What Is Credit Risk, And How Do You Manage It?

When it comes to running a business, you need to keep an eye on your cash flow. After all, cash flow is king! But another part of running a business is sometimes extending credit to your customers – especially if you’re supplying to other business owners. This opens you up to something called credit risk. Credit risk is the risk that a customer doesn’t pay back their loan, or pay for the goods or services delivered on credit. For example, if you have payment terms of 30 days, you are giving 30 days credit, and there is a risk associated with that. Luckily, there are some things you can do to mitigate your credit risk.

 

What’s A Good Credit Management Strategy?

If you want to protect your business from the impact of unpaid invoices and cash flow problems, then you need a good credit management strategy. This needs to start far before invoices go overdue, and involves much more than just reminding customers to pay. In fact, the most effective methods are put in place before your customers are even customers. It involves assessing the credit-worthiness of your potential and existing customers, potential changes to their circumstances, and any future events that could present a risk to their ability to pay.

Before your customers sign up, and during their time with you, you should:

  • Assess their credit rating. Does it meet your pre-defined conditions for extending credit? If you have any reservations, make sure you tailor your contract to meet them. Even if not, you should ensure your contracts include your terms and conditions and details like an exit period, should you decide you want to cease working with them.
  • Monitor your customers continuously, including obtaining their financials regularly. If a customer no long meets your conditions for extending credit, take steps to revoke their credit and, if needed, stop working with them. This may seem extreme, but if they aren’t going to be in a position to pay, then they present a risk to your business.

 

Mitigating Your Credit Risk

Beyond assessing the credit-worthiness of your customers, there are a few more ways you can protect yourself from credit risk. These methods will also work if you have doubts about your customers ability to pay in the short term, but don’t want to ban them from working with you. Some approaches to credit risk management include:

Credit Insurance: Credit insurance (also known as debtors insurance) can be taken out by many businesses as a way to protect your credit lines. Credit insurance covers all of your credit transactions so that if your customer fails to pay you, it’s your insurance company who foots the bill. This strategy is often used by businesses to help them grow with the confidence that they can invest without damaging their cash flow. It’s a specialist type of insurance, so you may need to do some research to find the right provider for you.

Cash on Delivery: The simplest way to avoid credit risk is to avoid extending credit. Demanding cash on delivery is a model many businesses operate on, and depending on your industry could be incredibly successful. However, if your competitors are offering more favourable credit terms then this strategy could mean you lose out on business, and you run the risk of ending up with a lot of surplus stock, so look at your options carefully.

Letter of Credit: This is a letter from your customers bank that essentially guarantees that the bank will honour the debt, even if your customer can’t pay. They are not very common, are expensive and contain conditions that have to be met before the bank will honour them (like providing evidence of delivery). And because you have to get a separate letter of credit for each individual invoice, these are usually only done for high-value transactions.

Factoring: A factor effectively pays your invoices (minus a fee) in return for the right to collect on them. A benefit is improved cash flow. A negative is that you could compromise the end-to-end personal relationship you develop with your customer.

Self-Insurance: In this instance, you do the due diligence to make sure your customers are able to pay. Here, you do your own research on the creditworthiness of your potential customers and the volatility of the market – or you pay an agency to do it for you. Then you put aside a provision to cover any bad debts should they occur. There are no ‘insurance’ costs here per se, but you do have to foot the bill if something goes wrong.

At Debtcol, we help business owners understand what risks there could be to their business finance, and support them in recovering overdue invoices and debts. If you would like to know more, just get in touch.

 

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