Part 1 in FinCred’s Credit Risk Management series
Credit risk is generally regarded as a factor of business that needs to be controlled. Whilst to a certain extent this is true, full and robust management of your credit risks can actually offer many competitive advantages as discussed in our recent blog on boosting growth.
But what does credit risk management entail? How do you set up robust procedures to ensure risks are minimised? What are the red flags you need to look for when talking to new clients?
In our new three-part series on Credit Risk Management, FinCred breaks down the ins and outs of the risk management process, how to optimise your strategy, and the ways in which your business will benefit.
Identifying the Risk
Credit risk management is a combination of systems, processes and procedures that identify, assess, evaluate, treat and monitor the risks of trading on credit terms. The first stage of any risk management process is to identify the risks.
If you trade on credit terms, the risk of default arises from the non-payment or insolvency of one of your customers. This could be due to a number of factors; cash flow difficulties, supply chain issues, poor management, or more. However, once a potential risk is identified, the next step is to investigate the likelihood of it being realised.
Analysing the Risk
If you sell goods or services on credit terms, a due diligence process is essential for screening new customers, and monitoring existing ones. The process of analysis can broadly be split into two steps; Getting to know your customer, and assessing their creditworthiness.
Know Your Customer
Getting to know a little more about a customer is known as a soft check, and typically takes place when you’re approached by a new lead. A soft check is a preliminary look at particular information, including where the customer is based, when it was incorporated, checking websites, email addresses and phone numbers and who has contacted you from the business.
You can begin this process by checking the company details provided during the onboarding process. Registered and trading addresses can be verified using a search engine, Be wary of virtual offices, serviced offices, PO Boxes and residential addresses. There are also many websites that allow you to ensure the legitimacy of their website registration details.
Verify the credentials of the person making contact with you, and be cautious if the contact method or person for an existing client changes.Take note of how the customer made contact with you, and look for potential clients reaching out from non-company emails addresses or mobiles.
Creditworthiness
Once you’ve established your lead is legitimate, you can proceed with a hard check and establish their creditworthiness.
Hard checks involve a more in-depth analysis of a customer’s existing and past financial information, credit limit recommendations, payment patterns and borrowings. It is essential to perform a check on a new customer when establishing their creditworthiness, and to regularly check existing customers, particularly if you are approached to extend new lines of credit. Financial information can be requested from the customer directly, or obtained from Companies House.
Credit status agencies such as Credit Safe, First Report or Dun & Bradstreet can provide company credit reports, which provide a useful starting point for analysis. They collate publicly available information on businesses such as statutory accounts, legal judgements, business ownership and use an algorithm to provide a credit score and recommended credit limit. The credit score also provides a probability of default.
“Trade credit insurance providers have access to non-public information such as management accounts, budgets, forecasts and payment practices.”
The financial information provided by this method is largely historic, typically at least 9 months old, so some caution must be exercised. However, it remains a valuable tool in your credit risk management process.
Additional Tools
In addition to using credit status agencies, trade references from a supplier or bank are another useful tool when looking to build a relationship with new customers. How long have they been a customer? Does the supplier extend credit to the customer? Has the customer ever paid late?
As your prospective customer provides the name of the supplier or bank willing to offer a trade reference, there may be an element of bias in the selection process.
Trade Credit Insurers
Finally, another source of information is a trade credit insurer. If your business mitigates and transfers its credit risk with a trade credit insurance policy, your insurance provider can offer a wealth of financial and intelligence information on the customer. In addition, insurance providers have access to non-public information such as management accounts, budgets, forecasts and payment practices, thus can provide insight and advice to you in real time.
Credit risk assessments and information on the financial viability of a business used to be available solely through the purchase of a trade credit insurance policy. However, some of the insurers now offer business information subscriptions, where you can access the business intelligence without needing to purchase a trade credit insurance policy as well.
What Happens Next?
How do you process this information? What should you be looking for? How can you use it to your business advantage?
In Part 2 of the series, FinCred details how to spot the red flags a customer may be facing financial difficulty.
