In order to protect your business's cash flow you need to understand the credit risks of your customers so that you can manage those risks effectively.
Maintaining a healthy cash flow is essential to a business's survival and is becoming more difficult in these tough economic times. This is why managing cash flow from debtors is all the more important and may be all the more troublesome. The problem is, that not all customers will pay on time - and this makes them a credit risk.
What is credit risk?
The credit risk of any transaction is an expression of the probability of financial loss after taking into consideration as many influencing factors as possible. Every customer and every transaction will pose a certain level of credit risk. There is the risk that they may not pay you at all, or the risk that they will pay you, but it will be beyond your trading terms. Both of these have a direct impact on your cash flow. By granting credit to creditworthy customers you will maximise your cash conversion rate.
Non-payment and delayed payment are both financial burdens that may be overcome by a good credit risk assessment. A good credit risk assessment will examine the customer's financial strength and payment capacity and evaluate the risk that the customer will have the resources required to settle their debts - and settle their debts on time.
An example of delayed payment risk is where your customer is a large company and a long-standing customer. You may be confident that this company will not collapse and you will be paid, but they may have limitations and a track record that indicate they pay their creditors outside trading terms.
Credit risks should not stop a business from transacting with its customers. Therefore it is important for each business to determine what level of risk it is able to bear without restricting its customer base, trade or reducing its income. Every business will have a different risk tolerance and understanding it will allow the business to take actions to reduce customer risk to an acceptable level that allows the relationship to continue.
Credit risk assessment process
Evaluate the credit worthiness of your customer by making an informed decision on the level of credit risk they pose to your business. This decision should be undertaken before the relationship commences with new customers, and then periodically, or when there is a change in the relationship, with an existing customer.
Credit risk assessment has three stages:
- Gather the required information
The primary source of information necessary for the assessment should be the account application form, and it may be necessary to review it to ensure all the relevant details are captured. Credit reporting agencies can be considered to obtain further information.
The minimum information that should be obtained from a prospective customer includes:
In some cases, additional information such as financial data, statement of assets and liabilities and trust deeds may be requested for higher credit limits or if the credit risk appears high.
- Registered name and trading name
- ACN or ARBN number
- Type of entity
- Registered address and primary business address
- Trade references
- Date of birth or drivers licence number if the applicant is a sole trader, partnership or individual
The financial data of a business is the best source of information on its financial strength. In most instances, financial duress is evident long before the business fails. Information such as the growth in turnover, the profitability, the gearing and the asset base are good indicators of financial strength and can be measured using financial ratios. It is important to take into account who provides the information and whether it has been audited.
Personal financial information, if accurate, gives an assessment of an individual's financial strength. The information can be gathered from a personal assets and liabilities statement, and some assets such as real estate, are easily verified. Credit reporting agencies provide access to land titles, other assets and encumbrances such as mortgages.
Trade references and credit bureau reports will indicate higher or lower risk. Trade references are an effective way to ascertain an entity's payment history and patterns with other credit providers; however you may only be given ‘good' references.
- Analyse, verify and assess the information
The above information should provide a basis for which to review your account application forms. If you are dealing with individuals, your terms and conditions should address the privacy obligations under the Privacy Act and you need authorisation to carry out credit checks.
Verifying the information is important to ensure you are contracting with the correct entity or person(s). Accredited credit reporting agencies, the ATO and ASIC may be used to verify the registered name, registered address, ACN or ARBN number, type of entity and Date of incorporation (or the date the business started).
If the entity is deregistered or any data is unmatched, the application should be held until you clarify the status and have the correct information. Entities that are under administration or other external control require special care.
Assessing the information involves understanding if there are any factors present which may make the entity low or high risk:
- Low risk - Indicators are a long time in business, a large number of staff and many years of business experience of individuals or management.
- High risk - Indicators are directors' links to failed companies, court actions or default notices.
- Make an informed decision
Based on the information accumulated, you should be able to make a judgement regarding the customers' credit risk. When all the information is positive, accept the customer and grant credit. If there are many negative findings - such as court actions against directors - decline credit and find another way to transact with the business. If the information is both positive and negative, assess its impact on the ability of the customer to pay its account and then decide if and how much credit to extend.
Credit scoring software is available to assist you in processing and assessing all the information. Credit scoring assigns a numerical value to measure the risk of a number of indicators and factors and is based on benchmarks and historical data. The result is usually presented as an overall risk percentage. Credit scoring takes out the subjectivity of assessing information and allows a business to make consistent and informed credit risk decisions for all its customers.
Where the credit risk is elevated, strategies to reduce the risk should be explored before turning the customer away. These could include obtaining personal guarantees, reducing credit limits and reducing trading terms.
Remember that while credit risk assessments are important in understanding customer risk, you should always use your professional judgement and consider other issues that may affect the situation.