Risk management: How to manage your debtors – Part 2

Last week on Wednesday, we were provided with highlights on the following:

  • Definitions of risk, risk management, and debtors,
  • Why risk management is important for any business,
  • What are the courses of bad debts, and,
  • Why debtors’ management is important for any business.

Today we shall look at how debtors should be managed. Before that, however, let’s get the justification as to why we should bother about debtors/account receivables.

As pointed out briefly in last week’s article, debtors constitute an important component of organizations’ assets. Any organization has both fixed and current assets (assets can also be categorized as ‘tangible vs intangible’. Tangible assets are those assets which can be seen. They can also be touchable like furniture, motor vehicles, buildings among others, while intangibles are those assets that cannot be seen or touched like goodwill).

Fixed assets, also called long-term assets, have more than one year of useful life, for example, buildings (if organizations own their building for offices, etc.), motor vehicles, machines, and land. Current assets are also known as short-term assets. These are those assets that have a maximum useful life of one year. These include cash (both at hand and bank), inventory/stocks, pre-payments (one good example of this is rent which is paid in advance), short-term investments (such as investment in treasury bills), and trade debtors/account receivables.

Different researches and studies indicate that debtors/account receivables are among the major components of current assets. More so, for Small and medium-sized enterprises-SME (we all know the importance of SMEs to the economy not only in Tanzania, but all over the word) in Tanzania, researches show that almost 56.3 per cent of them often sell on credit. Further, it is known that SMEs usually have limited access to external debt and equity. In this case, managing debtors is critical to financing their daily operations.

How should debtors be managed?

The risk management process emphasizes adherence to the steps involved. Step one deals with ‘objective establishment.’ Regarding debtors’ management, this calls for an agreement on the maximum amount that can be forgone due to bad debts. As an organization owner, you must know your risk limits. If you are a risk lover, this limit will be higher than those who are risk averse (those who don’t like high risks). Risk appetite, therefore, determines investors’ risk limits. The limits have to be stipulated in the organization’s risk management policy. This policy is among your key working tools if you are the Chief Executive Officer (CEO). The designing of the policy is under the CEO’s responsibility.

The policy must indicate, among others, which should be considered for credit sales (respective qualities), how a company should extend credit to its customers, how credit customers should be grouped (if necessary), what should be the duration of the credit (the duration should not be longer than the ability of the organization to finance that gap from its available cash), any accompanied benefits like discounts, how should debtors be monitored and what should be the collection procedures.

Further, what should be the cost to customers if they don’t pay on time, i.e., interest to be paid? The essence of the policy is to have a proper guide that assists management in extending credit sales to good customers on the one hand (i.e., those who are most likely not going to default) and minimize the amount of bad debt (just in case the debtors turn out to be bad customers). The absence of a written credit policy may also be a cause of poor debtors’ management. This is a common mistake for most MSMEs.

Step two is to identify possible risk factors. These are factors that can make your debtors not be able to make payments on time. Our previous article elaborated on these under the sub-title ‘what causes bad debts?’

Step three is to assess the prospective debtors and establish their quality. This means assessing debtors’ capacity to service the expected credit. The items to assess may differ if the customers are businesses (B2B) or individuals. For business customers, it involves checking the legality of the business (mostly do the checks with Business Registration and Licensing Agency-BRELA and Tanzania Revenue Authority- TRA), the length of time the client/customer has been in business, bank or trade references, and credit agency checks.  Prospective customers can also be assessed by using referrals from other suppliers. This is possible if the competition is not oligopolistic. The extent of checks also depends on the size of the credit to be given.

The cost for the search should not exceed the respective benefits to be realized from the transaction. For Micro businesses selling to other micro businesses or individuals, trust is important as it enables them to collect the required information through personal relationships and networking easily. Managing commercial relationships is thus critical in dealing with asymmetric information challenges and thus reducing the risk of having bad customers who will eventually become bad debts in your books. In a few cases, collateral can be used to screen customers as it is assumed that customers willing to pledge appropriate collateral are good customers.

We shall finalize the remaining step on Wednesday next week. Don’t miss your newspaper.

  • Author: Dr. Evelyn Richard (PhD) is a Senior Lecturer at the University of Dar es Salaam Business School, and a researcher at the Center for Banking and Financial Services Research (CBFSR). (mbwamboneema18@gmail.com and +255783 297 929)

 

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