Trading on credit terms both at home and overseas carries an ever-present underlying risk

Trading on credit terms both at home and overseas carries an ever-present underlying risk - from customer insolvency and default to economic and political upheavals. Many companies accept this as the essential price of expansion and of accessing new markets. However, in seeking to maximise these opportunities, many are taking wholly unnecessary gambles.

Companies should give greater thought to the level of trading risk they take on and how they can manage it more effectively by adopting a holistic approach to credit risk management.

  • Understand the risk environment be aware of the current economic, political and industry factors which influence insolvency statistics and company payment behaviour.
  • Identify individual risks know the risks associated with a particular company.
  • Spread risk find the best way to mitigate the potential impact of any loss (usually through some form of credit insurance).
  • Minimise risk take internal steps to limit the possibility of payment default, such as improving credit control and collections procedures.

    Understand the risk environment
    The global economy The world economy is showing signs of recovery after the slowdown of 2000, with growth of as much as 4.1% predicted for 2004. There are also signs that recovery is gathering momentum in the US, where the economy grew by 3.1% in the second quarter of 2003.

    However, there remains the fact that the US is still the engine of global growth. If growth falters there, the odds are that the global recovery will also falter, notwithstanding healthy signs in the Asian economies. So far, the end of the Iraq war, easing energy prices and rising share prices have failed to enthuse the American population; vehicle sales have lagged, and retail spending has slowed. Instead, over half of the country's second-quarter growth was driven by increased military spending.

    A further difficulty is the US trade deficit, which continues to widen (together with a huge budget overspend), with inevitable long-term implications for the country's competitiveness. Can the other global economies rely on a recovery which seems to have been built on less than stable foundations?

    The local economic climate The single currency and the pragmatic approach of the European Central Bank (ECB) have provided a relatively stable framework for intra-community trade. However, recovery in the region - traditionally export-led - has been hampered by the solidity of the euro against the dollar and sterling, which has affected investment and competitiveness at a time when domestic demand is also weak. In addition, individual euro-zone countries are straitjacketed by the terms of euro membership and have limited room for fiscal manoeuvre.

    The German economy, in particular, has continued to flirt with recession. Household consumption has remained sluggish, investment in manufacturing has been flat, and industrial exports have been stagnating. Cramped by a public deficit exceeding 3%, authorities have been unable to pursue expansionary fiscal policies. In this unfavourable environment, company bankruptcies rose 16% in 2002. Increasingly, companies have been failing to meet contractual payment deadlines. Payment times of 150 days have been relatively commonplace in industries such as textiles.

    The political situation The ability of a customer to honour financial commitments can be influenced by political factors, such as wars, revolutions, currency crises, and exchange controls.

    For example, the war in Iraq (and before it, the campaign in Afghanistan) has led to a worrying period of political uncertainty. The situation in Iraq remains volatile, hindering economic reconstruction. More dangerously, the 'war on terror' has exacerbated anti-western sentiment among Arab populations, leading to instability in countries such as Saudi Arabia and Morocco.

    Business sector The level of risk associated with individual companies also depends on the climate in their industry sector. For example, the war on terror has had a negative effect on fuel (particularly oil supply), airlines, and holiday companies (the SARS epidemic has also affected consumption for tour operators in Asia and Canada).

    Meanwhile, sagging household demand has affected the outlook for the car, mass distribution and textile industries, prompting them to increase promotional offers to attract custom (with inevitable consequences for profitability). Conversely, while electrical components virtually stagnated last year, there has now been a moderate upturn, underpinned by increasing demand in Asia. Sales are particularly strong for opto-electronics (used in telecommunications), flash memories and digital signal processors.

    New opportunities The positive outcome of referenda on EU membership has further enhanced trading prospects with companies in the emerging Eastern and Central European countries. Prospective European Union membership has continued to fuel growth in this region, thanks to domestic demand, increased investment and productivity gains.

    Membership of the EU also provides a new legal framework which will help to improve standards of business practice in these emerging markets, providing a less risky trading environment for exporters. The harmonisation of accounting standards and company reporting obligations, for example, will ensure companies have better access to financial information. In addition, companies within the new member states will have to abide by the EU's Late Payment Directive of June 2000, which gives all businesses and the public sector a statutory right to claim interest from late-paying companies and the right to reasonable compensation for debt recovery costs.

    Identify individual risks
    Businesses need to establish effective credit checks on trading partners (including, importantly, regular reappraisals of existing customers, as well as prospects) to ensure they do not represent a significant risk.

    This was rarely more apparent than during the 1990s, as technology companies proliferated, and effective checks were essential to sort the elite from the bandwagon-jumpers. All too often, however, this did not happen. At Coface UK, we had to deal with an influx of credit limit applications from clients dealing with this sector. Of these, some 85% were inaccurate in some way - the trading address was incomplete; the company director's details were illegible, and so on - but suppliers had simply failed to assess their customer with a critical eye. In short, enthusiasm about the new order had got the better of them.

    Credit management departments should investigate how long the company has been established and its business record, rather than rely on trade references. This includes checking its web site for financial reports, visiting the premises, asking for customer references and following them up before going any further. International financial ratings agencies such as Fitch, Moody's or Standard and Poor's, provide a guide to larger companies; while companies such as Experian, Dun and Bradstreet and Coface UK provide detailed company reports and ratings, with information on the financial history and strength of individual companies.

    Spread risk
    Many companies choose to self-insure their credit risks by putting aside funds to cover bad debts or by establishing a captive to finance them. This may insulate them against some of the effects of payment default, but it does not actually reduce their exposure to the risk. In addition, it ties up valuable working capital.

    In contrast, credit insurance companies have extensive experience in determining the level of risk attached to a particular trading partner and will then back their assessment with their own money (pure credit report agencies, of course, do not back their ratings with cash).

    To ensure an objective assessment of risk, a company such as Coface UK will use a number of methods, including information from registered accounts, legal judgements and press and media archives. To obtain a more up-to-date picture, a credit underwriter will also ask the company if it would be willing to submit its accounts for examination under a confidentiality agreement. In addition, most credit insurance policies include an obligation for companies to report relevant overdue accounts. This information will be used by the insurer to refine its credit assessment and, if appropriate, reduce its and the client's exposure to risk.

    Of course, a credit insurance policy is only a useful tool if it provides the right cover - whether it is based on whole turnover or certain key clients. For multinational companies, which have regional offices, requirements may vary across the group, depending on local business culture and legal requirements. In such cases, a 'one size fits all' approach is rather a blunt instrument, and things can rapidly unravel if the policy does not actually respond to the needs of the regions.

    The alternative - allowing each region the freedom to negotiate its own policy - may ensure local buy-in, but, as each will undoubtedly opt for the most favourable terms, it will obviously cost the group far more. In addition, it will result in any number of credit management inconsistencies.

    The third way is a company-wide policy which benefits from group purchasing power, but which has the flexibility to take account of local variations. Group headquarters can set the parameters, while the local office has the benefit of a more responsive service, dealing with people who speak the language and understand the local business culture. Realistically, such policies can only be delivered by larger credit insurance companies such as Coface, Euler Hermes and Atradius (formerly Gerling NCM).

    Holistic credit management
    A coherent credit management policy is essential for all businesses. It should provide detailed guidance throughout the sales process, including negotiating, making essential checks on customers, raising orders, invoicing and collections, to ensure that the credit control departments and customers have no doubt about their obligations.

    All companies should be conscious of the different risks attached to credit trading. Too many currently emphasise sales at the expense of essential credit management processes, and yet it is important that they recognise the futility of bringing in major new customers that simply damage the company's profitability if they do not pay.

    The holistic approach to risk obviously requires commitment from all departments. The initial transition may be uncomfortable, but once in place, it can actually be used as a sales tool, enabling companies to offer higher credit limits to their most valuable, prompt-paying customers and to approach new prospects with confidence.

    Ian Hollyhomes is risk director, Coface UK, Tel: 020 7325 7500, E-mail:

    Tackling credit fraud
    The Government's efforts to curb the rise in business fraud are failing because of ineffective legislation combined with insufficient resources, say fraud experts. Speaking at a recent CreditUK debate on business fraud, they urged companies to lobby for more support.

    Lawyer Steven Philippsohn, a member of the Fraud Advisory Panel, said it was estimated that fraud was currently costing businesses £14bn per year. He stated that legislation designed to help businesses prevent and detect fraud had only been partially successful. "It is still the case that almost half of all frauds are only discovered by accident," he said.

    Detective Chief Superintendent Ken Farrow, head of the City of London Police Economic Crime Department, admitted that many frauds across the country are never investigated because of the lack of police resources. "There are five, even six figure frauds being reported that forces do not have the manpower to investigate," he said.

    Steve Hancock, head of group money laundering prevention at financial services group Prudential plc, criticised anti-money-laundering legislation for 'clogging up the system'. "Current legislation says employees have a duty to report suspicious transactions, and if they don't they can be prosecuted. As a result they become paranoid and file hundreds of useless reports that all have to be processed."

    The debate marked the launch of CreditUK, a series of two-day conferences and exhibitions taking place next year across the UK. The first takes place at Manchester's International Convention Centre on March 25 and 26 2004, and is sponsored by the UK credit reference agency Callcredit plc.

    Credit management


    1 Be aware of the risk climate, including economic, political and sector-specific factors which may increase the likelihood of insolvencies or non-payment.

    2 Ask all new customers to fill in a credit application form (including payment address, accounts payable department contact, and acceptance of terms).

    3 Carry out thorough credit checks on all new and existing customers, including county court judgements, trade references, bankruptcy orders (via the Insolvency Service), bank references, credit circles etc. Use a credit ratings agency, where possible, to investigate further.

    4 Ensure the credit management staff contact accounts payable staff at an early stage and establish a business relationship.

    5 If possible, offer incentives for early payment, or request part payment in advance before releasing goods to a new customer. Funds can be held in a secure deposit account until the customer is happy.

    6 Make all customers fully aware of payment terms from the first meeting and ensure they are displayed clearly on account application forms, order acknowledgments, invoices and statements.

    7 Obtain a credit insurance policy to cover the risk of default, protracted late payment, political risk and so on.

    8 Issue clear and accurate invoices promptly (within 24 hours of delivery), and address them to a named individual.

    9 Deal with account queries promptly and efficiently.

    10 Ensure computer systems are modern, user-friendly and properly updated, and that sufficient resources have been devoted to manpower (a trained collector can manage about 600 accounts). Use a reputable collections agency if this is not possible.

    11 Ask the credit manager to establish a collections process for credit control staff, setting priorities for collection, a timetable for chasing accounts and the methods to be used, including phone (the most effective), letter, e-mail and possibly visit.

    12 If legal action is required, consult a solicitor sooner rather than later. Do not bluff. Any threat of legal action must be followed up to avoid perceptions of weakness.

    13 Set targets for DSO, Aged Analysis and cash collected; compare to previous months.