You may hear financial gurus, small business experts or bank representatives talk about it all the time: managing credit risk is important and it’s an aspect of business finance all business owners must regularly visit and focus on. Obviously, you know that the single-most important factor when it comes to business success, revenue and profit is getting paid, and hopefully getting paid on time. How can you design a plan to manage and mitigate credit risk when it comes to providing services for customers?
What is Credit Risk?
Credit risk is commonly referenced in the banking industry as the probability of a borrower defaulting on their loan or advance. For a business, credit risk takes the form of a client not paying their invoices when they become due. If a business does not examine credit risk when contracting services with new clients, they can lose out on a significant profit margin and they will be required to make up for the lost revenue in additional profit in order to maintain success. When it comes to making sales, too high of a credit risk
may make the transaction not worth it for the business, as the chance is too great that they will not obtain their funds on time or at all.
Internal vs. External Risks
Since you are a business owner, you probably understand how both internal and external risks affect your company. Internal risks are weaknesses that you can, to a certain degree, control but external risks are more difficult to manage. Risk isn’t always a bad thing. Sometimes risk signifies dynamic improvement and growth within a company. No ambitious business owner should shy away from
risk completely. Instead, they should seek to manage it effectively, straddling the line between safety and security and chance-taking that could pay off in dividends.
Some examples of internal risks include employee turnover or inadequate training, outdated equipment and systems, the physical state of the business building and other potential problems that are generally handled “in-house”. External risks include changes to the target market, increases in charges for supplies to carry on with your business or weather-related damages to your building. Credit risk is another external risk that business owners face. You cannot control whether or not your clients will pay on time or at all – but you can identify the warning signs, assess the possibilities and make an educated decision with policy to support future risk mitigations.
1. Evaluate All Business Relationships
If you want to make serious improvements in your credit risk management, the first step is to establish a baseline. What are the state of your business relationships with your clients? Depending on the size and scope of your business, set aside time to view individual client histories. You are obviously on the lookout for those who currently owe a past due invoice, but you are also looking for clients with a history of repeated late payments. Do certain clients constantly contact you asking for extensions on payment or discounts? It is time to set aside personal relationships and look at all clients from an objective, business-based perspective. Who poses the largest risk to your company? Who is causing you to lose capital
If you do not currently have a contract in place with your regular clients, it’s time to make a change. You must lay out your terms with payment specifications in writing. You can schedule meetings with current clients and ask them to read over the contract and communicate questions when necessary. It is best to be completely up front with clients when explaining your prices. This is a viable way to weed out potential clients who are not going to end up paying in the end. If they attempt to negotiate or show any sign that they do not accept the terms as they are, you might want to consider terminating your current business relationship or simply not contracting work with them in the first place.
2. Investigate New Clients Beforehand
Especially for businesses who are contracting high dollar amounts of work, running a credit check on potential clients is not unheard of, in fact, it is a smart, tactical solution to mitigating credit risk. First, have a lawyer look over any forms you will ask your clients to fill out. Make it clear
to the client that you plan on running a credit check before completing contract negotiations. When you obtain a credit report, you can see the amount of past due balances and payment trouble any individual may have had in the past. If they cannot explain the occurrences, it might be best to stay away.
If you are doing business with another business, you can pay a fee for unlimited monthly credit rating lookups of corporations. See how often they pay their invoices on time and monitor their credit report on an ongoing basis to spot problems before they begin affecting you. You could also check collections reports to see if certain companies have had claims filed against them in the past. If so, question them on the topic and make sure each client has a responsible payment history – knowing the facts can help you make sure you are working with a low credit risk client. You don’t want to base your business on revenues that will never materialize. If a client has a questionable background but you still have a good gut feeling, ask them to place a deposit up front to mitigate the credit risk for your company. Clients who truly want to commit to an agreement will have no trouble accepting this as a requirement.
When contracting with other businesses, you should also view what their clients have to say about them. Don’t hesitate to ask for corporate references. You can ask how long they have maintained their partnerships with other businesses. In some cases, you can ask for a reference from their bank, though
you may have to pay a charge, but you will view how long they have had credit accounts established in their name and whether or not those accounts are in good standing.
3. Invest in Effective Management Software
You can’t be everywhere at one time, and that includes all things involved with credit risk management. It might be time to invest in a risk management software system for your business, especially if you feel as if your company is losing out on potential areas of growth and you’re having difficulty pinpointing where the changes must be made. Credit risk software also monitors other factors, such as trends in financial markets, interest rate risks, natural disasters, attacks from the competition and more. You can easily view all the results on a digital interface, where all the data is categorized and organized according to your preferences.
4. Consider Purchasing Credit Risk Insurance
There is a way to invest in a monetary cushion for your business when credit risk of clients is a serious issue. You can purchase credit risk insurance, a policy that will pay out a certain amount towards unpaid business invoices in the event of a loss. Commonly called trade credit insurance, it is classified as a property and casualty insurance type.
This type of insurance policy is not purchaseable by individuals, but by companies alone. The price is normally calculated based on projected business revenue. It is normally a percentage of outstanding account totals or a percentage of total sales. Some credit risk insurance firms are able to monitor
the health of client finances and assign them a personal credit limit based on their account histories. They will then notify you of any changes to the client’s ability to pay and take care of all debt collection services if need be, while providing you with the expected funds.
Credit risk insurance helps business owners focus on growth rather than accounts payable. You can depend on a set amount of income from billed invoices, since you will be getting the revenue either way, and the cost for the policy is a calculated, expected expense you have agreed to beforehand. You are no
longer blindsided by sudden lack of client payments.
Credit risk insurance isn’t the right move for every business, but if you find your company spends an inordinate amount of time weeding through potential customers, conducting background financial and credit checks and enforcing overdue payment contract agreements, this solution may be worth the cost. In addition, it can allow companies to borrow against its receivables, giving you more power to expand your own reach and further boost your profits over time. It is also fitting for those who deal with international companies, as it may be more difficult to gain access to foreign accounts and enforce contract agreements in distant countries.
5. Establish a Working Policy on Overdue Accounts
One of the biggest obstacles in collecting late payments is the ignorance of the issue until too much time has already passed. As a company, you must put together a standard approach towards collecting payment. You get to decide what your terms are, but remember that you must stay consistent with each client across the board.
Every business approaches a past due invoice differently. Some companies decide to contact their clients one week before the invoice comes due, as a reminder to pay on time. You could decide to wait three days, one week or two weeks after the due date on the invoice as well. The easiest and most low-stress way to make contact with a client is to send an email, reminding them of the past due invoice. There are a number of factors that may have contributed to the late invoice. For instance, the client’s business may have been closed for vacation, they may have not received the bill in the mail or they may have missed the email with the invoice attached. In many cases, an email that alerts them to the situation can spur
them to action.
Be aware that the longer the invoice goes unpaid, the less likely it is that it will be paid at all. Establish a policy for late charges. Many businesses may accrue a late charge of a certain percentage once the invoice is 30 days past due, with additional interest accruing each month. Remember, whatever policy you select must be laid out in your initial contract with the client so they understand the terms and conditions and sign, legally binding themselves to the agreement.
It may be wise to automate another email message or phone call 3 to 5 days before the late charges apply, to give the client one last chance to pay their bill on time. If the invoice remains unpaid after all contact fails to initiate payment action, it’s time to write a demand for payment letter and start putting together a small claims court case against the client. Again, this process will differ based on the company you run, the industry you are in and the total amount of the invoice. If the cost is too small to justify a court filing, you may have to chalk it up to a business loss and resolve to cancel any remaining contract with the client.
The point? Having a policy towards how you handle late invoices and overdue payments that you lay out in advance to the client will hopefully encourage them to make good on their commitment and reduce your overall business losses. While it won’t always be effective, an overdue invoice policy will reduce your stress since you are doing everything in your power to mitigate your client credit risk from beginning to end.
Now that you have been educated on these five suggestions on how to deal with problematic client credit risk issues, approach your business in a business-like manner and take charge of your profit margins. You will see success, growth and development with these credit risk mitigation strategies in place.