Accounts receivable is one of the most sensitive topics in a business. If the company has credit policies that are too flexible it will increase the number of customers and sales, but may suffer from a poor collection which will affect its cash flow. If the company has credit policies that are too strict, there may be fewer customers that can “afford” to do business or there may not be as many sales as with lighter credit policies.
There are many factors that one needs to consider when deciding how strict the policies should be. Among the main ones are:
-Gains vs Opportunity Cost
This is a finance blog, so of course this is going to be here. What does a surge in sales or an increase in market share matter if at the end of the day it turns out the customers to whom credit was given don’t pay up. There are many ways to conduct credit risk analysis on the customer depending on the business segment and of course the company.
If the client has financial statements the company can analyze them to see their financial performance, assess their liquidity and ability to raise capital if needed with liquidity ratios (ex. current ratio or quick ratio) and ratios that look at solvency (ex. debt ratio or debt to equity ratio). Another important measure to consider is days sales outstanding; for example, a client with a high DSO would be too risky since he may delay payments until he gets paid (sadly I’ve seen this to be a common practice despite not being professional and ruining business relationships).
Another element considered when evaluating a client’s risk is to analyze its industry; however, I wouldn’t put too much weight on it as with the information provided by the financial statements. The company should be looking at how the business segment is affected by the current economic growth or fall. Also, is it a failing industry about to crash? Or is there room for development, that will bring even more opportunities for you and your client?
Additional data to be considered is their credit score or if you have an analytics tools it may ask for data such as years in operation, sales, payment behavior, etc. that will allow it to produce its own score and prediction for repayment or survival analysis (how long before the customer stops paying).
Finally, to mitigate risk and also as one more thing to check. Can the client offer any collateral as a security of payment? This should be a requirement when dealing with smaller clients that pose a heavier risk of default.
Not only should the financial statements of the client be analyzed to grade its liquidity, but also the ones for the company issuing credit. The analysis of its own liquidity allows the company to determine how many credit days it can grant, the amounts per client, and the risk of default or tardiness that it can tolerate. This analysis has to be carried out before beginning to issue credits because if the company later on finds itself needing cash it can’t just demand payment, it will have to offer incentives such as discounts in the repayment or in future purchases in exchange for the client paying before its deadline.
A company that has cash in excess to meet its financial obligations, to invest, and produce more if necessary can grant more days, amounts, and quantity of credits. If the company is operating in a business segment where margins are low and they run lean on cash then they need to reduce their liquidity risk by establishing shorter days of credit and lower amounts per customer.
Along with liquidity, production is also affected by having high balances in accounts receivable. If having a flexible credit policy will shoot up demand, the company must have the appropriate stock for an increase in sales to not be a detriment. A business that doesn’t have enough stock to cover the demand caused by a lighter credit policy is exposed to incurring additional costs that it may not have the liquidity or margins for; especially, in a low-margin industry.
The company must also be aware of how long it takes from the time it produces new inventory to when it makes the sale and then receives the money. Having a long operating cycle means it can’t afford having a high DSO since it will take a heavy toll on its cash balances.
Gains vs Opportunity Cost
This point should serve as a summary after all the other elements have been considered. As we have mentioned before, having a lighter credit policy opens the door to an increase in sales. It’s up to the company to decide if the gains in sales and maybe even market share, depending on the competition (having a lighter credit policy could turn out to be a competitive advantage), are worth more than the opportunity cost of opting for a stricter but less risky credit policy.
One approach would be to calculate how much sales would increase (either doing market research with the competition to see their credit policies and their situation with accounts receivable) depending on the credit policy minus the additional costs that would be incurred due to higher production. Then pit this against the opportunity cost of having less available cash for investments, debt taken to cover financial obligations, and lower production. If the company can tolerate the risk and the income from the increase in sales with longer payment periods is still worth more than sales with shorter payment dates and lower risk, than it’s a green light.
Once the company establishes how strict its credit policies are going to be it will need to implement KPIs and visualizations to monitor the clients and the corresponding accounts receivable. This however, will be a topic for the next chapter, until then thank you for reading.