Credit risk: The four steps you need to take to avoid credit risk
Extending credit to customers is a fundamental business strategy for improving sales and revenue. But it comes with additional risk, which requires careful management to ensure your cash flow and profit are optimised. Doubtful debt, which in turn can lead to bad debt, can jeopardise your cash flow and your ability to replenish stock, pay expenses and reinvest in your business. It can also detract from your available resources as you waste time and money in your efforts to recover payment.
For businesses at all stages of their development, but particularly start-ups and small to medium sized enterprises, unpaid credit can be crippling. So we’ve put together four steps you need to take to avoid credit risk.
Want to learn more about how to safeguard your business? Download our Dummies guide on Understanding Credit Risk.
Knowledge is power when it comes to credit risk
One of the best ways to avoid credit risk and late payment is to Know Your Customer. Following this principle ensures you verify the identity, profile and financial conditions of your client before you do business with them. And it’s not just for prospects – it applies to your existing clients as well. Understandably, if their finances have taken a negative turn, they’re not likely to broadcast this, so it’s up to you to do your research and make sure your business stays protected. As regulatory requirements continue to evolve there are clear due diligence processes you can follow. But beyond that, you can also conduct your own research – from online news searches to reading Companies House reports, asking other traders about their experiences with the client. You can also use a professional credit checking agency for a comprehensive view.
Get granular with financial statements
Annual reports should always be one of your first ports of call when evaluating current and prospective clients’ creditworthiness. Indeed, annual reports are designed to provide financial insight, so it’s worthwhile taking time to assess the information provided.
An annual account must, by law, include the following items:
- Balance sheet
- Profit and loss account (with the exception of small or medium companies)
- Auditor’s report
- Director’s report
Establishing a holistic view of these sources should give you plenty of information with which to assess your credit risk. As performance can change significantly year-on-year, it’s worth looking at the previous three-to-five years and asking some questions, such as:
- Are sales trending up or down?
- How about the company’s profits, net worth, and shareholders’ funds?
These are key indicators of financial health so you need to be able to put them in perspective – hopefully you’ll see a positive upward trend. You should also assess the business’s working capital ratio, which indicates its liquidity and, subsequently, its ability to meet short-term financial obligations. And, of course, look at the extent of borrowings. Armed with this insight, you’ll have a far more powerful picture upon which to base your credit risk decisions.
Implement a customer scoring process
Now you have all these tools with which to evaluate your clients, it’s important to embed within your business a systematic, process-driven approach to extending credit. Developing a customer scoring process is an effective way to do this. It’s also a simple way to improve profitability while reducing your credit risk. Quite simply, you’re categorising your customers and prospects so you can make better decisions about the volume of credit and the repayment terms you offer. This way, you can separate the major buyers who pay promptly from the companies who regularly pay late. This classification is sometimes referred to as a debtor matrix and allows you to convert risk into opportunity. You can create a customer scoring process by evaluating the company’s payment history, sales activity (including order size and frequency), business growth potential, and strategic importance to your business, among other factors, giving each aspect a weighting that provides you with quick, balanced insight.
Learn about sector behaviour to reduce your credit risk
As well as getting to know your customer to appreciate your credit risk, it’s also important to understand the different sectors with which you work. Specifically, you want to know:
- Who the market leaders are
- The growth prospects for the sector
- Which challenges lie ahead for the sector
This insight will help you better understand your supply chain. This is important because, as the name suggests, a supply chain is inherently linked; a positive or negative change further up the supply chain will trickle down and affect those below. And vice versa. Essentially, your customers’ problems can become your problem because if they don’t get paid, you may not either.
Another benefit of researching the different sectors in which you operate is that it helps you understand your clients better – and your credit risk. For example, the public sector may have slower repayment terms than other companies, but you’re sure to receive payment. When working with less stable sectors, you may want to reduce your credit risk by implementing shorter payment terms and higher interest rates for late payment.
The Graydon download centre contains many features on credit-related matters, including our handy Dummies guide on Understanding Credit Risk. If you can’t see what you’re looking for, let us know and we’ll post something as soon as possible.