Credit management is the process of monitoring and gathering payments from customers. A good credit management system (CMS) decreases the amount of capital tied up with debtors.
It is essential to have good credit management for efficient cash flow. There are instances when a plan is expected to be profitable when assumed theoretically, but it is not possible to practical execute it because of insufficient funds. In order to avoid such circumstances, the best alternative is to confine the likelihood of bad debts. This can only be accomplished through good credit management practices.
To run a business in profit the entrepreneur needs to prepare and design new policies and procedures for credit management.
Principles of Credit Management
Credit management plays an important role in the banking sector. As we all know the bank is one of the significant sources of lending capital. So, following are the principles, Banks follow for lending capital.
Liquidity plays a key role when a bank is into lending money. Usually, banks lend money for a short period of time. This is because the money which they lend is public money. This money can be withdrawn by the depositor whenever they want.
So, to avoid this chaos, banks lend loans after the borrower produces enough security of assets which can be easily marketable and converted to cash in a short duration of time. A bank is in possession to take over these assets if the loan seeker fails to repay the loan amount after some interval of time as decided.
To maintain liquidity, banks should always make investments in government securities and shares and debentures of reputed industrial houses.
Another most important function of lending is safety, the safety of funds lent. Safety means that the loan seeker should be in a position to repay the loan and interest at regular durations of time without any fail. The repayment of the loan depends on the nature of security and the capability of the borrower to repay the loan.
Unlike every other investment, bank investments are risk-prone. The intensity of risk differs as per the type of security. Securities of the central government are usually safer when compared to the securities of the state governments and other local bodies. Similarly, the securities of state government and local bodies are a lot more secure when compared to the securities of industrial concerns.
This variation is because of the fact that the resources acquired by the central government are much higher than the resources held by the state and local governments and also higher than the industrial concerns.
Even after considering the securities, the bank needs to check the reliability of the borrower which is monitored by his character, capacity to repay, and his financial standing. Most importantly, the safety of bank funds relies on the technical feasibility and economic viability of the project for which the loan is to be given.
While choosing an investment portfolio, a commercial bank should abide by the principle of diversity. It should never invest its complete funds in a particular type of securities, it should prefer investing in different types of securities. Diversification basically targets minimizing the risk of the investment portfolio of a bank.
The principle of diversity is applicable to the progressing of loans to different types of firms, factories, industries, businesses and markets. It should distribute its risks by lending loans to various trades and businesses in different parts of the country.
Stability is another essential principle of the investment policy of a bank. A bank should prefer investing in those stocks and securities which highly stabile in their costs. Any bank can’t incur any loss on the rate of its securities. So it should always invest funds in the shares of branded organizations where the probability of a decrease in their rate is less.
Debentures of industries and government contracts carry fixed costs of interest. Their cost differs with variation in the market rate of interest. But the bank is bound to liquidate a part of them to fulfil its needs of cash whenever stuck by a financial crisis.
Else, they follow their full term of a decade or more and variations in the market rate of interest do not disturb them. So, bank investments in debentures and contracts are more stable when compared to the shares in various companies.
Profitability should be the chief principle of investment. A bank should only invest if it earns sufficient profits from that investment. Subsequently, it should, invest in securities that have a fair and stable return on the invested funds. The procuring capacity of securities and shares depends upon the interest rate and the dividend rate and the tax benefits they hold.
Banks make money by lending money to borrowers and charging some interest on the amount. So, it is very important from the bank to follow the cardinal principles of lending. In this entire process, banks earn good profits and grow as financial institutions. Sound lending principles by banks also empowers the economy of a country to prosper and also advertise the expansion of banks in rural areas.
Chandrima is a Content management executive with a flair for creating high quality content irrespective of genre. She believes in crafting stories irrespective of genre and bringing them to a creative form. Prior to working for Hrtech Cube she was a Business Analyst with Capgemini.