Gain Leverage Over Slow Paying and Risky Customers by Holding Up Their Orders
Order Management Best Practices Relating to the Use of Credit Holds
When a business reaches the point of multiple team members making new sales and taking orders from existing customers, the credit approval process gets more complicated. The owner or other executives no longer have visibility and control over every new order. Meanwhile, customers who previously were approved during your initial credit evaluation may become past due, max out their credit limit, or, worse yet, be in a deteriorating financial situation, all of which become even more likely when the economy is volatile—the result: cash flow problems and more exposure to bad debt losses.
Once your accounts receivable (AR) portfolio exceeds several dozen accounts, it becomes impossible to stay 100 percent up-to-date on the risk status and creditworthiness of every customer. This is because customers and markets are dynamic. The only constant is change. Consequently, the credit hold—holding up a new order when a customer is past due or over their assigned credit limit— is an extremely valuable credit control tool.
A Cautionary Tale
A provider of recurring professional services (multi-billion dollars in annual sales) to the Fortune 1000 did not assign credit limits or use traditional credit controls. The rationale was that it sold to a “blue chip” customer base, and if accounts receivables (AR) became seriously past due, service would be suspended until the past due balances were paid.
Being listed among the largest companies in the world, however, is not evidence of being creditworthy. In practice, this company was slow to recognize serious delinquencies, suspension of service was rarely used, and million-dollar bad debt losses ensued.
This company’s evaluation of the risk/reward tradeoff was flawed because it underestimated the credit risk of “large” enterprises. If you doubt that, look at the number of leading companies who filed bankruptcy in recent years. Creditworthiness should never be taken for granted.
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Order Management Best Practices
Handling orders efficiently and effectively involves merging credit controls into your order approval process. Every order needs to pass through a Credit Check before fulfillment or manufacturing activities begin.
Such an order Credit Check supposes you already have a process for vetting new customers. The initial credit evaluation should set a credit limit for new customers that get approved for open terms and also include a risk ranking of low or medium (a high-risk flag is reserved for customers that subsequently exhibit financial distress). For additional insights into determining the creditworthiness of your customers, check out this article.
Every order that gets processed needs to be evaluated based on the new order amount, the amount of any existing balances on the customer’s account, and the age of those balances. Any order that meets either of the following two conditions is placed on Credit Hold:
The customer has exceeded its credit limit by a significant amount, not just a few dollars—automated systems typically allow a 5-10 percent overage
The customer has a considerable balance that has aged past due a set number of days—typically a week or 10 day grace period
Most accounting or ERP software can be configured to run an automated credit check on new orders. All orders meeting your credit parameters will be passed through to order fulfillment, with any rejections held in a Credit Hold Queue pending manual release by an authorized executive. You then want to first secure payment or at least a promise-to-pay from the customer before releasing the order.
Whether automated or manual, Credit Holds serve as the “credit control of last resort.” They provide a very effective control mechanism that compensates for vulnerabilities associated with vetting new accounts, credit evaluations, credit monitoring, or even collections.
Suppose an account lands in the hold queue, and, after manual review, cannot be released. In that case, all other participants in the order fulfillment process should be notified of the order status and when release is expected. Any changes to the hold status or anticipated release date should also be communicated to these stakeholders.
The Added Challenge of Custom Products
If you are a custom manufacturer or the product the customer is ordering requires raw materials that will not be used for other customers, credit approval should be handled prior to procurement. If the product is unique only to this customer, but no unique raw materials are required, then credit approval should occur prior to manufacturing.
In either of the above situations, if the customer’s balance due status causes it to exceed your credit approval parameters during the order fulfillment process, you now face a tough decision. Unless shipped to this customer, the product is essentially worthless (only has scrap value), so you may have to accept the risk of slow payment and possible default. You can as a last resort use the post-production Credit Hold as leverage to extract faster payments, but you need to weigh the risk of not getting paid against the risk of ending up stuck with useless inventory.
Mitigating Loss with Customers at Risk of Default
As mentioned above, customers who are low credit risks can over time become high-risk debtors. That’s why credit limits and risk ratings should periodically be reviewed. Immediate action is required for customers who become a high-risk debtor and are therefore likely to default or enter bankruptcy.
Review the way forward with the customer: Go over their cash flow situation and willingness to cooperate—get a signed payment plan, promissory note, or other acknowledgment of debt if you can.
Move decisively to halt sales, or at least use new sales to reduce the total balance due: One way is to require cash in advance for the latest sale plus a percentage of the latest sale that will be applied against the past-due balance—this reduces your exposure to a Preference Claim should the debtor file bankruptcy within the next 90 days.
Secure the return of product if possible: Section 2-702(2) of the Uniform Commercial Code allows a seller who discovers that the buyer is insolvent to reclaim the goods by making a written demand within 10 days after delivery. This right, however, is junior to the rights of creditors holding liens. Should the buyer file bankruptcy, §546(c) of the Bankruptcy Code provides the seller with expanded rights of Reclamation. Under this statute, a written request for Reclamation is permitted within 45 days after delivery of goods and not later than 20 days after commencement of the case as long as the goods are still in the debtor’s possession and not having been processed into something else.
Place the account with a Commercial Collection Agency or Attorney if your efforts fail: The sooner you do this the better—as a rule of thumb accounts should be turned over for collections when they reach 120 to 180 days past due. Prior to turning the account over, at 90 days past due you should consider sending a final demand letter. Follow this link for more insights on working with a collection agency.
Keep a sharp lookout for trigger events: There are any number of red flags that may indicate your customer will have trouble paying you, e.g., your customer defaulting on loans, being cut off by a major supplier, broken payment promises, etc.
Review your options and actions with a bankruptcy attorney: Most creditor’s rights attorneys also handle bankruptcy or can recommend a bankruptcy attorney—early on in your business you should initiate a relationship with an experienced creditor’s rights attorney so you don’t have to reach out to a stranger when faced with a intransigent debtor.
Final Thoughts . . .
Credit holds provide you with an opportunity to not just speak with your customers but also get to understand their business and challenges better. While your primary objective is to get paid in order to release the order and invoice the new sale, you should also try to find out why the customer ended up on a credit hold.
The answers will be revealing. In most circumstances, it will turn out to be nothing more than an easily rectified administrative issue on the customer’s part. If that’s the case, you benefit by having secured their immediate payment and hopefully accelerated future payments. If it’s a chronic issue, you will need also to try to find a way to mitigate the problem so it doesn’t keep cropping up. Should the underlying cause be of a more structural nature related to their business model or the result of financial distress, you now have the opportunity to work with your customer to find ways for you to continue to get paid for what is now owed and still realize additional profitable sales.