Are There Hidden Risks in Your AR Portfolio?
Periodic Account Reviews and Ongoing Portfolio Monitoring Are Essential
Approving a new customer for credit terms is merely the first step taken by a B2B vendor to begin an open credit relationship. Situations change, both for the vendor and for its customers. Economic circumstances may prompt a vendor to either tighten or loosen its credit policies and customer credit limits. Going beyond the impact of macroeconomic trends, a company’s customers operate in dynamic business environments, and for a majority of them, the credit risk they pose is either increasing or decreasing.
In fact, as a trade credit grantor, 20 percent of your customers will incur significant changes during any one year. New and small businesses, moreover, have high failure rates. Historically, only half of all new businesses make it to their fifth anniversary. Meanwhile, the number of commercial bankruptcies is accelerating. In February, Epiq Bankruptcy reported that commercial Chapter 11 bankruptcy filings climbed 118 percent year-over-year. The point is, where the risks are concentrated in your AR portfolio can change significantly from year-to-year.
The Imperative for Both Periodic Reviews and Ongoing Monitoring
One of the things you should do immediately upon approving a customer for credit terms is schedule their first Account Review. A review starts with the customer’s credit and payment history with your firm, details you don’t have with a new customer. Past is not always prologue, but how a customer pays you is one of the best predictors of how they will pay you in the future — so watch out for any negative changes. The remainder of your review will mirror an initial credit evaluation (here’s more information on Evaluating Credit).
Your Account Reviews provide the foundation for your Portfolio Monitoring. While Account Reviews provide for a systematic upgrading of customer limits and risks, Portfolio Monitoring goes a couple of steps further and involves the ongoing oversight that fills in the gaps in your Account Review process. Portfolio Monitoring, therefore, encompasses the Account Review Process by also incorporating the identification of red-flags (such as changing payment patterns) and other circumstances that trigger an Account Review. In other words, Portfolio Monitoring involves looking out for external factors that affect your customers and the distribution of risk in your accounts receivable (AR) portfolio.
A Case in Point . . .
About 25 years ago, a credit manager I know saved his company from a seven-figure bad debt loss by monitoring the Internet on his biggest customers. The intel he uncovered revealed the financial difficulties facing the foreign parent company of one of his large chain store customers. If the European parent company defaulted, the North American subsidiary would be pulled into bankruptcy even though its operations were profitable.
Consequently, the credit manager was able to purchase credit insurance on his customer, and was therefore able to continue approving credit sales, within limits, to the chain store customer. About 15 months later, the parent company defaulted on its debt and the chain store subsidiary was indeed pulled into the ensuing bankruptcy proceedings. The credit insurer was then compelled to pay the credit manager’s firm for the receivables lost because of the bankruptcy, which means this company was making profitable sales to the chain store for the entire 15 months after the high default risk had been identified.
There is also a sequel to this case study. The credit insurer, after learning how the credit manager had identified this potential bankruptcy risk, brought the credit manager in as a consultant to teach their credit analysts how to better monitor the insurer’s credit portfolio, especially in regard to using Internet resources and applications. He also got a well-deserved promotion. Today, utilizing the Internet for intelligence gathering is much easier (let us know if you need help in this regard).
Periodic Account Reviews, while certainly beneficial, would not necessarily have revealed this problem. Ongoing Portfolio Monitoring was critical to turning up the customer intelligence that avoided a huge bad debt loss.
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Five Credit Review Best Practices
The challenge inherent with credit reviews, especially as your customer-base grows, is finding the time. Failing to periodically and systematically review your customers, however, exposes your firm to potentially higher bad debt losses as well as slower payments. Companies get in trouble when the urgency of day-to-day issues trumps the importance of keeping up with the credit review process. Here’s some guidelines for Account Reviews that balance the time and risk equation:
Be periodic with your reviews: The top 20 percent of your customers in terms of sales volume should go through an annual, comprehensive review. Reviewing the remainder of accounts every 2 to 3 years should suffice. There will only be a minimal loss if a small volume account defaults, so the higher the sales volume and credit risk (and remember that new businesses pose a higher risk), the more frequently you should be reviewing those accounts.
Update financial information: This applies primarily to the top 20% of your customers or anybody else with a relatively high credit limit or high credit risk, and should be done annually. Public companies provide information quarterly to the SEC, so it is easy to capture these filings from EDGAR whether or not they are a large or small customer. As for the private companies you require to submit financials, you should insist on a yearly update, keeping the previous two years in your files for comparison.
Update credit and bank references: This should be done annually for the top 20% of customers and every 2 to 3 years for the remainder. This follows the same schedule as your periodic Account Reviews on the assumption this will be done manually. With an automated system, this can be done every six months if not continuously.
Update credit applications: This should be done every 5 years, unless triggered sooner by a change in the business (e.g., ownership, principals, locations, business lines, etc.)
Update credit bureau reports: every 2 years unless triggered sooner by a change in their relationship with your company (e.g., request for substantially more credit, change in leadership, merger or acquisitions, a significant reduction in credit score, etc.). Credit Bureaus will do incremental updates as information is available, but if no new information has become available, will typically let the report stand as is for 18 months before updating.
Identify Emerging Credit Risks with Portfolio Monitoring
Every AR Portfolio is dynamic. This constant change requires continuous monitoring, not just periodic Account Reviews. Having accumulated customer details through the credit application and customer onboarding process and Account Reviews, Portfolio Monitoring is the subsequent process by which you collect additional intelligence over the lifetime of the customer. There are several sources for the information that generates your customer intelligence.
Your company’s interactions with the customer: whether it be a sales call, responding to a customer service query, or requesting payment from the customer you are accumulating intelligence that expands your understanding of the customer. On-site sales visits can be particularly illuminating. Are the facilities deteriorating? Is there a lot of stagnant inventory? Is the business operating smoothly or are the employees running around putting out fires? Hopefully, you are capturing these details in your CRM solution. Derogatory situations, however, should be investigated immediately and, if necessary, spark an Account Review.
Change Notification Services: these are offered by commercial credit bureaus as well as public information compilers such as Lexis/Nexis. You provide the service with your customer list, and they provide you with a list of customers who have changes of address or ownership or incurred a derogatory event (e.g., liens, suits and judgments). This is typically done on a monthly cycle.
Credit Scores: while credit scores can be useful for establishing credit, especially for small businesses, they provide even more intelligence when viewed over time. Credit scores typically provide either a probability of default or of slow payment. In either event they are useful in highlighting trends — clearly sharp drops or extended downward trends deserve an Account Review. Credit Scores can be acquired from a credit bureau on a periodic basis (every three to six months is usually sufficient) or as part of a change notification service.
The Internet and Industry Trade Journals: even private companies get in the news. Publications covering the industries you are in should be monitored for news about your customers. You can also set up your search engine or web browser to monitor anything that comes up on the Internet about your customers (or at least your more important customers). Your customers’ own company websites are also a good source of information including details on their ownership and management, products and services, partners and customers, as well as containing press releases.
Get a New Perspective on Risks and Rewards with Portfolio Analysis
Periodic account reviews and portfolio monitoring will contribute to your cache of customer intel. All the information you acquire can provide actionable insights for mitigating credit risks and identifying sales opportunities. A segmentation analysis of your AR portfolio based on sales volume, credit risk, industry type, and so forth will reveal areas where there are concentrations of risk, as well as customers whose credit is being under-utilized. Such insights are enormously valuable but are often unrealized because the analysis is not being done on a regular basis.
For most companies, AR is one of the two largest assets on their books. Assuming all will be okay opens you up to unexpected losses. However, information is power, and you will be able to make more intelligent decisions about your customers and AR portfolio with ongoing account reviews, portfolio monitoring and portfolio analysis. As the saying goes, an ounce of prevention is worth a pound of cure.