We recently wrapped up an 8-week series on Cash Management solutions. I hope all of you found some value in those discussions and took some details back to make improvements within your business.
Credit was something that I was asked to discuss in more detail next so here we go! I have had a hand in this for many businesses over the years. From collecting billions of dollars annually and establishing credit for businesses ranging from $100k up to $20M+ I am super confident in helping you and your team thrive in this area. Stop worrying about collecting on time, bad debt, or if you are taking the right approach. Let’s put something on the calendar to make sure your Q4 shines.
Credit risk is the chance that a customer who has been granted credit will either delay payments or default entirely. This risk can seriously affect your accounts receivable, which is often one of the most significant assets on a small business’s balance sheet. Poor credit risk management can lead to cash flow issues, as delayed or uncollected payments prevent your business from paying its own obligations, purchasing inventory, or investing in growth.
To protect your business, it’s important to implement effective credit risk management policies that are informed by robust credit analysis. This involves assessing the creditworthiness of potential and existing customers before extending credit, as well as regularly monitoring their financial stability.
Impacts on Other Accounting Areas:
- Accounts Receivable (AR): Late or non-payments can directly affect AR and delay your company’s ability to collect on sales. Without proper analysis, your AR could turn into bad debt, which negatively impacts cash flow and can result in a need for costly write-offs.
- Accounts Payable (AP): When credit risk is not managed properly, it can disrupt your cash flow, making it harder to pay your suppliers on time, and potentially straining relationships with vendors.
- Treasury Management: Effective credit risk management supports better liquidity management by ensuring that incoming cash flows are stable and predictable, which is crucial for managing short-term investments, loans, and other financial strategies.
- Expense Management: Poor credit control may force you to allocate additional resources for collections or incur additional costs from financing short-term deficits. These additional expenses cut into profits and reduce your business’s ability to reinvest in operations.
What is Credit Risk Analysis?
Credit risk analysis is the process of evaluating a customer’s likelihood of fulfilling their payment obligations. For small businesses, this often involves examining a potential customer’s credit history, financial health, and payment behavior before deciding whether or not to extend credit. The goal is to determine the level of risk associated with a particular customer and to establish credit terms that mitigate that risk. What does your new customer/existing changes process look like? Does it exist?
Credit analysis typically involves a combination of qualitative and quantitative factors. Let’s break down each:
- Qualitative Analysis: This includes assessing the customer’s reputation, their position within the industry, and external factors such as market conditions or economic trends. For instance, if you are extending credit to a client in an industry undergoing a downturn, you might apply stricter credit terms as you don’t want to overextend.
- Quantitative Analysis: This involves examining a customer’s financials, such as their income statement, balance sheet, and cash flow statement. Key ratios, like the debt-to-equity ratio or current ratio, can provide insight into their ability to meet short-term obligations and looking into total assets let’s you know a few other things…Do you know what that is?
Steps to Conduct Credit Risk Analysis for Your Small Business
- Collect Financial Information Start by gathering relevant information about your customer’s financial situation. For larger clients, this could involve analyzing audited financial statements, while smaller clients might provide tax returns or unaudited reports. Look for indicators of liquidity, profitability, and overall financial health.
- Check Credit Scores and History Credit scores are a key part of the credit analysis process. You can access business credit reports from agencies like Dun & Bradstreet, Experian, or Equifax, which provide a detailed credit history, payment patterns, and any past defaults. This historical data can help you predict future payment behavior.
- Analyze Key Financial Ratios
- Liquidity Ratios: These measure a customer’s ability to meet short-term obligations. The current ratio (current assets divided by current liabilities) is a good indicator of short-term financial health. A ratio below 1 suggests that the customer may struggle to pay their bills on time.
- Leverage Ratios: These show the extent of a company’s debt relative to its equity. A high debt-to-equity ratio may indicate financial stress and an increased likelihood of default.
- Profitability Ratios: Ratios like net profit margin or return on equity (ROE) help assess the company’s long-term financial health and ability to generate sufficient profit to cover obligations.
- Evaluate Payment History A customer’s payment history is one of the best indicators of future payment behavior. Customers who have a history of paying late or defaulting on previous loans may pose a higher credit risk. Some businesses might opt for shorter payment terms or request upfront payments from customers with poor payment histories.
- Establish Credit Limits Based on the results of your credit analysis, set appropriate credit limits for each customer. If the risk is deemed high, you might offer a smaller credit line or require more frequent payments. Conversely, if the customer demonstrates strong financial health and a positive payment history, you can offer more favorable terms.
Strategies for Managing Credit Risk
Managing credit risk goes beyond simply conducting a credit analysis. Here are some strategies to help you mitigate risk and protect your cash flow:
1. Diversify Your Customer Base
Relying too heavily on a small number of clients for a large portion of your revenue can increase your credit risk. If one major client fails to pay, your business could face significant cash flow issues. Diversifying your customer base spreads the risk across multiple clients, reducing the impact of a single default.
2. Use Payment Terms to Your Advantage
Offering shorter payment terms or requiring upfront payments can help minimize credit risk. For high-risk customers, consider asking for a partial payment before delivering goods or services or 100% payment up front. Alternatively, you can implement early payment discounts to incentivize customers to pay their invoices more quickly, improving your cash flow. Discounts should only be granted when this makes sense for your business. Call me if you want to look at this together.
3. Monitor Accounts Receivable Regularly
Keeping a close eye on your AR aging report allows you to identify slow-paying customers before the problem escalates. Establish a process for following up on overdue accounts and send reminders as soon as a payment is late. The longer an invoice remains unpaid, the less likely you are to collect in full.
4. Consider Credit Insurance
Credit insurance can help mitigate the financial impact of non-payment by insuring your accounts receivable. If a customer defaults, the insurance company will compensate you for the loss, ensuring that your cash flow remains stable even in the face of a major credit risk event. I have a contact that can help you here, so let me know if you want a direct line to discuss options.
5. Factor Your Invoices
If your business frequently experiences cash flow problems due to slow-paying customers, invoice factoring might be a viable option. By selling your invoices to a factoring company at a discount, you can receive immediate cash without waiting for customers to pay. While factoring comes with costs, it can provide liquidity when you need it most. In all honesty, a business properly managing their receivables doesn’t need factoring and should avoid it. This is unnecessary costs if you train your team correctly. Totally get it, your background may not be accounting so that’s where a few hours of my time can go a very long way for your business…..saving tens of thousands of dollars in fees.
