Due Diligence Doesn't End with the Credit Application
Periodic Reviews & Ongoing Portfolio Monitoring Are Essential to Maintaining Accounts Receivable Health
Approving a customer for credit terms is merely the first step in an open credit relationship. Situations change, both for you and for your customer. Economic circumstances may cause you to tighten your credit policies and customer credit limits. Even more likely are changes to a customer’s business.
Statistics from Dun & Bradstreet suggest that 20 percent of your customers will incur significant changes during any one year. Furthermore, new businesses and small businesses tend to have high failure rates, and there is good reason to believe a wave of defaults is coming. Among other things, commercial bankruptcies have been steadily climbing over the past year. Consequently, where the risks are concentrated in your AR portfolio can change significantly from year-to-year, which is why you need to have a program that involves both periodic account reviews and portfolio monitoring.
The experts at Your Virtual Credit Manager are ready to help you improve cash flow and reduce AR risks during these challenging times. What do you need help doing? We are currently offering 33 percent off our standard small business consulting rates.
Case Study: Portfolio Monitoring Pays Off Big-Time
About 25 years ago, a credit manager I know saved his company from a seven-figure bad debt loss by monitoring the Internet on his biggest customers. The Intel he uncovered revealed the financial difficulties facing the foreign parent company of one of his large chain store customers. If the European parent company defaulted, the North American subsidiary would be pulled into bankruptcy even though its operations were profitable.
Consequently, the credit manager was able to purchase credit insurance on his customer, and was therefore able to continue approving credit sales, within limits, to the chain store customer. About 15 months later, the parent company defaulted on its debt and the chain store subsidiary was indeed pulled into the ensuing bankruptcy proceedings. The credit insurer was then compelled to pay the credit manager’s firm for the receivables lost because of the bankruptcy, which means this supplier was making profitable sales to the chain store for the entire 15 months after the default risk had been identified.
Periodic Account Reviews, while certainly beneficial, would not necessarily have revealed the parent company’s problem — after all, the domestic chain store subsidiary had strong financials and a good payment record. In this case, ongoing Portfolio Monitoring was critical to turning up the customer intelligence that avoided a huge bad debt loss.
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Account Reviews of Existing Customers Are Imperative
One of the things you should do upon approving a customer for credit terms is schedule their first Account Review. A review starts with the account’s credit and payment history with your firm, details you don’t have with a new customer. Past is not always prologue, but how a customer pays you is one of the best predictors of how they will pay you in the future. The remainder of the review will mirror an initial credit evaluation (here’s more information on Evaluating Credit).
The challenge inherent with Account Reviews, especially as your customer-base grows, is finding the time. Failing to review your customers systematically, however, exposes your firm to potentially higher bad debt losses as well as slower payments. Here’s some guidelines for Account Reviews that balance the time and risk equation:
Be periodic with your reviews: a complete review at least annually for the top 20 percent of your customers in terms of sales volume and every 2 to 3 years for the remainder of accounts. There will only be a minimal loss if a small volume account defaults, so the higher the sales volume and credit risk (and remember that new businesses pose a higher risk), the more frequently you should be reviewing those accounts.
Update financial information: at least annually. This applies primarily to the top 20 percent of your customers or anybody else with a relatively high credit limit or high credit risk. Public companies provide information quarterly to the SEC, and it is easy to capture these filings from EDGAR. As for the private companies you require to submit financial statements, you should get a yearly update, keeping the previous two years in your files for comparison.
Update credit and bank references: annually for the top 20 percent of customers and every 2 to 3 years for the remainder. On the assumption this will be done manually, this follows the same schedule as your periodic Account Reviews. With an automated system, updates can be done every six months if not continuously.
Update credit applications: every 5 years, unless triggered sooner by a change in the business (e.g., ownership, principals, locations, business lines, etc.)
Update credit bureau reports: every 2 years, unless triggered sooner by a change in their relationship with your company (e.g., request for substantially more credit, change in leadership, merger or acquisitions, etc.). Credit Bureaus will do incremental updates as information is available, but if no new information has become available, will typically let the report stand as is for 18 months before updating.
Readers of Your Virtual Credit Manager can access sharply discounted business credit reports from D&B, Experian, or Equifax through our partner accredit.
Boosting Your Game with Portfolio Monitoring
Your Account Reviews provide the foundation for you Portfolio Monitoring. While Account Reviews provide for a systematic upgrading of customer limits and risks, Portfolio Monitoring goes a couple of steps further and involves the ongoing oversight that fills in the gaps of your Account Review process. Portfolio Monitoring, therefore, encompasses the Account Review Process by also incorporating the identification of red-flags and other circumstances that trigger an Account Review. In other words, Portfolio Monitoring involves looking out for the external factors that affect the distribution of risk in your AR portfolio.
Every AR Portfolio is dynamic. This constant change requires continuous monitoring, not just periodic Account Reviews. Having accumulated customer details through the credit application and customer onboarding process, Portfolio Monitoring, is the subsequent process by which you collect additional intelligence over the lifetime of the customer. There are several sources for the information that goes into this customer intelligence.
Your company’s interactions with the customer: whether it be a sales call, responding to a customer service query, or requesting payment from the customer, you are accumulating intelligence that expands your understanding of the customer. On site sales visits can be particularly illuminating:
Are the facilities deteriorating?
Is there a lot of stagnant inventory?
Is the business operating smoothly or are the employees running around putting out fires?
Hopefully you are capturing these details in your CRM solution. Derogatory situations, however, should be investigated immediately, and if necessary spark an Account Review.
Change Notification Services: these are offered by the commercial credit bureaus as well as public information compilers such as Lexis/Nexis. You provide the service with your customer list, and they provide you with a list of those customers who have changes of address or ownership or incurred a derogatory event (e.g., liens, suits and judgments). This is typically done on a monthly cycle.
Credit Scores: while credit scores are useful for establishing credit, they provide even more intelligence when viewed over time. Credit scores typically provide either a probability or default or of slow payment. In either event they are useful in highlighting trends — clearly sharp drops or extended downward trends deserve an Account Review. Credit Scores can be acquired from a credit bureau on a periodic basis (every three to six months is usually sufficient) or as part of a change notification service.
The Internet and Industry Trade Journals: even private companies get in the news. Publications covering the industries you are in should be monitored for news about your customers. You can also set up your search engine or web browser to monitor anything that comes up on the Internet about your customers (or at least your more important customers). Your customers’ own company websites are also a good source of information spanning details on their ownership and management, products and services, partners and customers, as well as containing press releases.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
In the Final Analysis . . .
There is a sequel to the case study referenced at the beginning of this article. The credit insurer, after learning how the credit manager had identified this potential bankruptcy risk, brought the credit manager in as a consultant to teach their credit analysts how to better monitor the insurer’s credit portfolio, especially in regard to using Internet resources and applications. The credit manager also got a promotion.
Today, utilizing the Internet for intelligence gathering is much easier, especially with the Artificial Intelligence (AI) tools and alternative data sources that are emerging. The benefits are well worth the time spent implementing a monitoring process (let us know if you need help in this regard).
For most companies, accounts receivable (AR) is one of the two largest assets on their books. Assuming all will be okay opens you up to unexpected losses. As the saying goes, an ounce of prevention is worth a pound of cure.