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The Importance of Understanding Credit Risk Management

Topics: Finance, Credit & Payments, Management

“Risk comes from not knowing what you`re doing." Warren Buffett

The SBA Office of Advocacy defines small businesses as those with less than 500 employees. In fact, the majority of U.S. businesses (over 99%) are considered small. The SBA has also reported that 33% of small businesses don't make it past the second year and that survival rates are similar across industries, which suggests the issue is operational

Allowing customers to delay paying in cash gives you an advantage, but it also turns your company into a lender that makes loans at 0% interest. How many small businesses that failed in the first two years of business also failed to make the connection between sales growth, cash flow and invoicing. In other words, how many small business owners failed to understand the importance of credit risk management?

According to the reports of various studies, approximately 20% of total assets are accounts receivable. The corresponding number for accounts payable is 10%. This represents a substantial and yet hidden cash flow gap that businesses have to manage to remain operational. And, if one of your customers is responsible for more than 25% of sales or profitability, the risk is magnified. In the face of such risk, a risk that facilitates both success and failure, it seems the CFO must develop the superhuman ability to see around corners. This ability is also known as credit risk management.

The State of The Credit Risk Market

The Great Recession is often generalized as a financial crisis, but in reality it was a credit event. America bailed out AIG (NYSE: AIG), a company that provided credit insurance (put options, pre-petition vendor agreements, credit default swaps and collateralized guarantees) to the nation's largest banks. While analysts can talk about what happened in great detail now, the Great Recession took most of the banking world by shock. Even those banks with credit insurance, the ones that had covered themselves against this very event, would've taken a bath had it not been for the bailout.

What's the state of the credit banking market today? The S&P Global Fixed Income Research group warns that U.S. corporate default rates are expected to jump 30% by mid-2017. The group also said that there were at least 87 global defaults in 2016 -- the same level there were in 2009 -- and that the number of credit risk  downgrades outpaced upgrades by a margin of 2 to 1. According to a report by Euler Hermes, the total number of bankruptcies are expected to increase by 1% in 2017, and it would be the first time there's been an  increase since the Great Recession. The issue may worsen as interest rates rise and debt is refinanced at a higher rate, especially for companies with low gross margin.

The Credit Risk Trap

Accounts receivable is one of the largest assets on the balance sheet and the longer the receivable is unpaid, the more likely it will become a write-off. On average, 39% of invoices are paid late and 48% of customers have a delayed payment. In addition, 26% of invoices 3 months old are uncollectable, 70% of invoices 6 months old are uncollectable and 90% of invoices 12 months old are uncollectable.

What happens in the extreme case -- your largest customer files for bankruptcy. When your largest company files for bankruptcy, it's too late. The speed with which a credit event of this nature impacts cash flows can be  operationally debilitating. The issue is that bankruptcy is still considered a viable operating strategy even if it's not due to bank debt. Litigation, under-funded pension liabilities and labor conflicts are only a few examples used for a company to enter bankruptcy these days. How can you manage customer defaults when a company doesn't have to be technically insolvent in order to file? In fact, losses or deterioration in profitability are not requirements for bankruptcy.

The credit risks inherent in doing business are clear, but not so easy to discern. The only way to avoid them completely is to stop selling. That's not going to happen, especially in difficult situations. In fact, all too often companies get caught in the credit risk trap. They extend  terms and then continue to extend terms to companies in financial  distress without an adequate review of the customer, essentially doubling-down on the risk.

In a study entitled Trade Credit Risk Management: The Role of Executive Risk-Taking Incentives published in the Journal of Business Finance & Accounting, it was found that executive risk-taking incentives are positively related to the level of  risk found in customer credit relationships. The suggestion is that risk-taking is pathological, condoned and often rewarded. The suggestion also provides insight into the psychology of the firm that provides credit to firms under financial distress. In other words, credit risk is tied to reward and that reward can become blinding to sales staff. This is why it's important to maintain a robust credit risk management system. It is the only proven way for CFO's to see around corners.

Credit Risk Management: A Framework For Understanding Credit Risk

The first step in credit risk management is the creation of a credit policy and then a credit review process. The policy and review process should define the credit risk, define the trade credit terms and determine what the credit qualification will be for each customer with sales made on credit.

  • Credit risk is the amount of risk you are willing to take on by lending money to another entity. It is the risk of involuntarily giving away free products and services.
  • Trade credit terms define the cash you are willing to lend and for how long. Terms generally vary  from 10 to 90 days. Average days payment terms is 28 days. The average days sales outstanding is 61 days. The degree of flexibility given is generally determined by the industry.
  • Credit qualification is defined by creditworthiness. Credit applications and business credit agency reports are often used to make a determination.
  • The development of a credit policy is required to provide a business with a consistent process for the evaluation and extension of credit, from application to past-due procedures.
  • Credit reviews are conducted once a month or quarterly. Financials are gathered and analyzed. Metrics  like days sales outstanding (DSO), percentage of current accounts receivables, and the aging of schedule of receivables, are used in the  credit review process.

In Summary: Credit Risk Management Is Directly Related To Your Success and Survival

“Risk is like fire: If controlled it will help you; if uncontrolled it will rise up and destroy you.” -Theodore Roosevelt

Whether you're trying to manage risk at your own company or you're just trying  to get risk management credit, the study of credit risk management provides a framework for understanding the true nature of credit risk in your organization. While profitability is a consideration, credit risk  management is about seeing beyond profitability, which can be manipulated. The purpose of credit risk management is to help the CEO and CFO to develop a quantifiable sixth sense about operational cash flow. Failure to do so can lead to an ambush.

Net terms accounts receivable

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Apruve enables large enterprises to automate long-tail credit and A/R so you can stop spending 80% of your time and resources on 20% of your revenue. We partner with each of our customers to solve their unique credit, payment, and accounts receivable challenges and build the right credit solutions for your markets, customers, and goals. 

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