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Ongoing Credit Risk Assessments Complement Your Collection Efforts
We often talk about the importance of having an efficient and effective collection process and how, from a process improvement perspective, collections automation provides substantial benefits. We don’t, however, want to minimize the importance of the credit side of the equation. As discussed in a recent post, gathering customer information doesn’t stop with the credit application.
Risk assessment is an ongoing process. You put your firm at risk by limiting credit assessments to only new customers, which is too often the case. Here’s a case study that illustrates the need for comprehensive and ongoing customer risk assessments.
A Hard Lesson Learned
A client manufactured and sold packaged coffee and tea to large retailers (supermarkets and “dry goods” stores). They had well-known products and robust sales. This firm believed their customers were financially okay and had ample borrowing capacity given their size and scope of operations. They did not sell to small customers; just chain stores and major distributors, who in turn sold to the smaller retailers.
Based on this industry outlook, there was staff performing collections and deduction resolution, but no credit function. New accounts were evaluated, but there were very few of those in any given year. In addition, orders were not held when a customer was past due. Making uninterrupted sales was deemed more important to their distribution network.
This company was fortunate to avoid significant bad debt loss until Ames Department Stores, Kmart, and Fleming Foods (a distributor) all filed bankruptcy within the same year. Bad debt losses were understandably huge.
Where They Went Wrong
The huge bad debt losses and resulting cash flow reduction were the direct result of an absence of an operating Credit Policy and ongoing Credit Control process.
While the firm vetted new customers, they never updated their initial credit decision with a subsequent credit investigation. The customers’ financial conditions changed over time, but their credit limits did not.
The volume and quality of their collection effort was adequate, but not being able to hold the orders of past due customers deprived the collectors of a very valuable collection tool. The overriding goal was to maximize sales volume. Collections was looked upon as a housekeeping function.
This company did not perform ongoing risk assessments as part of an effective credit control process. Customers were allowed to continue buying up to their assigned credit limit, even when their financial condition was deteriorating and the limit set five years ago reflected a completely different set of financial and economic circumstances.
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What Constitutes Valid Risk Assessment Parameters?
There needs to be standards for both evaluating credit risk and setting credit limits for new accounts as well as for the periodic monitoring of existing customers. This is the core of your credit policy.
Will you be relatively liberal or conservative in granting credit? To a large extent, that will be determined by the size of your gross margins and the current economy. The tighter your margins, the more conservative you need to be, especially when interest rates and inflation are issues. Likewise, when the economy is benign, as it was from 2012 to 2020, you can loosen your credit policy, although you should subsequently tighten it up again when economic headwinds emerge, as they have for the past several years.
Another factor in your credit policy is your production capacity. If you are producing at or near capacity, you will want to adopt a conservative credit policy, thereby reducing the risk of bad debt without having to worry about foregoing any profit opportunities. There is no good reason to sell to risky accounts on open terms when you can replace those sales by selling low-risk accounts.
From a Credit Control perspective, best practices include a rigorous credit evaluation for new customers, monitoring your accounts receivable (AR) for derogatory events, which includes deteriorating payment trends, and then reviewing existing customers on a predetermined, regular basis. Click on this link to read more about AR portfolio monitoring and periodic account reviews.
The key elements of Credit Control are:
A Credit Policy that reflects your firm’s appetite for Credit Risk versus incremental revenue: Your gross profit margin is the key factor here. The higher your margins, the less damaging a bad debt loss will be because you can recover the lost profit with a modest amount of additional sales compared to when margins are tight. Also, when gross margins are high, you risk losing sales, and their associated profits, due to restrictive credit standards. With low margins, every sale is vital to your company’s profitability, so you can’t be overly generous in extending credit. If you must sell to marginal accounts, the use of collateral or credit enhancements such as guarantees, UCC security agreements, and credit insurance help mitigate your risk.
Indicators of customer financial strength: These are found in the information you collect on a customer such as credit bureau reports and ratings (e.g., D&B, Experian, Equifax, CreditSafe, CreditRiskMonitor, etc.), analyzing the customers financial statements (liquidity is key), references from other suppliers (including industry credit groups), bank references, public record filings, industry news, and so forth. These inputs help you determine whether you should extend credit and how much. For more insights, check out the ABCs of Credit Evaluations.
Enforcement of your Credit Controls: It is essential to employ controls that hold orders when customers have exceeded their credit limit or gone a specified number of days past due. Orders remain on hold until a payment is received, bringing the account back within the release parameters, or the hold is manually overridden, typically based on a promised payment. If you don’t have a system that automates this process, every order should go through a manual credit check before being released. Here’s more on the order approval process.
Escalation Protocols: Escalation protocols define the collection steps to be taken and their timing to protect your company from bad debt losses. Your determination of a customer’s financial strength, and the size of their purchases, should inform the prioritization and sequence of collection steps (aka: collection strategy) you assign to each account. Within this strategic framework, collection activities should become increasingly more assertive and the intervals between steps shorter, as receivables age. The timeline starts with routine collection follow up when amounts are a few days past due, progressing to holding orders, involving sales and/or management in the collection effort, and ending in the referral of the account to a collection agency/attorney. Here’s more on systematic collections.
Wrapping Things Up . . .
Credit Controls are critically important to corporate profitability. They must be designed to fit an individual company’s situation and be executed with a well-defined, formal process that is adequately resourced and monitored. Automation tools can help tremendously in both effectiveness and efficiency.
While collections often make the most significant demand on your time and resources, effective credit approval and risk monitoring protocols help define your collection efforts. Too little effort on the credit side of the equation will result in more collection efforts being required and a higher risk of bad debt losses. By the same token, overly restrictive credit policies and procedures will ease your collection burden, but also result in lost profit opportunities. The key to achieving optimal AR performance is finding the appropriate balance between credit/risk and collections/remediation.