The idea of exchanging goods or services in return for a promise of future payment developed only after centuries of trade: money and credit were unknown in the earliest stages of human history. Nevertheless, as early as 1300 B.C., loans were made among the Babylonians and Assyrians on the security of mortgages and advance deposits. By 1000 B.C., the Babylonians had already devised a crude form of the bill of exchange, so a creditor merchant could direct the debtor merchant in a distant place to pay a third party to whom the first merchant was indebted. Installment sales of real estate were being made by the Egyptians in the time of the Pharaohs.
Traders in the Mediterranean area, including Phoenicia, Greece, Rome and Carthage, also used credit. The vast boundaries of the Roman Empire, at the beginning of the Christian era, encouraged widespread trading and a broader use of credit. In the disorganized period that marked the decline and fall of the Roman Empire, credit bills of exchange or promissory notes were widely used to reduce the dangers and difficulties of transferring money through unorganized trading areas.
During the Middle Ages, a period which spanned 1000 years from about 500 to 1500 A.D., credit bills were essential to the trading activities of the prosperous Italian city-states. Lending and borrowing, as well as buying and selling on credit, became widespread practices; the debtor-creditor relationship was
found in all classes of society from peasants to nobles, even including the Pope and other high dignitaries of the Church. A common form of investment and credit, especially in Italy, was the “sea
loan” whereby the capitalist advanced money to the merchant and thus shared the risk. If the voyage was a success, the creditor got the investment back plus a substantial bonus of 20 to 30 percent; if the ship was lost, the creditor could lose the entire sum.
Another form of credit was the “fair letter” which was developed at the fairs held regularly in the centers of trading areas during the Middle Ages. The fair letter amounted to a promissory note to be paid before the end of the fair or at the time of the next fair. It enabled a merchant, who was short of cash, to secure goods on credit. This gave the merchant time either to sell the goods brought to the fair or to take home and sell the goods that had been purchased on credit.
The discovery of the New World provided new opportunities for the growth of capitalism and the expansion of credit. The first recorded use of open credit in early America took place with the establishment of the first permanent colony in New England. In September 1620, the Mayflower set sail from England for Virginia. Because of bad weather and navigational errors, the Pilgrims ended up off the coast of Cape Cod and eventually established the village of Plymouth in Massachusetts. While the journey itself was a tremendous achievement, so was its financing.
The Pilgrims had spent three years of arduous negotiations in England attempting to raise the funds necessary for the trip. A wealthy London merchant financed the trip and provided for “all credit advanced and to be advanced.” In return, the Pilgrims contracted to work for a period of seven years. At the end of that period, payment would be made to the creditors based on the size of the individual investment.
The original credit of £1,800 could not be paid at the end of seven years, so an alternative arrangement was agreed upon: £200 to be paid annually for a term of nine years. This arrangement had to be renegotiated and finally, after 25 years, the last payment was made. This was the first example of credit in early America.
To finance the American Revolution, the Second Continental Congress made efforts to finance the Army of the United Colonies. The Congress had only three alternatives: borrow the money from sympathetic countries abroad which was an impossible task since the Colonist’s credit in the world stood at zero; impose taxes which was unpopular and the very cause that had brought about the American Revolution; or issue bills of credit.
In June of 1775, the Continental Congress authorized the printing of $2,000,000 in various denominations ranging from one dollar to eight dollars. Trouble for the Continental currency began almost at once; each note had to be hand signed which was not a simple task considering 49,000 of them had to be signed. Counterfeiting of the currency was rampant. The principle behind the Continental currency was, in essence, a promise to pay the final bearer, at some point in the future, the face value in Spanish coins, the coins in widest circulation at this time.
In 1783, the Treaty of Paris was signed bringing an official end to the war and official recognition of the United States by England. Trading resumed and American importers and wholesalers extended generous terms to their customers. Generally, sales were made on terms of 12 months but even where six- or nine-month terms where offered, it was not uncommon for an account to remain unpaid for a much longer period, up to 24 months or more.
With the restoration of pre-Revolutionary trade customs and habits, credit references assumed importance, although in most instances, proper information was still lacking. Some prospective purchasers took the precaution of using the names of prominent people they knew when placing orders on credit. Credit references accompanied orders, however in most cases, merchants took their chances.
Terms of sale, as they developed during the 1800s, reflected the changes in the rapidly expanding economy. The 12-month period, which had prevailed, showed a tendency to become shorter. By the 1830s, the average term of sale was about six months.
Hard financial times hit the country in the mid 1830s. The population was rapidly growing and business was expanding. The sale of land on credit went virtually unchecked. The banking system was not centralized. By the summer of 1837, bank after bank closed its doors and thousands of businesses went into bankruptcy. The financial panic of 1837 saw the beginnings of the Mercantile Agency, established in 1841 by Lewis Tappan. It was this credit information agency which eventually became Dun & Bradstreet and helped transform credit, and with it, the course of American commerce.
The story of American credit, as we now know it, was not solely influenced by Dun & Bradstreet. Another organization important for credit managers worldwide was formed in 1896 in Toledo, Ohio. A group of credit executives, representing a hundred or so of their colleagues, organized themselves into a national association for credit managers, the National Association of Credit Men. Their exchange of credit information was initially conducted on a local and regional level. The association expanded into the National Association of Credit Management (NACM), which today with its network of Affiliated Associations, represents approximately 30,000 credit executives worldwide.
Edited by Michael C. Dennis
To establish an appropriate credit-risk environment, the company President or the CFO should periodically review with the Credit Manager the company’s credit-risk strategy and credit policies to confirm that they reflect the company’s tolerance for credit risk, and will support the level of sales and cash flow that the company expects and requires. Establishing the appropriate credit risk environment is a balancing act. For example, it is possible to generate higher sales by offering longer payment terms to customers. It is also possible to generate higher sales by offering higher credit limits and/or open account terms to marginal or high risk customers. The need for higher sales must be balanced against the possibility of higher DSO and higher bad debt write offs.
The credit manager is responsible for implementing the credit-risk strategy approved or established by senior management. In addition, credit professionals remain responsible for developing and implementing policies or procedures for identifying risk, as well as for measuring, monitoring, and controlling risk. Credit granting authority and credit granting criteria should be carefully documented and thoroughly understood by everyone with authority to extend credit or release orders.
Credit professionals should have a written process for approving new accounts, as well as for periodically re-evaluating existing customers. In addition, creditor managers need to periodically update every active account. How frequently should this be done. The answer depends in part on the company’s credit risk strategy. If the company wants to invest the time and money necessary to update every active customer account every year, not surprisingly the numer and severity of payment delinquencies will likely decrease [assuming the credit department takes appropriate action in response to indications that the customers identied in this annual review as representing a higher risk of default or payment delinquency are managed accordingly]. However, the company needs to provide the credit department with the resources necessary to conduct these reviews along with the authority to react to individual customers’ deteriorating creditworthiness.
One useful tool involves evaluating the credit risk environment involves scoring customers on the basis of their degree of credit risk. Customers identified as high risk should be subject to more stringent follow-up if and when the account becomes delinquent, and should be scheduled for more frequent credit file updates.
One final comment: Many companies look at payment history, but payment history is not necessarily a good indicator of the risk associated with extending credit to a customer. At least some high risk customers will pay certain creditors on time fearing that if they fail to pay some creditors consistently they will not be able to secure open account terms from new suppliers.
© 2012. Michael C. Dennis. All Rights Reserved.