## **Learning Outcomes**

By the end of this article, you will be able to explain the objectives and components of a credit policy, assess methods for credit risk evaluation, and outline procedures for the management and collection of receivables. You will understand the impact of credit policy decisions on working capital, liquidity, and risk, and evaluate the effects of credit decisions on both payables and inventory. You should be able to apply these concepts in line with ACCA AFM exam requirements.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand how working capital management decisions—particularly those relating to receivables, payables, and inventory—directly influence organisational liquidity and risk. You must be familiar with:

- The main objectives and features of an effective credit policy
- Techniques for assessing creditworthiness, including credit scoring and analysis
- Approaches to receivables collection and control
- The relationship between credit policy, payables management, and inventory strategy
- The impact of credit decisions on working capital funding and financial performance

## **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 typically **not** a direct objective of a company's credit policy?
   a) Maximising sales
   b) Minimising irrecoverable debts
   c) Increasing inventory turnover
   d) Controlling risk

2. State one qualitative and one quantitative factor commonly included in a credit scoring system.

3. True or false? Extending longer credit to customers always increases overall profit for a company.

4. What is factoring and how does it affect receivable management?

## **Introduction**

Effective management of receivables, payables, and inventory is critical to the financial health of any organisation. Credit policy—the rules for granting credit to customers—directly impacts sales, cash flow, and risk exposure. An overly lenient policy may boost sales but increase bad debts and require more funding, while a restrictive policy can hurt sales growth. In the ACCA AFM exam, you are expected to analyse how credit, collection, and payment policies affect working capital and organisational objectives, and to apply credit assessment and control tools to real-world scenarios.

> **Key Term: credit policy**
> The set of guidelines and procedures that defines a company's approach to granting credit terms, assessing customer risk, and managing receivables.

## **CREDIT POLICY: OBJECTIVES AND ELEMENTS**

A well-designed credit policy balances profitability and risk. Its core aims are to maximise sales and profits by selectively offering credit, while minimising bad debts, controlling collection costs, and ensuring cash flow stability.

### Key Elements of Credit Policy

The main components include:

- Terms of credit (e.g. allowed period, early settlement discounts, interest on overdue accounts)
- Standards for granting credit
- Procedures for assessing new customers and monitoring existing ones
- Collection and follow-up protocols for overdue accounts

A policy must be consistent, clear, and aligned with overall business strategy.

> **Key Term: credit terms**
> The specific payment conditions granted to customers, such as credit period length, discounts, and penalties for late payment.

## **CREDIT RISK EVALUATION AND CREDIT SCORING**

Granting credit involves risk. Companies must assess whether potential customers are likely to pay on time. To do this efficiently and objectively, a variety of tools are used.

### Methods of Credit Assessment

1. **Credit scoring systems**—assign points for financial and non-financial factors and produce a creditworthiness score.
2. **Credit ratings**—based on external agency data for larger clients.
3. **Qualitative assessment**—management judgement about customer risk based on history, reputation, or strategic value.

> **Key Term: credit scoring**
> A quantitative method that assigns numerical values to key indicators of a customer's creditworthiness, helping standardise and automate credit decisions.

### Typical Factors in Credit Scoring

Credit scoring usually evaluates:

- Financial ratios: liquidity, profitability, gearing
- Payment history
- Years in business
- Size of account
- Industry risks

The total score translates to specific credit limits or terms.

### **Worked Example 1.1**

**A manufacturer is considering offering \$30,000 credit to a new retailer. Their internal system allocates a score out of 100, with 70+ required for standard terms. The retailer scores high for profitability and business history, moderate on liquidity, but low on repayment history due to two late payments with other suppliers. Calculate whether standard terms should be offered if the total score is 68.**

> **Answer:**
> The retailer's score of 68 falls below the threshold for standard credit terms (minimum 70). Therefore, standard terms should not be offered; the company might offer stricter terms, a lower credit limit, or require prepayment.

### **Worked Example 1.2**

**An international wholesaler uses a credit scoring model with these weights: payment history 40%, net profit margin 20%, current ratio 20%, years in business 20%. How could changes in a customer's payment history impact their overall credit rating and the firm's decision to increase credit?**

> **Answer:**
> As payment history carries the most weight (40%), a significant worsening in payment discipline could sharply reduce the overall score. This would likely result in the company reducing or refusing additional credit to the customer, protecting against higher risk.

## **RECEIVABLES COLLECTION AND CONTROL**

Granting credit always carries the risk of late or non-payment. Robust control procedures are essential to reduce risk and optimise cash flows.

### Collection Procedures

- Setting clear payment terms at the outset
- Regular monitoring and prompt follow-up of overdue accounts
- Use of reminder letters and account holds for persistent defaulters
- Implementing interest or penalties for late payment
- Escalation: external debt collection, legal action, or factoring

> **Key Term: factoring**
> The sale of accounts receivable to a specialist company (factor), which advances cash to the seller and assumes responsibility for collection.

### **Worked Example 1.3**

**Company Z’s receivables average \$1.2 million with average collection period of 60 days. By hiring a debt collection agency, it reduces the period to 45 days at a cost of \$15,000 per year. If the company’s cost of capital is 10%, calculate the annual benefit from improved cash flow and net gain or loss from using the agency.**

> **Answer:**
> Reduction in receivables = 15 days/360 × \$1.2m = \$50,000 freed up. Annual cost saving on finance = \$50,000 × 10% = \$5,000. Net benefit = \$5,000 - \$15,000 = -\$10,000, i.e., the agency solution is not justified unless other benefits arise.

### **Revision Tip**

_Remember: Any change in credit policy (terms or collection efforts) may impact both sales revenue (positively or negatively) and costs—always consider both when evaluating policy changes._

## **CREDIT POLICY AND WORKING CAPITAL**

Credit policy decisions affect the whole working capital cycle:

- Relaxed terms may increase sales but tie up more cash in receivables, increase risk, and require more funding.
- Tighter credit may reduce bad debts but could lower sales and damage customer relations.
- Choosing between cash, early payment, or late payment terms for payables can affect liquidity and supplier relationships.

### Linking Payables and Inventory

Payables policy (how quickly the company pays its own suppliers) must also be managed to optimise cash flow without risking supplier goodwill or incurring penalties.

> **Key Term: payables policy**
> The company's strategy for the timing and method of paying suppliers, balancing liquidity needs and supplier relationships.
>
> **Key Term: inventory policy**
> The rules controlling how much stock is held, when to reorder, and how much to order, balancing availability and holding costs.

Matching inventory and credit policy ensures that stock levels are funded efficiently, and that working capital is not locked up unnecessarily.

## **Summary**

An effective credit policy balances increased sales against the risk and cost of borrowing. Credit scoring and regular risk assessment are essential for limiting exposure to bad debts. Efficient collection minimises overdue balances and improves liquidity. Combined, proper credit, payables, and inventory policies result in a balanced working capital cycle that sustains business growth while controlling risk.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Identify the objectives and main elements of a credit policy
- Explain credit terms and their impact on sales and risk
- Describe credit scoring and its typical evaluation factors
- Outline effective receivables collection procedures
- Link credit, payables, and inventory policy to working capital management
- Assess the effects of policy changes on cash flow, risk, and profitability

## **Key Terms and Concepts**

- credit policy
- credit terms
- credit scoring
- factoring
- payables policy
- inventory policy

Receivables, payables, and inventory - Credit policy, scoring, and collection