Mark Woolhouse outlines a five point plan to help businesses manage credit risk in an uncertain business environment

Historically, the bulk of small and medium size business failures happen on the way out of recession. While the economy is in recession companies’ cash reserves are depleted by months of losses, but this is offset by reductions in the need for working capital as stock and receivables contract.

When the economy improves, business activity starts to increase again and companies need more stock to fulfil new orders. Their requirement for working capital expands but with less cash in the bank, many need to ask for overdraft extensions. This is the point at which banks tend to pull the rug out, declining requests for more credit until the economy is significantly improved, leaving businesses unable to raise finance.

Restocking offers businesses the potential for a bounce in activity and profitability as markets regain confidence. However, credit managers may find that the lag in the availability of finance means that customers face illiquidity.

If the global economy is starting to recover, that means we are now entering a critical phase; over the next six to nine months the pace of business failures will accelerate. So what can businesses do to minimise losses?

“Over the next six to nine months the pace of business failures will accelerate.

Managers must adopt a more proactive approach to managing credit risk over the next year to ensure the survival – and success – of their business.

Five point plan to reduce credit risk

Adopt a credit management culture

The effective management of credit should permeate the organisation. Do finance, operations and sales work in an integrated way? Incentivise the sales team to arrange favourable credit terms with customers and leverage the strength of their business relationships to help resolve payment problems if they arise. Make managing credit risk part of the business planning process. Consider whether sales growth is a good thing at this point in the economic cycle, if credit losses might bankrupt the business. Prioritise or target customers based on their financial strength and be prepared to drop weaker customers who pose a credit risk, or the finance function will be left to tally losses instead of revenue growth.

“Don't be afraid to refuse credit.

Think like a bank

In giving trade credit, a company becomes a lender as well as a supplier, so it needs to think like a bank. Have a clear policy on extending credit and use rating agencies like D&B and Equifax to assess risk during the decision making process. However, it is important to remember that source data is up to 20 months old. If there are concerns about a customer’s credit-worthiness, ask to see their accounts three months after their financial year end. It could be another seven months before those figures are filed with Companies House and the agencies update their data. If the customer is in real trouble, they may file their accounts even later than this. Rank customers by quality (or credit limit) and focus on the bottom 10% of sales and the largest credit exposures in this group. How good is the data on each customer? How much is known about their current operating performance? Speak with the sales team, who should be aware of indicators that a customer is in trouble, such as having to move to a three-day week. This will afford greater insight into the business’s real level of credit risk and the potential impact on profit margin and cash flow. Don’t be afraid to refuse credit - it is better to work on getting more business from customers without credit problems than worry over and potentially lose all on weaker customers.

Monitor customer behaviour and support accounts staff

The leading indicators of distress are easy to see in a customer’s behaviour: delayed payments; petty complaints and quality disputes used as excuses for re-invoicing to start the credit clock ticking again; failure to meet promises; avoiding calls and not replying to emails. Accounts staff can become demoralised over troublesome customers and just go through the motions. An active programme of monitoring, follow up and litigation can improve morale and the quality of dialogue with problem accounts. If accounts staff know that managers are serious about dealing with problem customers and will back them up with action, they will be encouraged to have a more robust dialogue with clients in the first place.

“Find out whether there is a market in the customer's credit default swaps.

Be prepared to litigate

Customers who can’t pay or be open and honest are a liability. They are probably in denial about the depth of their problems and if they need to duck and weave to keep one step ahead of creditors, they are nearly bust (if not already technically insolvent). Going to the County Court is a very cheap procedure and may help to secure payment (or partial payment at least) from a distressed client before they finally run out of cash. Equally, if the problem is simply that the customer’s accounts department is arrogant or unprofessional, the prospect of explaining a Court summons to their board can make them more responsive. A customer who values your pricing, product and service will soon demand their accounts department falls into line, unless the business is in trouble or it is a core part of their strategy to bully suppliers.

Remember that no business is ‘Too big to fail’

Lehmans and the dozen or so US mortgage banks which have failed in the past year give the lie to this old truism. No business is too big to fail. To assess the credit risk of larger customers, use rating agencies. Even better, find out whether there is a market in the customer’s Credit Default Swaps (CDS), which will highlight the real-time cost of borrowing for that particular customer. If this is 10% when market rates are historically low, the message is clear – the market does not consider that company a good risk. It’s also important to monitor what other suppliers are doing so the business does not get left behind, continuing to extend credit after other suppliers have walked away.

DSG international plc (DSGi), the owner of Currys and PC World, ran into liquidity problems towards the end of 2008 as credit insurance cover was pulled; sensible suppliers refused to be the lenders of last resort and give stock on credit. While DSGi has gone on to try and resolve its financial situation, the worst case scenario did play out at Circuit City in the US, which went bankrupt in January as its trade creditors withdrew.