Most of us would probably associate the risk of bankruptcies and past-due defaults with tough economic times, commodity down cycles and industry recessions. However, credit risk has proven to be a much more constant threat than originally thought. The general perception that a rising tide raises all ships ignores the reality that it actually swamps some boats.
At a certain point in an improving economic or industry cycle, increased prices, increased volumes and overall higher levels of activity can overwhelm the capital resources of some companies. Caught in this crunch, often without additional readily available capital resources, some companies quickly can lose control. Vendor payments get stretched, defaults occur and, in some cases, insolvencies erupt.
As we look ahead at the coming year with guarded optimism, it’s important to keep this risk in mind. It often takes a back seat to the pressing matters of sourcing product and filling orders. Now as much as ever, you need to continue developing and implementing prudent credit risk management policies, using the best tools available.
Ineffective credit risk management
Businesses cannot afford the uncertainty and financial risk of excessive payment delays, cash-draining delinquencies or, worse, bad debt write-offs. These issues are further magnified in today’s challenging economic environment where delays, delinquencies or defaults can threaten a company’s survival.
What may seem obvious isn’t always the case, and the implications, while understood, often are ignored because of the ineffective ways some businesses deal with these issues.
Many scrap recycling businesses have traditionally relied on the relationship approach to manage their credit risk. The days of a handshake being good enough are long gone. Businesses can’t afford to think they know a company based upon what a buyer or executive has told them. Many credit decisions often are wrongly influenced by long-standing relationships with a strong personal connection but without sound, objective analysis. This is an ineffective way to manage credit risk. If credit decisions solely are based on intuition or a gut feeling, that can lead to poor financial results. Take emotion out of the credit decision process. Companies must make credit decisions based upon objective data that deliver a clear, accurate view of a customer’s credit status.
A properly structured credit insurance program can more than pay for itself while removing the risk of a large, unexpected credit loss from the company’s balance sheet.
Too many businesses rely on a customer’s historical payment record as a way to manage credit risk. It is widely used and deeply flawed. Unfortunately, in many insolvency cases we see, the customers are paying suppliers in a timely fashion right up until the filing date. A warning sign is not always provided via payment deterioration. Many will see timely payments up until the one time the payment doesn’t come at all. A customer’s payment information does not provide good insight into how that customer is paying other suppliers. The business could be getting paid on time while one of its customers stretches its other suppliers well beyond terms. If this business is a critical supplier, it has no idea others are not getting paid. Again, this is hardly a prudent way to manage credit risk. The customer only needs to default one time on a payment for a business to be caught with a big exposure.
Depending on mass market credit reporting services is another common and rather marginal credit risk management approach. To be truly effective, credit reporting should be industry-specific and be handled by analysts who specialize in that sector. The generic credit reporting products that many in the industry rely on today are based on publicly available and self-reported information that can be dated and inaccurate. Nonindustry-specific providers can be spread too thin across every business category to provide real insight and decision support that is of measurable value to a recycling company.
Effective credit risk management
It’s a simple fact of business that every sale puts capital, profit and net worth at risk. You owe it to yourself, therefore, to find effective ways to manage such risk, especially given today’s uncertain environment.
If the old ways of managing credit risk do not work anymore, what can you do to protect your company? To start, you have to make a philosophical shift. That means acknowledging that credit risk is a serious—even potentially fatal—threat to your business. It means setting up procedures to aggressively address credit risk on an ongoing basis.
Ideally, it also means putting someone in your company in charge of managing credit risk and, most importantly, giving him or her the tools and time to do the job properly. In reality, most scrap companies cannot afford to employ a full-time credit manager, so this role must be filled by an existing staffer with at least some financial experience.
A good credit policy is an essential component and a fundamental part of a successful business strategy. It is critical to design and implement a policy to mitigate future credit loss potential and to capitalize on new revenue opportunities. Your policy must account for all phases of the credit life cycle—from account acquisition through collection. You need to evaluate your business’ historical performance data, focus on your business’ goals and examine your appetite and tolerance for risk.
A good credit policy is an essential component and a fundamental part of a successful business strategy. It is critical to design and implement a policy to mitigate future credit loss potential and to capitalize on new revenue opportunities.
Sound credit policies, diligently following these policies and a clear understanding of how they affect revenue and profit are key drivers of success. A well-written policy and its implementation will ensure that your revenue translates into cash according to the terms of the credit extended.
Consider partnering with a specialized credit reporting service with core expertise in your industry. These niche companies understand your industry better because they are following your industry, the markets of your customers and the related supply chain. They have the ability to obtain information from market-derived relationships with access to multiple industry participants selling the same accounts. Acting as a third-party noncompetitive threat, these specialized reporting services may be able to leverage their unique relationships to secure industry-specific payment and financial information. ProfitGuard was founded to address the specific needs of the scrap recycling industry and seeks to support customers in setting initial credit limits and in monitoring accounts on an ongoing basis.
Insuring against risk
Consider implementing an accounts receivable insurance program. Credit insurance can provide substantial benefit to your company in a number of different areas, including protection from catastrophic credit losses, providing the ability to extend open credit terms and capturing additional sales above your internal risk appetite, enhancing your receivables based borrowing arrangements and providing some level of credit decision support. A properly structured credit insurance program can more than pay for itself while removing the risk of a large, unexpected credit loss from the company’s balance sheet.
Extending credit is a necessary element of doing business. The decision companies must make isn’t whether to grant credit but rather how to mitigate the risks when doing so. The bottom line is that extending credit without meaningful insight can put any business at great risk, or, conversely, not extending credit when perceived risks are not real can stunt growth potential. Investigate all of your options while avoiding common mistakes and you’ll increase your chances of being able to safely navigate through this difficult environment.