Essay Example: Theoretical Review of the Credit Management

Published: 2019-10-29
Essay Example: Theoretical Review of the Credit Management
Type of paper:  Essay
Categories:  Finance Banking Debt
Pages: 7
Wordcount: 1746 words
15 min read

Van Hove and Karimov (2015) conducted research to determine the effects of risks emanating from the payment method and period on e-retailers as evidence for transitional economies. The study analyzed how the operation of such retailers in affected by the mode of payment as well as the time. The study revealed that the retailers preferred a pay in advance mechanism for a sustainable transitional economy during their operations. Kumari and Pakkala (2015) examined the inventory policies about trade credit. The duo focused on the time of payment when it is attached to uncertainties. The retailers are bound to repay the advanced credit within the specified time. The study conducted by the duo revealed that there is no guarantee that the client will make payment at the expected time Hove & Karimov, 2015). The lack of customer adherence to policy guarding credit transactions may result from uncertainty in cash flows and unpredicted occurrences. The study found out that the depending on the payment pattern of a retailer, it is important to incorporate the probabilistic considerations. The study proposed a method that included the net present value of the costs incurred to set an optimal policy (Jibrin and Success Blessing Ejura, 2013). The shortcoming stifles the growth and productivity of organizations and putting potentially successful enterprises at high risk of the operation.

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Moreover, late credit payment is a nightmare to organizations. According to Business Matters (July 2009), the late payment of credit is associated with the ripple effect in groups. The problem is noted to have affected more than half of the United Kingdom SME businesses Hove & Karimov, 2015). The research conducted showed that about 53% of business owners in the United Kingdom are also defaulting the payment dates for other parties to cater for the gap created by the customers who were advanced credit. Most of the enterprises are spending more than a month to recover the payments. The process of recovering the debts is an additional cost to the organization as it affects the business operation by dragging the intended financial activities and investment (Scherrer, 2003). The late payment of credit causes delayed funding of suppliers thereby stagnating progress of transactions. The scenario of lateness in payment is a crucial subject because the vicious cycle caused by the phenomenon is complicated and concerns the progress of organizations. Besides, research carried out by the Public Opinion Program at Hong Kong University found out how delayed payment is affecting the Small and Medium-Sized Enterprises (Scherrer, 2003).

Previous studies on the effect of credit management indicate that there exists evidence asymmetry in evaluating bank loaning applications which are a condition in which vital information is not shared effectively on parties engaging each other. Research studies on transaction costs have revealed that transaction costs take place whenever a good or a service is moved through a technologically separable platform (Jibrin and Success Blessing Ejura, 2013). Transaction costs will always emerge every time a product or service is being transferred from one stage to the next especially when new sets of technological implements are required to arrive at the product. It is the responsibility of the organizational managers to keep a close watch of the internal and external operations of an organization especially the engagement with suppliers, manufacturers, and other business stakeholders. It helps to keep vigil on the progress of the organization and what measures to be taken to arrive at the set organizational goal. Credit management is one of the core aspects of any business venture and requires frugal treatment for the organization to gain economical stability and be profitable (Scherrer, 2003). Deteriorating credit the quality in an organization is one of the shortfalls experienced by the management which in return leads to poor financial performance and conditions.

A proper credit management should always lower the resources that are locked with the debtors, and minimizes the possibility of getting into bad debts since it is the greatest risk creditors get. Organizations should adopt effective management of accounts receivables which includes designing and documentation of a sound credit policy Hove & Karimov, 2015). Most businesses face fluidity and insufficient working capital hitches because of lax credit standards and inappropriate credit policies. A realistic credit policy is a benchmark for how the organization communicates with and treats its most valuable asset, the customers. This section will review the asymmetric information theory and Transaction cost theory in credit management.

Asymmetric Information Theory

Asymmetric Information Theory is a scenario in which the lenders have insufficient information about the prospects and risk facing business that usually borrow from them. It describes a business scenario in which the stakeholders involved in a transaction are devoid of the relevant information regarding the undertaking (Scherrer, 2003). In a debt sector, information asymmetry occurs when a borrower outsourcing for a loan facility has better information about the anticipated risks and returns associated with the investment projects for which the funds are channeled. The lender, on the other hand, does not have sufficient information concerning the borrower making it riskier which might affect the business operations of the lender. Perceive information asymmetry poses two implications for the banks which are; moral hazard (characterized by monitoring entrepreneurial behavior) and adverse selection (which is making errors in lending decisions). The commercial and the lending sectors will find it hard to overcome these problems as it is not economical to commit resources to appraisal and monitoring processes especially when lending is for relatively small amounts (Scherrer, 2003). Most bankers are faced with a situation of information asymmetry in the event of assessing lending applications. The information needed to assess the eligibility, competence, and commitment of the entrepreneur and the speculations of the business is either not achievable, uneconomic to obtain or difficult to interpret.

Transactions Costs Theory

The theory stipulates that suppliers may have an upper hand over traditional lenders in evaluating the real financial situation or the creditworthiness of their clients. The suppliers have the advantage to monitor and force repayment of the credit (Jibrin and Success Blessing Ejura, 2013). All these requirements may give suppliers a cost advantage when compared with financial institutions.

Financial Profitability

Return on Assets falls within the domain of performance measures and trails MFIs capacity to produce income on the basis of the assets. Return on assets provides a broader perspective in comparison with to other different measures as it surpasses the fundamental activity of MFIs that includes providing loans, and follows income from operating proceedings including investment, and also evaluates profitability regardless of the MFIs funding structure (Scherrer, 2003). Return on assets is expected to be positive as a reflection of the profit margin of the Microfinance Institutions. Otherwise, it reflects non-profit or loss.

Client Appraisal

The best strategy to limit credit involves screening clients to ensure that they posses the willingness and ability to repay a loan. Microfinance Institutions use the 5Cs approach to lending to evaluate a customer as a potential borrower Hove & Karimov, 2015). The 5Cs help the microfinance institutions to increase loan performance, as they get to know their customers better. The 5Cs includes character, capacity, collateral, capital and condition (Scherrer, 2003).

Empirical Review

The financial institutions and bank need to meet imminent regulatory standards for risk measurement and capital. It is a horrible misconception to think that meeting regulatory requirements are the sole reason for establishing a sound, scientific risk management system. Managers need sufficient risk measures to direct capital to activities with the best risk/reward ratios for the organizations they work for (Scherrer, 2003). They need to estimate the size of potential losses to stay within limits imposed by readily accessible fluidity by creditors, customers, and regulators. The organizational managers need to adopt mechanisms to track situations and build incentives for practical risk taking by individuals. Risk management is a changing process that can ideally be developed during normal times and tested at the wake of risk. It calls for careful planning and commitment on the part of all the parties taking place in the engagement (Jibrin and Success Blessing Ejura, 2013). It is possible to reduce the risks related to losses through diligent management of portfolio and cash-flow through building a robust institutional infrastructure with skilled human resources and encompassing client discipline, via operational management of stakeholders.

There is a significant relationship between financial institutions performance concerning profitability and credit risk management. Appropriate credit risk management results in better performance. Thus, it is of critical importance that financial institutions exercise sensible credit risk management to defend the resources of the institutions and protect the investors motivations. It is also true for microfinance institutions (Scherrer, 2003). The method used by the researchers is mixed research method. The aim of credit risk management is to maximize a banks risk-adjusted rate of return by upholding the credit risk exposure within an acceptable boundary. The efficient management of credit risk is a vital part of the whole risk management system and is essential for every banks bottom and ultimately the existence of all the banking creation (Hove & Karimov, 2015). It is therefore important that credit choices are made by sound examination of risks involved to avoid harms to banks profitability (Burn-Callander, 2015). Effective management of credit uncertainty is an essential component of an effective technique to risk management and important to the long-term success of all banking institutions.

The short-term debt will significantly impact the microfinance outreach positively in most countries. Studies have revealed that long-term debt shows a positive relationship with outreach of customers, but it is not significant concerning default rates.

Credit risk controls emulated by microfinance institutions have an effect on credit insurance, loan performance, the signing of covenants with customers, the credit rating of customers, diversification of loans reports on financial status, refrain from further borrowing have an impact on loan performance (Scherrer, 2003). Collection policies adopted by microfinance institution had an impact on credit performance. A stringent policy has a great impact on loan performance, and the appropriate policy has an effect, but it is not as great as that of strategic policy.

Summary of Literature Review

Once the credit or loan policy is correctly stipulated, carried out and well understood at all tiers of the financial institution management, it allows the organization to maintain the necessary standards of the bank loans to avoid unwanted risks and correctly assesses the opportunities for business development (Jibrin and Success Blessing Ejura, 2013). Retailers prefer a pay in advance'mechanism for a sustainable transitional economy during their operations. The retailers are bound to repay the advanced credit within the specified time. The study conducted by the duo revealed that there is no...

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