Credit risk is associated with a borrower failing to repay a loan. It also applies to goods or services delivered on credit.
For example payment terms of 30 days = 30 day credit. You can minimise credit risk with strategies such as:
- Cash on delivery
- Credit insurance
- Factoring
- Letters of credit
- Self insurance
What is a good credit management strategy?
A good credit management strategy can help you minimise credit risk. It involves much more than reminding customers to pay. The most successful strategies assess credit-worthiness of potential and existing customers, as well as potential changes to the political or legal environment, and feature steps to reduce risk.
- Assess your customers’ credit rating. Does this meet your pre-defined conditions? Ensure contracts include your terms and conditions and details such as the exit period should you wish to cease trading.
- Monitor your customers continuously, including obtaining their financials. Take steps to terminate trading relationships once a customer no-longer meets your conditions.
- Issue invoices either manually or via an automated system and make sure your bookkeeping system is up to date.
- Operate a strong customer relationship management (CRM) system. This can be manual or automated and can form the basis for issuing payment reminders for invoices as well and other customer communication.
- Take steps to mitigate your credit risk and protect your account receivables with a tool such as credit insurance.
Mitigate credit risk with credit insurance
Credit insurance, also known as debtor insurance, is an excellent way of avoiding the impact of a bad debt. It is often a strategic credit risk management requirement made by stakeholders or boards of directors.
Trade credit insurance covers your credit transactions so that if your customer fails to pay you, your insurer foots most of the bill. Credit insurance applies to your customer, not the individual transaction, so you only have to do it once and then every invoice is covered within the exposure limit agreed. In addition to trading confidence, you’ll benefit from the due diligence work of your insurer who will check on the credit-worthiness of your customers. Credit insurance is a strategy that can help you grow your business while giving you comfort that you will be paid.
Other ways to protect your account receivables
Credit insurance is only one way to minimise the risk of unpaid invoices. Alternative approaches include:
Cash on delivery
One way to avoid bankruptcy is to demand payment on delivery. Some potential buyers may be happy with that, but you could lose out if your competitors are offering favourable credit terms. You also run the risk of being saddled with a surplus of unsold stock if your customer doesn’t pay up immediately and you have to hang on to your goods.
Letter of Credit
This is a guarantee from your customer’s bank that they will honour the debt. They can be expensive and contain conditions before being honoured (such as providing evidence of delivery). You will need a Letter of Credit to cover each individual invoice.
Factoring
A factor effectively pays your invoices (minus a fee) in return for the right to collect on them. A benefit is improved cash flow. A negative is that you could compromise the end-to-end personal relationship you develop with your customer.
Self-insurance
With self- insurance, you do your own research on the creditworthiness of a potential customer and the volatility of the market, or pay for an agency to do so. You won’t have insurance costs but you may have to provision for bad debts and will have to take the hit if your customer goes bust or fails to pay.