase their market share at the expense of smaller vendors who do not have an ability to offer lenient terms to customers. See, for instance, the role of accounts receivables in furniture wholesale industry discussed in Chapter 8 Section G-3.

Credit departments of vendors monitor accounts receivables with the help of aging schedules. Aging schedules show how long debts of customers have been outstanding: current, 30 days, 60 days, 90 days and beyond. A credit department will immediately send out reminding statements when clients are delinquent. Indeed, it is well known to credit managers that the longer a debt is unpaid the more likely it will never be paid. Occasionally, companies seek the help of collections agencies, but that is usually too expensive for the amount involved. Taking legal action is rare and only in cases of large amounts. Usually, vendors just absorb losses with the provision for bad debt created specifically for that purpose. The provisions for bad debt ranges from 2% to 5% of peak season accounts receivable balance. In addition, vendors report customer's failure to pay to credit reporting agencies. In the United States, clients who fail to pay one vendor for their purchases will find it extremely difficult to buy on credit from any vendor thereafter, because a clean credit history is a prerequisite for buying on open account.

See review questions Q-4A1.1 through Q-4A1.7.

See research assignment R-4.1.

2) Factoring

As noted earlier, vendors of moderately priced items would, in general, like to avoid having any credit and collections function because of its added expense, and because it is outside the major activity of the firm. When clients are far apart and purchase by mail or phone, a supplier may find it too expensive for its in-house credit and collection department to obtain quickly information about distant clients. For industries such as toys, textile and furniture, the best solution is often factoring.

A factor is usually a bank (or a finance company) which
- 1 takes on the responsibility of client financial evaluation (which the factor may require to conduct prior to any sale by the vendor),
- 2 bears some of the risk of nonpayment if factoring is with recourse (i.e. the right to ask for payment from the vendor if a customer fails to pay),
- 3 bears all the risk of nonpayment if the factoring is without recourse,
- 4 collects the receivables, and
- 5 in some arrangements, provides credit.
The fee can be anywhere from 1% to 20% (or even more) of the amount of the invoice depending primarily on the risk assumed by the factor, with an average of about 3% to 5%. The fee is less when the factor has a right of recourse, than in factoring without recourse. Naturally, when the factor also acts as a lender, an interest is charged on the amount advanced on behalf of customers from whom the factor will collect.

As mentioned earlier, in the United States, factoring is most common in industries such as textiles, toys and furniture manufacturing. Small manufacturing firms in these industries ship small quantities to distant retailers. It would be too costly for such firms to know the recent history of each one of these hundreds or thousands of retailers. Whereas, a factor specializes in conducting an analysis of groups of these retailers for a large number of similar vendors. The small manufacturing firms are also often short of cash, and are quite willing to pay factor's fees especially if the factor can also advance the payment of the invoice.

A typical example of a factoring arrangement is that of a furniture manufacturing which sells to several hundreds of furniture outlets throughout the United States. Each outlet only buys a few thousands of dollars of merchandise at one time. Furniture outlet stores are know to suffer from a changing demand affected by regional demographic and economic cycles. For the furniture manufacturing firm, it would be expensive to keep track of regional trends that may cause some outlet to experience sales and financial difficulties. The factor can do the analysis more extensively, efficiently, timely and at a lower cost than the furniture manufacturer.

The credit analysis department of the factor can afford to have analytical procedures more extensive than those of a credit department of a regular vendor, because a factor that specializes in a given industry (and factors do specialize), can serve as factor for many suppliers of a given client. So the cost of analysis is spread over much larger sales volume than that of a single vendor. Thus, in addition to analyzing liquidity and liabilities, and obtaining financial statements and references, factor's procedures can also include a quick analysis and projection of sales and profits based on regional and industry trends.

In Russia, vendor credit has been widely abused in the early 1990's and is considered to be in a state of crisis in the late 1990's. This abuse seems to have been the result of a practice in the past of not charging interest on this form of debt, and the custom that the bank account payment system was a clearing mechanism between organizations belonging all the same owner, the government. With privatization and interest charges on bank loans soaring to over 100% per year, late payment or non-payment of purchases to suppliers has exploded. Many manufacturers are in financial difficulties because of their inability to collect receivables. Moreover, because of prior unpaid purchases, many plants are unable to operate as suppliers refuse to ship any more raw material or spare parts. This shows the importance of financial analysis. One can predict that supplier credit evaluation is likely to become a required procedure in Russia for all sales in the future.

-- show stats on debt crisis --

See review questions Q-4A2.1 through Q-4A2.6.

See research assignment R-4.2.

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Last modified: Jun/01/01 Next: Lenders