Extending credit is the financial backbone of Business-to-Business (B2B) commerce. If you require payment in advance or upon delivery of goods or services, you are unlikely to find many customers willing to trade on those terms causing your business to not generate enough revenue to survive.
In most cases, you therefore have to extend credit to your B2B customers, which entails the following risks:
Not being paid anything
Being paid an amount less than the full invoice value
Not being paid on time, whether in full or in part
These outcomes are known as credit risks. Not being paid in full or in part causes a bad debt loss. Not being paid on time reduces profits commensurate with your cost of capital and cost of collections — the longer the time it takes to be paid, the higher those costs. To avoid unacceptably large credit losses, a system of credit controls and procedures must be implemented.
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Effective Credit Control – What Is It?
Effective credit control involves controlling credit risk to the level desired by management. It should not be the elimination of all credit risk. Accepting higher credit losses that facilitate higher sales volumes, whose net impact is an increase in profits making it to the bottom line is a good business strategy. Unacceptable risk occurs when there is a negative impact to the bottom line from taking on too much credit risk.
The better your credit controls, the more risk you can assume. If you have poor credit controls, you won’t be able to afford as much risk in your accounts receivable (AR) portfolio. Examples of poor credit controls include a cursory rather than formal new customer approval process, ad-hoc rather than systematic collection efforts, error-prone billing practices, and poor dispute handling.
Read on to learn:
Effective Credit Control Defined
Gauging the Right Amount of Credit Risk for Your Firm
Measuring Credit Risk in Your AR Portfolio
Risk Mitigation and Maintaining Credit Control
How Much Credit Risk is “Right” for Your Firm?
Answering this question provides the foundation for a company’s Credit Strategy. The first step is to estimate how much bad debt loss you can absorb as a percentage of sales in a year. This will determine how much credit risk you can bear and how tight your credit controls need to be.
The principal determinant is your overall Gross Margin. If it is high, you can bear more credit risk, since the incremental profit on a sale to a risky customer when paid, will deliver significant profit. Conversely, if the profit margin is low, bad debt losses will have a much greater impact, and credit controls will have to be tighter. The following examples illustrate the point:
A wholesaler had a 2 percent gross margin. It required $500,000 in added sales to compensate for a small, $10,000 bad debt loss.
Many pharma manufacturers have a gross margin above 80%. They can sell to high risk customers on credit, because when they do get paid, the profit they gain exceeds even a substantial rate of bad debt in the aggregate. New sales of only $12,500 compensates for a $10,000 bad debt loss.
A second determinant is your Company Credit Strategy. It can be designed to:
Maximize revenue growth. This strategy will require a higher tolerance for bad debt expense as you will sell to customers with a higher credit risk to increase revenue.
Maximize profitability and cash flow. This strategy calls for tighter credit controls to minimize credit loss and late payments. It will limit the number of customers you sell to on credit which will constrain revenue.
Most firms opt for a more balanced strategy that lies somewhere in between these two extremes. The idea is to quantify the amount of bad debt loss you can tolerate and still meet your objectives. Keep in mind that to achieve the outcome you want may require tolerating a higher level of credit risk than you currently have.
A third factor that comes into play is your production capacity. If you are running at close to one hundred percent capacity, you should be prioritizing less risky sales over those of customers that are more likely to default or pay late — there is no need to take on risky sales. However, if you have extra production capacity, you may be able to accept more risk because your embedded fixed costs have already been covered.
Finally, look at your actual bad debt loss percentage for the past three or four years in the aggregate — that is the total bad debt loss over three or four years versus the total sales over the same period. Next, take the gross profit budgeted for the next fiscal period and factor in an estimate for bad debt losses for that year that might occur to any changes contemplated that will affect your anticipated credit risk. Then you are able modify the “tightness” of your credit policy based on your strategic goals. In the end, this will likely involve changing credit limit guidelines as part of your implementation of a new set of credit controls, which is a process requiring a separate discussion.
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Credit Control: Measuring Portfolio Risk
Measuring the credit risk in your AR portfolio can done a couple of different ways. One involves assigning a risk score or rating to every account. The other involves using historical bad debt losses.
If you are only selling to public companies, you can use the rating assigned to each of your customers by the rating agencies (Moody’s, Standard & Poor, or Fitch Ratings). If 80 percent of you customers have an investment grade rating, and 20 percent are below grade (in the junk category), raising the percent of total AR owed by below grade customers will raise your aggregate portfolio risk; decreasing it will reduce your risk.
Dun & Bradstreet (D&B) provides credit ratings as well, and covers private companies, but not all companies qualify for a rating, which leaves you with a lot of blank ratings. However, all the commercial credit bureaus (D&B as well as Experian, Equifax, and CreditSafe) provide commercial credit scores on virtually every US business that predict default or financial distress.
Scoring your portfolio and then ranking your accounts by their credit score will provide you a good picture of aggregate risk. The scores typically are assigned on a scale of 1 (low risk) to 5 (high risk) or some variation thereof. If you have 50 percent of your AR dollars in the lowest risk category, 40 percent with medium risk scores, and 10 percent with scores in the highest risk category, as with using the agency ratings, it is easy to gauge the impact of adjustments to your credit policy and controls over time.
Viewing actual bad debt loss (as a percentage of revenue) for the past three or more years provides an alternative gauge. This perspective yields a view of the credit risk assumed and the effectiveness of controlling credit loss in the past, which can the provide a scorecard for judging the effectiveness of any changes you make to your credit policy and controls. Keep in mind, however, that past is not prologue. The economic environment is another variable that affects bad debts. We enjoyed almost ten years of a benign economy and then Covid hit, and then interest rates went up, so what happens in the coming years is not likely to reflect the recent past. If you have bad debt loss data going back 25 years, you will have a much better gauge for evaluating current trends.
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Credit Control: Mitigating Risk
Risk mitigation begins with the initial customer credit evaluation and subsequent reviews. These activities result in setting a credit limit, which is a tool for capping exposure. Once the sale is made, your collection efforts afford a back-up means of mitigating the risk you have assumed. An effective, systematic, strategy-based collection process can go a long way to reducing potential bad debt losses that have slipped through the credit evaluation process. More aggressive collection strategies for your high risk AR can substantially reduce your exposure to potential bad debt losses.
Going back to the point of the credit decision, there are tools for mitigating credit risk. Credit insurance, Irrevocable Letters of Credit, third party guarantees, and receivables financing (selling your receivables) reduce the risk of selling on open account. Perfecting a security interest with a UCC filing is another means of reducing credit risk. Some of these tools may also provide substantial cash flow benefits at a relatively modest cost. They are best deployed when aligned with your credit strategy. For more on risk mitigation tools, go here.
Managing the level of credit risk you have assumed should be consistent with your company’s credit strategy. Tactics need to be customized for each individual company (or similar class of companies) to guide the level of credit risk assumed, all the while supporting the company’s revenue and profit goals.
While strategy should remain stable, tactics need to be dynamic to meet the challenge of the day. When risk increases in one area, you need to employ a tactical solution to deal with it. This includes keeping an eye on your order-to-cash (O2C) processes, which can have a significant impact on bad debt write-off levels — for example recurring billing errors or an accumulation of unresolved payment deductions. A solid credit strategy provides the baseline you need to exert effective credit control.