Credit management is the process of monitoring and collecting payments from customers. A good credit management system minimizes the amount of capital tied up with debtors.
It is very important to have good credit management for efficient cash flow. There are instances when a plan seems to be profitable when assumed theoretically but practical execution is not possible due to insufficient funds. In order to avoid such situations, the best alternative is to limit the likelihood of bad debts. This can only be achieved through good credit management practices.
For running a profitable business in an enterprise the entrepreneur needs to prepare and design new policies and procedures for credit management. For example, the terms and conditions, invoicing promptly and the controlling debts.
Credit management plays a vital role in the banking sector. As we all know bank is one of the major source of lending capital. So, Banks follow the following principles for lending capital −
Liquidity plays a major role when a bank is into lending money. Usually, banks give money for short duration of time. This is because the money they lend is public money. This money can be withdrawn by the depositor at any point of time.
So, to avoid this chaos, banks lend loans after the loan seeker produces enough security of assets which can be easily marketable and transformable to cash in a short period of time. A bank is in possession to take over these produced assets if the borrower fails to repay the loan amount after some interval of time as decided
A bank has its own selection criteria for choosing security. Only those securities which acquires enough liquidity are added in the bank’s investment portfolio. This is important as the bank requires funds to meet the urgent needs of its customers or depositors. The bank should be in a condition to sell some of the securities at a very short notice without creating an impact on their market rates much. There are particular securities such as the central, state and local government agreements which are easily saleable without having any impact on their market rates.
Shares and debentures of large industries are also addressed under this category. But the shares and debentures of ordinary industries are not easily marketable without having a fall in their market rates. Therefore, banks should always make investments in government securities and shares and debentures of reputed industrial houses.
The second most important function of lending is safety, safety of funds lent. Safety means that the borrower should be in a position to repay the loan and interest at regular durations of time without any fail. The repayment of the loan relies on the nature of security and the potential of the borrower to repay the loan.
Unlike all other investments, bank investments are risk-prone. The intensity of risk differs according to the type of security. Securities of the central government are safer when compared to the securities of the state governments and local bodies. Similarly, the securities of state government and local bodies are much safer when compared to the securities of industrial concerns.
This variation is due to the fact that the resources acquired by the central government are much higher as compared to resourced held by the state and local governments. It is also higher than the industrial concerns.
Also, the share and debentures of industrial concerns are bound to their earnings. Income varies according to the business activities held in a country. The bank should also consider the ability of the debtor to repay the debt of the governments while investing in their securities. The prerequisites for this are political stability and peace and security within the country.
Securities of a government acquiring large tax revenue and high borrowing capacity are considered as safe investments. The same goes with the securities of a rich municipality or local body and state government of a flourishing area. Thus, while making any sort of investments, banks should decide securities, shares and debentures of such governments, local bodies and industrial concerns which meets the principle of safety.
Therefore, from the bank’s way of perceiving, the nature of security is very essential while lending a loan. Even after considering the securities, the bank needs to check the creditworthiness of the borrower which is monitored by his character, capacity to repay, and his financial standing. Above all, 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 selecting an investment portfolio, a commercial bank should abide by the principle of diversity. It should never invest its total funds in a specific type of securities, it should prefer investing in different types of securities.
It should select the shares and debentures of various industries located in different parts of the country. In case of state governments and local governing bodies, same principle should be abided to. Diversification basically targets at reducing risk of the investment portfolio of a bank.
The principle of diversity is applicable to the advancing of loans to different types of firms, industries, factories, businesses and markets. A bank should abide by the maxim that is “Do not keep all eggs in one basket.” It should distribute its risks by lending loans to different trades and companies in different parts of the country.
Another essential principle of a bank’s investment policy is stability. A bank should prefer investing in those stocks and securities which hold a high degree of stability in their costs. Any bank cannot incur any loss on the rate of its securities. So it should always invest funds in the shares of branded companies where the probability of decline in their rate is less.
Government contracts and debentures of industries carry fixed costs of interest. Their cost varies with variation in the market rate of interest. But the bank is bound to liquidate a part of them to satisfy its needs of cash whenever stuck by a financial crisis.
Else, they follow their full term of 10 years 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 of industries.
This should be the chief principle of investment. A bank should only invest if it earns sufficient profits from it. Thus, it should, invest in securities that have a fair and stable return on the funds invested. The procuring capacity of securities and shares relies on the interest rate and the dividend rate and the tax benefits they hold.
Broadly, it is the securities of government branches like the government at the center, state and local bodies that hugely carry the exception of their interest from taxes. A bank should prefer investing in these type of securities instead of investing in the shares of new companies which also carry tax exception. This is due to the fact that shares of new companies are not considered as safe investments.
Now lending money to someone is accompanied by some risks mainly. As we know that bank lends the money of its depositors as loans. To put it simply the main job of a bank is to rent money from depositors and give money to the borrowers. As the primary source of funds for a bank is the money deposited by its customers which are repayable as and when required by the depositors, the bank needs to be very careful while lending money to customers.
Banks make money by lending money to borrowers and charging some interest rates. So, it is very essential from the bank’s part to follow the cardinal principles of lending. When these principles are abided, they assure the safety of banks’ funds and in response to that they assure its depositors and shareholders. In this whole process, banks earn good profits and grow as financial institutions. Sound lending principles by banks also help the economy of a nation to prosper and also advertise expansion of banks in rural areas.