One of the main reasons why small businesses fail is due to poor credit risk management. There is a good reason why banks and lenders give priority to risk management. They understand that if you are clearly aware of your customers’ creditworthiness and the local political and economic climate that may affect a customer’s ability to pay, protecting your receivables gets easier. The rule of thumb in credit risk management is to act and not to react. Most small businesses react to credit issues and that is why they fail to achieve their full potential.
Although credit risk management is not as straightforward, having the right discipline and making use of a few pro tips can help achieve your goals without the risk of incurring a loss. Here are a couple of tips that will help you improve your insight into credit risk as well as enable you to take the most appropriate measures to maximize the risk/return profile.
Check the credit record of new customers thoroughly
Just because a new client walks in with a fine cut suit does not mean you should ignore his credit record altogether. This is a mistake made by most small businesses. Other times, the need to look into the credit record of a new client is ignored all together. Needless to say, this is the worst mistake you can make as a business owner/manager.
As aforementioned, when you understand the creditworthiness of a client, you will be able to predict his ability to pay. Finding local and foreign corporate information can be hard more so for the emerging markets. The best way forward is to rely on the services of local consulting firms to assist you with the background check.
Establish credit limits
Even where the credit record is impressive, when dealing with new customers, you have to establish credit limits. This is for the simple reason that you use the first sale to start building a customer relationship. When setting up credit limits, you can use tools like credit-agency reports, bank reports as well as audited financial statements. These will give you a great view of the customer’s financial history, borrowing capacity, level of debt as well as cash flow, profitability and liquidity.
Set clear credit terms
The last thing you want is to lose a case in court against a debtor. This happens when the credit terms of the sale agreement are not clear. A good sales agreement should be well-worded and have comprehensive terms of credit. This will help reduce the risk of disputes as well as improve chances of your getting paid on time and in full.
Pay for political and/or credit risk insurance
During business formation, it will be wise to think about credit and political risk insurance. This will keep your business from collapsing in case of non-payment. There are numerous insurance products that have been tailored to protect your small business against contract cancellation, non-payment, expropriation, breach of contract, political violence, currency restrictions and so much more. Make sure the cover you take is comprehensive and that the fee is cost-effective.
Don’t focus only on the new customers
It is human nature to assume that the long-term business relationships are solid and stable and built on trust. The truth, however, is that approximately 80% of bad debts involve the relationships that are years old. Credit risk management should not be treated as a one-time process. You have to constantly evaluate credit risk for all customers, suppliers and vendors. Keep an eye on trends in business credit profiles which signal imminent trouble.
Don’t ignore your colleagues
The best credit professionals are not in the credit department. They are in the support, sales, customer service and the executive suite. For example, sales calls can help the sales team know that a current customer is downsizing or the executive officer may hear that a certain customer is having trouble with loan payment. Trusting your colleagues means you have more ears on the ground. The information they bring to the table will help evaluate the credit risk in a more effective manner.
Business fraud should be taken seriously
In an effort to build more relationships with customers, most small businesses overlook signs that a deal may be too good to be true. You must always apply consistent risk management practices to all customer relationships. Every red flag should be investigated. Pay more attention to customers with murky business histories, absurd terms, and unusual references. Put everything on hold until you evaluate the credit risk.
Review and monitor covenants
Covenants are basically the conditions that are agreed to by borrowers as part of the loan term in commercial loans. These may also be applied in sales. When you monitor these covenants closely and effectively, you will be able to get early signs of loan deterioration or non-payment.
Have regular update of customer key financial data
How often do you review customer report and financial data? If you take too long to do this, you might not notice when the finances of a customer are being depleted. To be able to build a better client relationship and improve credit risk management, you must have the current state of affairs of your customers. The timelier their profit & loss and balance sheet information is, the more likely the ratio analysis will signal deterioration of financial performance.
Closing the doors and going home is the only way to eliminate risk. So long as you are running a business, you will always have to deal with risks. The best you can do is to manage these risks. You have to invest in the right technologies, tools, processes and consulting firms in order to effectively manage credit risk. When you are able to manage credit risk in a cost-effective manner, you will be striking the right balance between risk and reward. The more you learn about credit risk management and the more meticulous and disciplined you are the more effective you will be in running a profitable business.