CHAPTER TWO

LITERATURE REVIEW

2.0 Introduction

This chapter consisted of literature of credit management and financial performance and the review of literature relating to the objectives of the study. During the study, the researcher primarily looked towards the concept of credit management variables i.e. Client appraisal techniques, Credit control tools and Collection policies, financial performance variables included Revenue, profitability, cash flows and liquidity position. And the chapter ended with the summary conclusion of the literature review.

2.1 Theoretical Review

Previous literature has shown that there exists information asymmetry in assessing bank lending applications (Binks and Ennew, 1997). Information asymmetry describes the condition in which relevant information is not known to all parties involved in an undertaking (Ekumah and Essel, 2003). Studies on transaction costs have shown that transaction costs occur “when a good or a service is transferred across a technologically separable interface”. Therefore transaction costs arise every time a product or service is being transferred from one stage to another, where new sets of technological capabilities are needed to make the product or service. Therefore, it may be very well more economies to maintain the activity in-house, so that the company was not use resources on example contacts with suppliers, meetings and supervision. Managers must therefore weigh the internal transaction costs against the external transaction costs, before the company decides whether or not to keep some activity in-house. Wasiamson (1981).This chapter was review the asymmetric information theory and Transaction cost theory in credit management

2.1.1 Asymmetric Information Theory

Information asymmetry refers to a situation where business owners or manager know more about the prospects for, and risks facing their business, than do lenders (PWHC, 2002)  cited in Eppy.I (2005). It describes a condition in which all parties involved in an undertaking do not know relevant information. In a debt market, information asymmetry arises when a borrower who takes a loan usually has better information about the potential risks and returns associated with investment projects for which the funds are earmarked. The lender on the other hand does not have sufficient information concerning the borrower (Edwards and Turnbull, 1994).

Binks et al (1992) point out that perceived information asymmetry may pose two problems for the banks, moral hazard (monitoring entrepreneurial behavior) and adverse selection (making errors in lending decisions). Banks may find it difficult to overcome these problems because it is not economical to devote resources to appraisal and monitoring where lending is for relatively small amounts. This is because data needed to screen credit applications and to monitor borrowers are not freely available to banks.

2.1.2Transactions Costs Theory

First developed by Schwartz (1974), this theory conjectures that suppliers may have an advantage over traditional lenders in checking the real financial situation or the credit worthiness of their clients. Suppliers also have a better ability to monitor and force repayment of the credit. All these superiorities may give suppliers a cost advantage when compared with financial institutions.

Three sources of cost advantage were classified by Petersen and Rajan (1997) as follows: information acquisition, controlling the buyer and salvaging value from existing assets. The first source of cost advantage can be explained by the fact that sellers can get information about buyers faster and at lower cost because it is obtained in the normal course of business.

That is, the frequency and the amount of the buyer’s orders give suppliers an idea of the client’s situation; the buyer’s rejection of discounts for early payment may serve to alert the supplier of a weakening in the credit-worthiness of the buyer, and sellers usually visit customers more often than financial institutions do.

2.2. Conceptual Review

2.2.1. Credit Management

Credit management is one of the most important activities in any company and cannot be overlooked by any economic enterprise engaged in credit irrespective of its business nature. It is the process to ensure that customers will pay for the products delivered or the services rendered. Myers and Brealey (2003) describe credit management as methods and strategies adopted by a firm to ensure that they maintain an optimal level of credit and its effective management. It is an aspect of financial management involving credit analysis, credit rating, credit classification and credit reporting. Nelson (2002) views credit management as simply the means by which an entity manages its credit sales. It is a prerequisite for any entity dealing with credit transactions since it is impossible to have a zero credit or default risk.

The higher the amount of accounts receivables and their age, the higher the finance costs incurred to maintain them. If these receivables are not collectible on time and urgent cash needs arise, a firm may result to borrowing and the opportunity cost is the interest expense paid. Nzotta (2004) opined that credit management greatly influences the success or failure of commercial banks and other financial institutions. This is because the failure of deposit banks is influenced to a large extent by the quality of credit decisions and thus the quality of the risky assets. He further notes that, credit management provides a leading indicator of the quality of deposit banks credit portfolio.

A key requirement for effective credit management is the ability to intelligently and efficiently manage customer credit lines. In order to minimize exposure to bad debt, over reserving and bankruptcies, companies must have greater insight into customer financial strength, credit score history and changing payment patterns. Credit management starts with the sale and does not stop until the full and final payment has been received. It is as important as part of the deal as closing the sale. In fact, a sale is technically not a sale until the money has been collected. It follows that principles of goods lending shall be concerned with ensuring, so far as possible that the borrower will be able to make scheduled payments with interest in full and within the required time period otherwise, the profit from an interest earned is reduced or even wiped out by the bad debt when the customer eventually defaults. Credit management is concerned primarily with managing debtors and financing debts. The objectives of credit management can be stated as safe guarding the companies‟ investments in debtors and optimizing operational cash flows. Policies and procedures must be applied for granting credit to customers, collecting payment and limiting the risk of non-payments.

2.2.2. Financial performance:

According to the business dictionary financial performance involves measuring the results of a firm’s policies and operations in monetary terms. These results are reflected in the firms return on investment, return on assets and value added. Stoner (2003) as cited in Turyahebya (2013), defines financial performance as the ability to operate efficiently, profitably, survive, grow and react to the environmental opportunities and threats. In agreement with this, Sollenberg and Anderson (1995) assert that, performance is measured by how efficient the enterprise is in use of resources in achieving its objectives. Hitt et al., (1996) believes that many firms’ low performance is the result of poorly performing assets.

The firm financial performance can be measured in terms profitability, Revenue, cash flows among others. Van Horne (1989) said that a firm should evaluate its credit policy in terms of return (profits) and costs and are of three types which include; selling and production costs, Administration costs and bad debts losses. Management needs to establish a system on its trade debtors by critically addressing factors like cash discounts offered for prompt payment, credit period offered, evaluating customers credit worthiness and stating clearly the steps regarding late payment in its credit policy and thus credit standards which is the strength and credit worthiness of customer must be exhibited in order for potential client to quality of credit.

2.2.3 Profitability.

Profitability is measured by the incomes and expenses. Income is the money generated from the activities of the business for example the sale proceeds. Expenses are the costs of resources used up or consumed by the business. These costs include the opportunity costs for tying up funds in debts, cost of running the credit operations, cost of time to chase debts, cost of bad debts and the cost of dept. recovery (Leong, 2009). Profitability can be defined as either accounting or economic profits. Accounting profits is excess of the income over the expenses. However, a single non-profit financial year may not really harm the business of the firm, but when the firm incurs losses in the consecutive years it may jeopardize the viability of that business (DONs, 2009).

The accounting profits are measured to ascertain the success of the business. To see the business chances of survival; and to ascertain its ability to reward the owners for their investment into the business and this is the main goal to management.

The measurement of accounting profit is done by several instruments some of them include income statement which accounts for the financial, the income statement that measures project profitability of the business for the coming accounting year.

Economic profits is computed by deducting the opportunity cost from the net income (Graham, 2000). The opportunity cost includes money, labor and the management ability directed towards credit allocation. Economic profits are computed to provide the business with long-term perspective to oversee its continued operation. The firm’s profitability is influenced by the structure of the revenue generating assets like credit in Microfinance institutions which generate revenue in terms of interest incomes. Also profitability is dependent on the firm’s ability to eliminate risks in the asset operation to ensure correspondence between the assets and liabilities. (Bobakova, 2003).

2.2.4. Cash flows and liquidity position.

Cash discount is the percentage reduction on the amount of debts to be paid by the creditors. This acts as an incentive to induce the customer to repay the credit obligation within or lesser than the credit period. Cash discount act as a tool to accelerate credit collections from customers and this helps the firm to reduce the level of receivables and their associated costs Reigner and Hill (1997), Mosic (1982), Pandey (1995). Defines cash management as away concerned with management of cash flows into or out of the organization / firm’s cash flows within the firm and cash balances held by the firm at appoint of time.

Pandey (1995), Cash management is concerned  with managing of cash flows of the firm and cash balances held by the firm at appoint of time by financing deficit or investigating surplus. Cash sale generate cash which has to be disbursed out, the surplus cash has to be invested while the deficit has to be borrowed .Cash management needs to be accomplished at minimum cost.

Bodil (1999), a business cannot survive without enough cash to pay bills and finance growth. On the other hand, having too much cash is inefficiency cost of capital. Therefore firms should endeavor to their money at work to maximize value and when they invest excess cash they must strive a balance between risks and expected returns.

Business analysts report that poor cash management is the main reason for business failure. Poor cash flow handling is said t be the most crucial stumbling block for entrepreneurs. Therefore managers who don’t consider the effectiveness of the cash flows hinder the management of cash is the life blood of the business.

2.3. Empirical literature review.

2.3.1Effect of Client Appraisal on financial performance

The first step in limiting credit risk involves screening clients to ensure that they have the willingness and ability to repay a loan. Microfinance support Centre uses use the 5Cs model of credit to evaluate a customer as a potential borrower (Abedi, 2000). The 5Cs may help to increase loan performance, as they get to know their customers better. These 5Cs are character, capacity, collateral, capital and condition.

Character – refers to the trustworthiness and integrity of the business owners .it’s an indication of the applicant’s willingness to repay and ability to run the enterprise. Capacity assesses whether the cash flow of the business (or household) can service loan repayments. Capital – Assets and liabilities of the business and/or household. Collateral -Access to an asset that the applicant is willing to cede in case of non-payment, or a guarantee by a respected person to repay a loan in default. Conditions-A business plan that considers the level of competition and the market for the product or service, and the legal and economic environment

The 5Cs need to be included in the credit-scoring model. The credit scoring model is a classification procedure in which data collected from application forms for new or extended credit line are used to assign credit applicants to „good‟ or „bad‟ credit risk classes (Constantinescu et al., 2010).Inkumbi (2009) notes that capital (equity contributions) and collateral (the security required by lenders) as major stumbling blocks for entrepreneurs trying to access capital. This is especially true for young entrepreneurs or entrepreneurs with no money to invest as equity; or with no assets, they can offer as security for a loan.

Any effort to improve access to finance has to address the challenges related to access to capital and collateral. One way to guarantee the recovery of loaned money is to take some sort of collateral on a loan. This is a straightforward way of dealing with the aspect of securing depositors‟ funds. However although the company uses the 5Cs model of credit to evaluate a customer as a potential borrower according to (Abedi, 2000), Does not fully g defaulted according to end of year financial report of the company hence the researcher intends to carry out a further study to address the gap.

Sheilah (2011) commented that, the ability of financial institutions to promote growth and financial performance depends on the extent to which financial transactions are carried out with trust, confidence and least risk. This requires sound and safe loan appraisal to assess and unearth the financial character of the loan applicant before any step is undertaken. This will dictate on the conditions to be applied on the loan covenant to help curb bank–customer relationship that may have positive influence on financial performance of the commercial banksin Uganda. Sheilah is of the view that proper and adequate loan appraisal is the key to controlling or managing the level of income interests hence return on assets as well as return on equity therefore positively influencing on financial performance. The study established that loan appraisal did not adequately assess the value of assets to be invested on customers apart from return on equity to guide the execution of appropriate credit decision.

In a study by Nagarajan (2011) it was observed that the time taken to appraise the bank’s clients is very important in order to identify the return on deposits. This influences the bank’s financial performance. This reflects the bank management’s ability to utilize the customer’s deposits in order to generate profits. Moreover, Dhankal (2011) added by saying that the challenge with this policy is attractiveness of the banks to customers so as  to frequently make deposits and to offer incentives on delayed deposits so as to make use of these deposits to generate more revenues towards improved financial performance  of these banks. However, the study identified a gap in that this does not just involve only collection procedure details provided by the bank but also the procedure on how the lawful collection should take place.

2.3.2. Effect of Credit Risk Control on financial performance

Key Credit controls include loan product design, credit committees, and delinquency management.

(Churchill and Coster, 2001). Although most of microfinance institutions have tried to apply these tools, there is still a challenge among the credit committees in determining the institution’s credit policy and spotting potential risks of various transactions assumed by the institution. Therefore, the researcher intends to carry out further study to evaluate the effectiveness of the above credit risk control tools in relation to credit management and financial performance.

Mwangi (2010) investigated on factors that affect MFIs credit risk management practices in Kenya. The study’s specific objectives included how portfolio quality, market infrastructure and market concentration affected the credit risks of MFIs. According to the study results the three factors did affected credit risk of MFIs. Nyakeri (2012) carried out a research on how practices relating to management of credit affects financial performance in SACCOS in Nairobi .The research specific objectives included the effect of credit approval process, loan portfolio, credit score and the Risk analysis on the profitability of the MFIs. According to the findings the credit risk analysis improved the firm’s profitability, loan portfolio and returns of the MFIs.

Nagarajan (2011) assessed the risk management for MFIs in Mozambique concluded that the process of managing risks is ever changing and could be developed and tested when risk occurred. The processes need to consider the commitment of all the firm stakeholders for it to be planned and executed properly. An encouraging finding was that minimizing losses was possible by managing cash flow properly management of cash flows and portfolios, by coming up with robust institutional infrastructure, use of skilled employees and insisting of client discipline and effectively coordinating the stakeholders.

Moti (2012) studied the effectiveness of credit management system on loan performance: empirical evidence from microfinance sector in Kenya. The goal of the research was to determine how effective credit management was on the performance of loan in MFIs. The specific goals was to determine the effect of  control measures, credit terms, credit risk, credit collection policies and credit appraisal on the performance of loans. The study used a descriptive research method. The respondents who provided the data were officers who worked at MFIs in Meru. The findings showed that the collection policy highly affected the repayment of loans with =12.74, P=0.000 at 5% significance level.

2.3.3 Effect of Collection Policy on financial performance.

There are various policies that an organization should put in place to ensure that credit management is done effectively; one of these policies is a collection policy, which is needed because not all customers pay the firms bills in time. Some customers are slow payers while some are non-payers. The collection effort should, therefore aim at accelerating collections from slow payers and reducing bad debt losses (Kariuki, 2010).  Although the application of these policies to ensure timely payment of its accounts receivables the microfinance institutions  still face challenge of bad debts hence  the researcher needs to carry out a further study to assess the effectiveness of the collection policies to financial performance of microfinance institutions.

Owino (2012) in his study on effects of lending policies on  loan defaults on commercial banks says that the purpose of loan appraisal is to assess the likelihood that the loan asset to be offered to customers has higher interest margin that drives increased return on assets hence financial performance of the commercial banks. It includes assessing the borrower’s needs and financial conditions that identifies the borrower’s character, capacity, collateral, capital etc. Interested lenders will expect the loan applicant to have contributed from their own assets and to have undertaken personal financial risk to establish the business before advancing any credit. The study identified that the hindrance of loan appraisal is information asymmetry that spells doom on the success of fully assessing the loan applicant due to hidden information and history

According to Nyorekwa (2014) on the study of effectiveness of lending policies on financial performance of the banking sector in Tanzania observed that before lending out money, a bank has to assess all important factors that have a bearing on the financial soundness of the customer as well as the returns expected to be generated from the loan assets prime focus being the purpose and need of the credit and ability of the borrower to repay the credit advanced as per the terms of the loans. The borrower’s character, experience and competence to manage the business and to utilize the funds for the purpose for which they are lent are normally taken into account. The project or activity proposed for financing should be capable of generating sufficient income so that the loan is serviced and repaid to have targeted return on assets invested by the banks. There was a gap with how the loan appraisal could be conducted to establish if the bank’s lending could be too little or too much in relation to the need so as to cause problems

2.12 Summary of Literature Review

Following all the reports made by a above researchers,

The chapter begun by providing a brief discussion on key theoretical approaches and findings reported in earlier related studies credit management and financial performance. Key theoretical approaches discussed are Asymmetric Information Theory and Transactions costs theory. The chapter also concentrated on empirical facets of credit management and financial performance.

A credit policy forms part of a larger credit management systems. Most scalars have analyzed credit policy but little has been done on analyzing the relationship between credit management and financial performance of Microfinance institutions. Since most companies want to create a sustainable business with profitable growth both now and in future. The literature review has indicated that credit managers need to be critical when setting their credit policy and carrying out assessment of their customers before advancing any credit.

The theory stated the use of 5s, but did not critically state the ingredient to be looked at and to what extent it’s considered good for decision making.

Local studies that have been done on microfinance sector do not focus on the effect of credit management on the financial performance of Micro finance institutions; there is therefore a gap in the empirical evidence available hence the researcher seeks to study to bridge that gap.