Managing Customer Credit Risk

 

Decreasing line on chart

This is how your cash flow will look with a faulty (or nonexistent) credit policy!

Here is a guest post regarding the need to manage customer credit risk and how to do it by Cerkez Lena. Although I do not agree with everything he says, I agree with his basic reasoning and many of the options he presents to manage customer risk. I do believe you’ll find this article informative and helpful. -TCW

Managing Customer Credit Risk

Default arising from customer credit risk is inherently guaranteed across all industries, however taking certain steps can minimize this risk. You are bound to face customers that either file for bankruptcy, or are slow payers that can dampen your cash; especially if you have substantial cost associated with servicing that same customer. Keeping your Days Sales Outstanding ratio (DOS) as low as possible will translate into your business always having the adequate funds to keep the operations going.

DOS ratio

The DOS ratio simply measures your ability to convert accounts receivable into cash. The lower the ratio, the quicker you are at getting cash in the door. On the other hand, a high DOS ratio translates into your business having a higher risk of customer default on their debt. First of all refrain from automatically granting every customer credit on account. Establish a strict credit policy that is both effective, and adaptable. The first line of defense is the Credit Application, which should be a robust and rigorous process.

Stamp "approved"

Assess your customers and provide the creditworthy ones with a stamp of approval.

Customer credit approval process

Every customer credit approval process should include credit references from existing vendors that the customer has, recent financial statements, recent tax return, as well as included language about late fees and finance charges. In addition, it should spell out the amount of credit the customer is approved for, and payment terms. A common mistake businesses make is that they let a customer purchase beyond their approved credit amount, this is a mistake as it undermines the entire credit application approval process, in addition your customer now will not take your credit limit amount serious.

Cut losses or continue?

As a business owner you need to understand when it’s time to cut your losses; selling more, or continuing to provide services to a delinquent customer does not increase your chances of collecting on already past due invoices. Instead, it only drives you deeper in the hole. Concerted effort needs to be placed on collecting outstanding invoices. One of the best methods that always worked for me is analyzing outstanding accounts receivable on a weekly basis, as well as keeping in constant communication with each of my customers on where their balances stood, in addition to ascertaining an expected payment date.

Maintain customer contact

Keeping in constant communication with your customer is crucial, as this will signal to your customer that you are keeping an eye on your receivables. Not keeping in constant communication with your customer,s however, signals that you are in no rush to collect on outstanding invoices.Providing early payment discounts, or charging late fees is a proper way to encourage a customer to pay their invoice early, and prior to the due date. Common discounts provided are 2%/Net 10. This essentially means that you will give a customer a discount of 2% on an outstanding invoice, only if paid within 10 days from the date of the invoice.

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