Is Granting Credit Terms Worth the Risk?
Four Questions to Consider when Evaluating Customer Credit-Worthiness
Imagine a world where extending trade credit was completely risk-free, and granting open terms of sale to business customers required no second thought. In such an ideal scenario, every customer would have both the ability and the integrity to pay their bills in full and on time, eliminating any need for a credit management. But reality matches to a different tune. In the real world, some customers inevitably face cash flow challenges, while others might be outright bad actors, creating a landscape where the role of credit management is not just necessary but vital.
The world of commerce is becoming more complicated by the day. Just 25 years ago, credit executives were primarily concerned with financial risks — except of course for the Y2K bug that briefly stole the spotlight. Back then, the main question was simple: will this account pay us? Delinquency risk and the risk of default were the primary focus. Now, the landscape has changed dramatically. Risks are multiplying at a dizzying pace, demanding that credit functions adopt a more comprehensive and forward-thinking approach to safeguard their organizations. It's like moving from checkers to chess overnight, with strategies becoming more complex, the moves more intricate, and the stakes higher than ever.
As we've shifted from a consumer-driven, industrial society to an information-driven, service-oriented economy, a flood of new risks have worked their way into the credit function. Regulatory and compliance risks have surged with the Gramm-Leach-Bliley and Dodd-Frank acts. Mass digitization has opened the door to cyber threats. Whether it’s fair to blame climate change or not, heightened awareness of natural disasters has amplified fears about supply chain disruptions—fears also exacerbated by the Covid-19 pandemic and the near collapse of the financial system in 2008. And as global economic integration deepens, so does the complexity and scale of these risks. The pressure is on for executives with credit responsibilities to navigate this ever-expanding minefield with precision and foresight.
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Four Questions to Consider when Evaluating Customer Credit-Worthiness
As noted above, the credit function has evolved far beyond assessing the ability of an account to make timely payments. While financial risk remains a core concern, the scope of risks that need to be managed has broadened significantly, demanding a more holistic approach. As the landscape continues to evolve, executives making credit decisions must adapt to effectively mitigate these diverse and expanding risks.
Within this still emerging socioeconomic framework, it’s constructive for credit executives to re-examine how they will manage risk from a holistic perspective. It all starts with asking the right questions. Here are four primary questions to ask regarding your accounts receivable (AR) portfolio that will help you get started:
1. What are the risks?
To fully understand the risks of doing business with a specific account, it’s essential to look beyond just financial statements and credit reports. Ask yourself the following questions to get a comprehensive view of the risks involved:
Are they who they say they are? Ensure you can identify both the business and its representatives. Confirm that the business and its agents are genuinely connected. This verification process is crucial for “Know Your Customer” (KYC) compliance and fraud prevention. Also, check if the company or its officers are listed on any government sanctions lists, such as those maintained by the Office of Foreign Asset Control (OFAC).
What is, or will be, your firm’s level of exposure to this account? This should be assessed in respect to the level of exposure your customer, including related entities, presents to your entire AR portfolio as well as in relation to their peer group. This evaluation should not only focus on sales opportunities but also on potential profits and the impact on your competition.
Is their data secure? Ensure the account meets your cybersecurity requirements. Be cautious about sharing sensitive information. For example, even if they prefer to pay via ACH, consider whether you want them to store your bank account number in their systems.
What does sentiment data reveal? Review what your customer’s customers are saying about the business and any media coverage, whether positive or negative. Online information, particularly about mid-size and larger companies, can provide valuable insights into their stability.
What are the risks associated with the account’s location? Consider risks related to the account’s geographical location. These can include political risks when you are exporting goods and services, hazard risks such as natural or man-made environmental disasters, and economic risks. This last factor is extremely important for a small business, whose success is largely influenced by its local economy.
2. How have the risks been changing over time?
Don’t limit your assessment of customer risk to the present moment. It’s more informative to track how risks evolve over time. Look for patterns or trends that indicate an account’s situation may be deteriorating.
As the preceding chart illustrates, different commercial credit scores on a specific customer can move in different directions, and will also vary trend-wise compared to the averages for your portfolio. In this case the delinquency risk score has been increasing, while the default risk score has just moved above the portfolio average in the last two quarters. Experience will be informative in helping you recognize if a trigger point is near and the chance of default increased. Plotting other risks such as environmental or political (see question #1 for more ideas) will provide additional insights as well as plotting AR balance and payment trends against the risk metrics. A holistic view of risk over time for individual customers as well as your entire AR portfolio will be very informative.
Note: Don’t worry about different scores being on different scales. My preference is to convert everything to a 1-100 scale for easier plotting.
3. What Are the Factors Behind the Total Risk Level?
To grasp why a particular account has its current risk level, dig into the specifics. Financial risks often don’t exist in isolation. They may stem from structural issues, such as under-capitalization or excessive leverage, or from external events like losing a key customer, supply chain disruptions, or natural disasters. In some cases, a combination of these factors can drive risk higher.
Knowing the causes of an account’s risk level helps predict how its risk environment might change and guides your response. Is the heightened risk due to a temporary business interruption the account can manage? Is it from growing pains that will likely resolve? Or, is there a good probability that the risk level will continue to rise?
4. How does the risk compare to industry peers?
It’s widely understood that how a customer pays other suppliers in your industry can indicate how they will pay you. Comparing your customers’ risk profiles with those of their industry peers is equally valuable. For example, compare the delinquency and default scores for a particular customer against the average scores for your entire AR portfolio and those in the same industry as was done in the above chart.
Ranking accounts by risk across your entire AR portfolio helps you see where each account stands relative to others and to industry norms. Determine if they fall into the top, bottom, or middle quartiles. This ranking helps you analyze your dollar exposure for low, medium, and high-risk accounts, providing insights into whether your AR portfolio’s risk level is increasing or stabilizing.
Something to Think About . . .
The focus of much credit executive training is on the credit and financial analysis of individual accounts. That is all well and good, but a holistic understanding of risk across an entire AR portfolio requires the comparison of one account relative to another and ultimately to every other account. That is best done by ranking your entire AR portfolio based on a single quantitative score. When that has been done, it is much easier to see where a new customer fits into the mix, which is your AR portfolio. Ranking, along with segmentation, is also your gateway into more sophisticated portfolio risk analysis insights. It’s all about actionable intelligence.