How to assess and manage your credit risk

26/10/2021

Many businesses offer their customers credit terms to maximise their sales opportunities and remain competitive. But it can be risky business. If a customer pays late – or not at all – cash flow can become stretched, and this can be fatal for businesses.

Therefore, businesses must constantly analyse the credit risks they’re exposed to, take proactive steps to protect themselves and balance the potential for increased sales with the risk of reduced cash flow.

In this post we learn more about credit risk, including what it is, why it’s important and how to manage it.

What is credit risk and why is it important?

When trading on credit terms there is always a possibility that a customer will not pay on time or in full. This potential for a loss resulting from a customer’s failure to adhere to the agreed credit terms is known as a credit risk.

Put simply, it’s important for businesses to manage their credit risk because, if a customer doesn’t pay on time, their cash flow can be impacted, making it difficult to meet commitments such as paying suppliers, VAT and PAYE.

Should losses occur on a large enough scale, it can lead to severe cash flow problems – one of the biggest causes of business failure.

Given the interdependence of supply chains, the level of risk your business is exposed to isn’t limited to your direct customers. If one part of the chain breaks, perhaps due to a supplier going out of business, this can cause a domino effect through the chain.

Although it’s impossible to know exactly who will default on obligations, properly assessing and managing your company’s credit risk can reduce the severity of a loss.

How do you assess your credit risk?

There are a number of things to consider when assessing the level of risk your business is exposed to.

The complexity of your supply chain and your dependence on certain customers are both key considerations, but perhaps the most important is the creditworthiness of your immediate customers.

A common method of determining the creditworthiness of a company or individual is by using the five Cs of credit:

1. Character

Does the customer have a solid track record of making payments on time?

2. Capacity

Does the customer have the financial capacity to pay the invoice on time?

3. Capital

Does your customer have the capital available to pay for your goods or services?

4. Collateral

If your invoices remain unpaid, does your customer have any assets they could liquidate to settle the debt?

5. Conditions

Are there any external factors, such as economic challenges or sector issues, which could impact the customer’s ability to pay?

The more you know about your customers, the easier it is to know if they pose a credit risk.

Things like account opening forms, credit checks and regular contact are all essential to spotting potential issues as early as possible. Using this information, you can decide how to proceed.

Remember, just because you offer credit terms to one business doesn’t mean that you have to do it for everyone.

Any businesses that are deemed to present a high risk can easily be excluded and only supplied to with a deposit or payment upfront.

Also, remember that situations can easily change. Especially in the current economic climate, customers who once paid on time could now find themselves in financial difficulty through no fault of their own.

Keeping in regular contact will allow you to spot any potential issues at an early stage.

Learn how to tell if a customer is in financial difficulty

How else can you manage your credit risk?

There are a number of strategies you can use to manage your credit risk and reduce the impact of customer defaults on your business.

1. Have a solid credit management strategy in place

Nurturing good credit control practices within your business can help to reduce your credit risk, prevent late payments and contribute towards a healthier cash flow.

The key to achieving this is to have a solid credit management strategy in place. This should cover everything from the moment an order is placed until payment is received.

2. Spread your customer base as widely as possible

When a single customer comprises a large share of your business, losing that customer can have a devastating effect on revenue, profit, and cash flow.

Therefore, to protect your cash flow it’s important to try to spread your customer base as widely as possible.

It is also good practice to try and spread your customer base across multiple sectors. This limits your exposure to sector-related issues.

3. Regularly update your financials

Without proper monitoring, a single late payment can have a devastating impact on your cash flow.

Therefore, it’s vital that you keep your financial admin up to date so that you can spot any potential cash flow issues before they become a problem.

Your sales ledger provides an instant overview of your outstanding invoices. Knowing exactly when each invoice exceeds terms allows you to spot any potential issues and take the necessary steps to safeguard your business.

Also, by regularly updating your cash flow forecasts with anything that could impact your cash flow, you will be much more likely to spot cash flow shortages before they happen.

Discover how to forecast your cash flow effectively

4. Protect your cash flow

Credit insurance offers a great way for businesses to protect themselves against the risk of bad debt, by safeguarding cash flow against the risks of debtor insolvency or protracted default.

Whilst facilities can be provided by credit insurance companies as a standalone product, bad debt protection can also be incorporated into an invoice finance facility, which will additionally advance up to 90% of an invoice’s value within 24 hours of its issue to assist with cash flow management.

If you’re looking for ways to improve your cash flow or protect it from the risk of customer insolvency, our team can help. As a specialist commercial finance broker, we can introduce the most suitable finance facilities and credit insurance policies for your business’s requirements, giving you the confidence to trade on credit terms in confidence. Contact us on 0800 9774833 or request a call back to discuss your options with our award-winning team.