What To Know About Credit Risk

According to the Small Business Association (SBA), 20% of the businesses started in 2014 failed by 2015. The SBA estimates that only half will make it past five years, and only one-third will survive past ten years. Why do these businesses fail? In his book Small Business Management, Michael Ames gives the reader eight reasons why businesses fail. Of the eight reasons, six are related to cash flow and profitability. 

Here's another set of interesting statistics related to credit risk management. Due.com recently conducted a survey on business owners. The study found that 18% of invoices are paid within 24 hrs, 63% of invoices are paid on time, and 16% of invoices don’t get paid at all. How much of a difference could those '16%' of invoices have made for the '20%' of businesses that failed in 2014? Did these businesses understand the critical link between cash flow, profitability and credit risk management?

What is Credit Risk 

Academically, credit risk occurs when the seller agrees to provide goods or services on credit. It is the risk of extending credit to your customers. This risk is that the customer defaults on the loan. If you make sales on credit, even if your customer is the United States government, there’s a risk involved. What’s unique about credit risk is that it impacts all levels of the organization from the sales team to the finance team. And, not surprisingly, the sales team often has a higher tolerance for risk than the finance team.

Do You Have Credit Risk?

You don’t need a team of consultants to know if you have credit risk. If you make credit sales, you have credit risk. Here's another test: look at your accounts receivable, allowance for doubtful accounts and bad debt expense. If these accounts aren’t valued at $0, you have credit risk. 

Accounts receivable is a direct draw on cash flow and bad debt is expensed directly against profit. So, from a business perspective, and in terms that the entire organization can understand, credit risk is a direct draw against cash flow and profitability. It also increases your cost of capital. 

Measuring and Accounting For Credit Risk

Measuring credit risk allows you to understand the primary drivers of credit risk in your organization. You need to be able to predict, with high accuracy, if an invoice will get paid on time. You should also be able to estimate the magnitude of the delay and implement credit indicators down to the account level. 

Perhaps the most popular credit risk indicator for measuring the level of credit risk is days sales outstanding (DSO), defined as the number of days an invoice has been issued. A high DSO means the business is also functioning as a bank that gives out loans at 0% interest. 

You may also want to look at current accounts receivable vs past due accounts receivable, collection performance vs collection forecast, and cash collected as a percent of beginning AR. These indicators can help to identify the most urgent cases of delinquency as well as the reason behind the delinquency. You need to determine if there’s a trend or if the issue is due to a special circumstance (i.e., bankruptcy).

What Can You Do About Credit Risk

Measuring and accounting for credit risk will only get you so far. Minimizing the risk requires action. Some companies resort to trade insurance, others engage in factoring. Letters of credit are also a tool used for international sales. In some cases, the issue isn’t related to the financial distress of the customer, but invoicing. In such cases, expanded payment options, up-front billing, electronic invoicing and prompt early identification of late payments may help more than insurance or factoring. The challenge is finding a credit management solution that can solve problems related to financial distress and invoicing. You need a strategic and tactical solution.

Takeaway

Becoming involved in a lawsuit is like being ground to bits in a slow mill; it’s being roasted in a slow fire; it’s being stung to death by single bees; it’s being drowned by drops; it’s going mad by grains. –Charles Dickens

Going out of business due to declining profitability and poor cash flow is a difficult and unyielding process. It is a bit like being involved in a lawsuit. It happens by drops, and then one day you’re in deep waters. The good news is that there are credit risk management solutions on the market designed to help measure and reduce the water levels before it gets too deep.

Posted in Finance, Credit