Credit Control: What is It, How It Works, Different Methods

A healthy cash flow is the lifeblood of every business, enterprise or institution, no matter how big or small it is. This is why businesses use different strategies not just to improve cash flow but also to boost sales. One such strategy is credit control.

At its core, credit control is used to ensure that credit is only extended to customers who have a high probability of repaying. It also ensures that the businesses remain afloat and minimise the chances of bad debts. In this blog, we will explore the concept of credit control in detail and explain how it works.

What is Credit Control in Banking and Businesses?

Credit control is a business strategy that involves the extension of credit to customers to facilitate sales at the lowest financial risk. It entails providing credit to customers who are most likely to repay. This strategy enables businesses to boost sales by making purchases easier and more appealing, all while maintaining their financial stability.

Credit control is an important component of financial management, as it helps businesses find a balance between growing sales and reducing the risk of bad debts. This strategic decision-making helps maintain a constant cash flow and minimises potential losses from unpaid invoices.

Also Read: What is Repo Rate?

How Does Credit Control Work?

Suppose a manufacturing business sells the products to a distributor on credit, where payment is made within 30 days. The company checks the payment history and creditworthiness of the distributor before approving this credit. The business then establishes strict payment conditions and credit limits.

The business now reminds the distributor in case of late payment. In case of additional delay of payment, it calls the distributor to make a payment plan. This is done to ensure a constant cash flow, reduce the risk of non-payment of invoices, and maintain a healthy business relationship.

Importance of Credit Control

Credit control is critical towards maintaining a stable cash flow in a business. Customers making their payments on time ensure that a business has sufficient funds to cover its daily operational costs, salaries and payments to suppliers, as well as to invest in future growth opportunities. Here are all the reasons why credit control is essential:

• Help maintain a stable cash flow to run the business smoothly.
• Reduce the risk of financial loss through bad debts and defaults.
• Ensure liquidity and financial stability to cover day-to-day costs.
• Enhance profitability through accelerated collection of payments and minimised costs.
• Improve credit management and forecasting to improve financial planning.
• Improve customer relations by providing clear terms of credit and communication.

Also Read: Gross Receipts: What Is It & How to Calculate

Different Types of Credit Control Techniques

Companies employ credit control techniques that are suited to their market objectives and risk tolerance:

1. Preventive Credit Control

In this type, a business assesses the reliability of the borrower and then establishes payment terms and restrictions before granting credit. It aims to prevent bad debts and overdue accounts by giving credit only to reliable customers.

2. Curative Credit Control

After the issuance of credit, a business monitors its accounts, sends reminders if payment is delayed, and collects past-due invoices. The primary goal of these credit control techniques is to reduce losses by collecting unpaid amounts through meticulous follow-up and escalation.

3. Restrictive Credit Control Policy

A business grants credit only to clients with strong credit histories and minimal default risk. The credit, however, is offered with strict credit restrictions, constrained payment windows, and thorough reviews. It is ideal for businesses that place a high priority on risk reduction and cash flow.

4. Moderate Credit Control Policy

It is a balanced approach where a business extends credit to customers with moderate to good credit histories. Some of its key features are a reasonable credit limit and adjustable payment terms. This policy aims to manage credit risk cautiously while supporting business growth by allowing more customers to purchase on credit.

5. Liberal Credit Control Policy

To increase sales and market supremacy, a liberal credit control policy extends loans to riskier customers. Some of its key features include fewer barriers to credit approval, more flexible terms, and a higher chance of bad debt. Market leaders looking to maximise growth or high-margin sectors might benefit from this.

Also Read: Top Credit Bureaus in India

Different Methods of Credit Control

The methods of credit control are divided into qualitative and quantitative. These strategies aim to regulate both the availability and the cost of credit in the economy, helping maintain monetary stability and support economic growth.

Qualitative Methods

• Credit Rationing: RBI restricts the credit supply to specific industries or individual borrowers. This assists in redirecting credit to productive and priority sectors and limiting it in the speculative or less desirable sectors.
• Margin Requirements: This is the difference between the value of securities or collateral provided and the loan provided. Increased margin requirements decrease the loan value in relation to the collateral value, which regulates the growth of credit in times of inflation.
• Moral Persuasion: RBI advises, persuades or encourages lending institutions to be consistent in their credit practices to meet national economic objectives. This fosters price stability and responsible lending without any directives.
• Method of Publicity: RBI publishes reports, media and publicity to bring out good and bad credit practices. This necessitates lenders to implement responsible credit policies.
• Regulation of Consumer Credit: Consumer loans are restricted by controls, e.g. by a limit on the number of EMIs or loan tenure of certain goods, particularly vulnerable to inflation or deflation.
• Direct Action: In cases where banks or lending institutions fail to comply with the policies of the RBI concerning the control of credit, the central bank may impose penalties or limit their lending rights in addition to other control measures.

Quantitative Methods

• Bank Rate Policy: Bank rate is the interest rate charged by the RBI to commercial banks without security. Raising the bank rate increases the cost of borrowing and decreases the supply of credit to curb inflation.
• Open Market Operations (OMO): RBI buys or sells government securities in the open market to control the supply of money. The sale of securities absorbs liquidity, decreasing credit availability, and the purchase of securities injects liquidity, increasing credit.
• Cash Reserve Ratio (CRR): It is the percentage of the total deposits of a bank that should be retained as reserves at the RBI. An increase in the CRR decreases the amount of money that banks can lend.
• Statutory Liquidity Ratio (SLR): Banks are required to hold a specified amount of their deposits in liquid form, such as government securities. RBI modifies SLR to regulate the liquidity available to banks to create credit.

Also Read: Loan Basics: What is NMI & Why It Matters

Conclusion

A credit control shows a definite commitment to sustainable cash flows and long-term business performance. Effective credit control not only protects businesses from potential losses but also builds strong customer relationships. This is why you must choose the right credit control type that helps you achieve your business objectives.

Frequently Asked Questions

Are credit control and credit management the same thing?

The primary goal of credit control is to collect debt without losses. In contrast, credit management involves verifying a customer's credit, establishing credit limits, granting credit, keeping track of payments, and pursuing past-due accounts.

How frequently should companies evaluate their credit policies?

Businesses should examine their credit policies at least once a year. However, in volatile markets, quarterly assessments might be even more helpful.

What are the warning signs that a company's credit control is ineffective?

Frequent late payments, mounting bad debts, cash flow concerns, and invoicing conflicts are all red flags that indicate ineffective credit control.

How does credit control affect financial planning?

Credit control enables a company to receive payments on time. This results in a continual flow of money. With consistent cash, a corporation may better plan its spending.

What's the distinction between credit control and credit management?

Credit control is concerned with developing rules and processes for managing credit risk. In contrast, credit management is concerned with the overall process of regulating all elements of credit, including evaluation, monitoring, and collection.