Credit Policy is an inextricable part of a company’s Sales Policy. If you choose to sell on open credit, the terms you offer are in effect part of the price. If you discuss credit terms with a competitor, you are in violation of anti-trust statutes forbidding price fixing. Credit industry groups discuss the payment history of common customers, but they always have an independent moderator present so that customer discussion do not veer off onto the topic of how individual companies plan on selling those same customers in the future.
Because Credit Policy is a part of Sales Policy, how you manage credit impacts company profits. How then does your Credit Policy affect your overall profitability?
It affects the level of bad debt loss (uncollected Accounts Receivables) you suffer. This is a direct, dollar-for-dollar reduction of profit. You expended costs to fill a customer order, but never received payment.
Its impact on revenue: it can result in higher sales (and gross profit), or lower sales and gross profit depending on how much risk your Credit Policy tolerates and how well it is executed.
What’s Right for Your Firm?
Selling only to financially strong customers reduces the risk of bad debt loss, (and the cost of Credit and Collections activity required).
Most companies, however, need incremental sales volume from higher-credit-risk customers to break even and achieve profitability.
The solution to this challenge depends a lot on your gross margins. If you have a high gross margin, (for example 50% of sales), you can replace a $20,000 bad debt loss with an incremental $40,000 in revenue. However, if your gross margin is only 10%, you’ll need to generate $200,000 in incremental sales to break even. A low gross margin encourages a tighter credit policy.
Fortunately, there are a number of actions you can take to facilitate sales to higher credit risk companies on a profitable basis. To do that you will want to consider your pricing policy, insurance options, credit extension and risk mitigation protocols, as well as collection efforts.
Risk-Based Pricing
The first option is to charge higher prices to customers with higher credit risk. Doing this will compensate your firm for:
The additional administrative cost incurred in closely managing and controlling these customers’ accounts receivable balances.
The increased risk of a significant bad debt loss that your firm bears.
Should you go this route you will need to be careful to treat all customers in the same risk segment the same way. There needs to be a clear delineation between customers that get better pricing because they are a lower credit risk and the customers that are paying a higher price due to their higher credit risk.
Credit Insurance
Another option is to obtain Credit Insurance. Purchasing Credit Insurance, however, will only reduce the risk problem if:
The policy covers the financially weak, higher risk customers. Credit Insurance policies often exclude individual, high risk accounts. However, if the customer is a public company you may instead be able to purchase a Put Option Contract as protection.
The policy cost is acceptable. Insurers want to be paid for the risk they bear. If your high risk customers are very risky and numerous, the insurance premium may far exceed your average yearly bad debt losses.
The other policy conditions (deductibles, co-pays, etc.) are acceptable and make economic sense.
On the positive side, Credit Insurance may help you get a higher credit line and a lower interest rate if you are pledging your receivables as collateral for a bank loan or line of credit. For more on the ins and outs of Credit Insurance, check out this post.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
Tightly Manage the Credit Extended
If Credit Insurance is not a viable solution, you’ll have to manage the credit risk and exposure yourself. This involves setting lower credit limits (considering customer requirements, economic order size, etc.) for high risk customers, then closely monitoring these customers supported by aggressive collections. If you go this route:
Ensure you thoroughly review your financially marginal customers paying particular attention to financial strength (profitability), cash flow and leverage. Here’s more information on Credit Evaluations. Those that are too weak for you to extend credit will require up front payments — find the payment format (COD, Cash In Advance, down payment, credit card, etc.) that is most compatible with the customer.
Try to get a guaranty from a financially strong related party who will pay the AR if the customer defaults. This reduces the credit risk substantially and can lead to a higher credit limit. Make sure with Personal Guaranties that you both vet the person making the guarantee as well as the property laws for their state of residence - an individual guarantee in a joint property state can turn out to be useless.
Look at other risk mitigation instruments such as bonds, liens, and UCC security filings. Here’s more information on these risk mitigation instruments.
When you have established a credit limit, explain it and your expectations to the customers. A key element is to encourage truthful communications, because there will be bumps in the road.
Ensure that every order from these customers passes through a credit check. An automated order approval system is best if you have significant order volumes. If the customer account is in an acceptable state in terms of available credit and terms status, the order can be released. If not, the customer must be contacted. Typically a payment (or strong promise) will be required before the order can be released. Here’s more insights on Order Approvals.
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Flag Higher Risk Accounts for Aggressive Collections
The order hold routine will control AR exposure and trigger collection activity. However, substantial additional Collection activity may be required. More Collection activity, effectively administered will accelerate receipt of cash from these customers. These customers will require more intense follow up of past due invoices (e.g., every few days versus weekly), and collection follow up (e.g., at 4-7 days past due versus the two weeks or more that is typical).
If the additional collection activity looks like it will require adding staff (even part-time), there are AR automation solutions you may consider that are both low-cost and efficient. These can be easily implemented to increase and improve the AR management effort, thereby increasing cash flow with existing staff levels. These automation solutions also facilitate “work-from-home” which has become very important in retaining and attracting employees. For more on collections, check out this post.
A Case in Point…
International Paper Company (IP) produces a wide variety of paper products. One of their legacy products was the paper stock used to produce manila file folders and tickets for toll roads (for those of you who remember). As electronic storage of documents and EZ Pass type toll collection proliferated, the demand for this paper declined substantially. IP had one old paper machine that manufactured manila stock. It was very old and too costly to convert to manufacture other grades of paper.
Consequently, IP continued to sell this paper (in declining volumes) to a few distributors whose sales volume and financial condition deteriorated over time. IP used the Credit and Collection strategies described above to continue to serve these customers and collect the AR incurred. It finally ended when these few customers went out of business, but the bad debt losses (which were fully reserved for) were far less than the profits the company earned while keeping this product line alive. A clear example of the astuteness of the policies described in this article!
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The Bottom Line
Even if you implement risk-based pricing, you will still want to adjust your credit and collection policies in regard to those accounts. The increase in price should be calculated so that you still realize a profitable sale when calculated against the additional administrative credit and collection cost as well as any subsequent increase in bad debts. Credit Insurance, in contrast, eases the burden of credit, collections, and bad debt.
Implementing a more conservative credit and collections policy for financially vulnerable customers will unavoidably require more time and effort. Managing tight Credit limits to financially weak, slow paying customers requires a lot of communication and analysis, and almost daily monitoring of the account status.
Selling profitably to high credit risk customers on credit is possible and often necessary. Follow the steps described above and you will be able to reap profits and increase your cash flow from these customers.
Whichever tack you take, the one thing to keep in mind is that credit controls exist for the purpose of maximizing profits. The more risk you assume the higher your losses, which impact profits. A successful credit policy will be one that balances the risks against your profit potential in alignment with your Sales Policy.