Trade Credit Management – a non-technical guide
“Best practice”’ in credit management
Why is credit management so important to businesses?
What are the key components of credit management?
What is meant by using trade credit strategically?
How can the use of trade credit management services help a business with their cash flow?
What are the options to protect debts?
Am I legally obliged to buy credit insurance?
What are the options for having access to finance?
Isn’t invoice discounting just for businesses that are in financial difficulty?
There are lots of different definitions of credit management. Most of them just describe one component of good credit management - for example, getting a credit information report on a buyer, or collecting the money. My definition of credit management is a very broad one.
Credit management is managing all aspects from the company’s strategic decision to offer credit terms to buyers in order to win profitable business. The key point here is that nobody forces a company to sell its goods or services on credit terms. Businesses do it because their customers value it.
We all experience the results of credit management policies. As consumers, paying for a pint of beer in the pub, using a credit card to buy on line or signing a direct debit form or the ultimate extreme of some of the deals offered by retailers to make you buy a new three piece suite with nothing to pay for four years.
The motive is simple. The business wants you to buy, now, from them rather than somebody else. They are using credit to win more business.
Receivables management is a bit narrower in scope than credit management. Most people are now familiar with the term (originally used in the US) “accounts receivable”also called trade debtors. I like the term receivables - because it describes actually what it is.
Accounts receivable or the sales ledger is shown in the accounts as an asset. Receivables management, also called ledger management, is all about the management of that asset. Turning it into Cash. The asset only gets created when you raise an invoice - or the equivalent (an obligation to pay - e.g. timesheet)
So credit management includes all the stages of assessing the risk, setting the terms (so pre and post invoice) whereas receivables management is just post invoice activities.
The question any business should ask is “Am I managing all aspects of credit management or just a few?”
The most common failure in credit management is not realising how important it is. It isn’t a job for Nellie on a Friday afternoon.
Most businesses see credit management as a necessary evil. A cost. In fact they are investing in a massive asset, which should be allowing them to win more business. They don’t use this asset as a source of finance (the cost of which should be easily covered by incremental sales) and as a source of competitive advantage.
Without adequate financial planning and support, use of credit can drain a company of cash so it must be managed. Many businesses confuse profit with cashflow – but businesses fail when they run out of cash not when they declare a loss.
There is an assumption that, because they've got a great relationship with a customer that this will remain the same for ever. Customers, especially like now in times of uncertainty, can get into financial difficulties – and move from “happy to pay” to “can’t pay”. Warning signs are usually there but sometimes personal relationships blind people to these. Sometimes people are almost embarrassed to discuss credit terms, despite it being a clear contractual obligation.
Best practice is performing all components of the credit management process well - not just one bit. It is also about clear simple procedures – the process itself is simple. There are lots of sources of best practice, such as the ICM – below is a synopsis.
Ask them to fill in a Customer Credit Facility application form – these days they can do it online. Your sales team should have this as part of their process. This is standard practice and these days with “know your customer” and anti money laundering requirements you really should be doing some of this even for cash sales.
Use this information to carry out thorough credit checks, including county court judgements, trade references, bankruptcy orders (via the Insolvency Service), bank references, credit circles etc. There are a number of providers of this information and its not that expensive. As the credit squeeze increases pressure on businesses, credit history and trading experience are less reliable than the hard financial information – ask the question “How robust is this customer to withstand long term pressure?” If they haven’t filed recent accounts and credit is really important to them you can ask for a copy of management accounts – offering of course to do this under a confidentiality agreement
Once established, keep monitoring this information for established customers. As mentioned above, some will deteriorate over the next few months.
Have a credit approval process and a database of your credit exposures to any company or group. This allows low value credit risks to be delegated and for senior managers to sign off on the larger and riskier credit lines.
Negotiate your credit terms always where possible. Providing you are winning as much business as possible and don’t have to discount on price, start from the basis that cash is best. Early payment incentives and part payments make sense if you can negotiate them.
Payment is a contractual obligation so avoid the "battle of the forms". One of the benefits of having long payment terms is that it very clearly is a contractual commitment. The UK has a poor track record for overdue payments compared to European countries despite having generally quite tight payment terms.
So try to make even your standard terms appear as some thing to negotiate about and ensure they are displayed clearly on account application forms, order acknowledgments, invoices and statements.
Prepare the ground well in advance of any due date. Make it as easy as possible for the customer to deal with you. Good best practice is to check just before due date that everything is in order. It’s a much more pleasant conversation as well! After all most companies do want to pay and for those who can’t pay or won’t pay the sooner you know the sooner you can handle it.
Issue clear and accurate invoices promptly (within 24 hours of delivery) and address them to a named individual. There are lots of things to minimize disputes – all of them around the idea of a customer relationship. Have a procedure for settling or escalating disputes quickly – if using credit insurance or receivables finance disputed invoices get excluded.
Its a simple process, one of the most basic and simple of all processes. As always, people benefit from good basic training and modern collection systems are excellent. Have a quick and consistent escalation and review process so you classify debtors as about to pay, can’t pay or won’t pay
What is good performance somewhat depends on the shape of the business.
Be clear about what your objectives are and don’t necessarily set conventional measures as targets. Clearly less bad debt is better, and less credit exposure is better, but remember the purpose of giving credit to customers in the first place. Using extended credit to win more business for example may actually increase your exposures – possibly even your bad debt provision and definitely your DSO so its how you manage your cash using this strategy that is more important than these measures.
That said, I'd measure as much as I can - what I'd target people on I'd be much more careful.
Basic measures include those around cashflow:
Operational measures include:
Risk measures include:
All these can be analysed by showing trends - the twelve month trailong chart is excellent at cutting out seasonal effects.
Many of these can be converted into cost of capital and profitability effects.
Firstly we need to recognise why offering credit is so important. In most industries, try selling on cash. Credit helps the buyer’s cashflow - easier and cheaper than going to the bank for money. For most of this decade, cash has been relatively easily available, and cheaply too. That's now changed. In particular, since the start of the global bank credit crunch, this is the single quickest way a company can survive if they are under pressure. Its of real value to your customers, in fact it could be life or death to them, which means you can use it to win more business or make more profits.
Offering credit has big implications for the supplier. The largest single asset on a companies balance sheet is their sales ledger. Many business this is well over 40% of their assets. For a service company then it is definitely the largest single element of your working capital. Extending credit has a knock on effect on your own cash flow if you don't manage it. So you'll need to manage your finances, make sure you collect the money due on time and have a strategy in the case a buyer goes bump. 25% of all businesses fail because they in turn aren't paid by their customers.
Credit management obviously looks very differently depending on the type of business you are in. In particular there is a distinct difference between Business to consumer credit and business to business. B2C generally means lots of buyers who you don't know much about, whereas B2B often means you can be very dependent on a few key customers paying you on time for your own cash flow. There many common principles, but the methods of management are very different.
Credit Management is made up of 3 distinct processes in a business.
The first - which many managers take for granted - is the decision to offer credit, actually strategy setting. This involves putting in place credit management policies & procedures and working out whether to get third party support - in terms of advice, processes, risk management and specific services such as information, insurance, finance and ledger finance.
The second is the agreeing of credit terms including risk assessment and getting the buyer to agree to the terms. This also can be missed. This is the pre-credit component before an invoice is raised.
The third, which is the bit most people think of, is the receipt of the cash. This component is called Receivables or Ledger management. This is all after the invoice is raised. Abe Walking Bear Sanchez, the American credit guru says “collection is just the final stage of the sales process.
Good Credit management is doing all three processes well.
It should go without saying but have a strategy. I've met many financial controllers who say their credit terms are "industry standard” or “it’s what customers force me to offer”. That’s not a strategy.
The head of any business should be able to answer the following questions:-
To answer these questions you need to assess the overall business risk, work out the cashflow implications and look at how to manage these.
In terms of process you need to work out how you decide if and on what terms to trade on credit with a customer. Why have one set of terms for all? What are your processes and who is responsible? How do you make sure if you offer credit you get the cash?
There is a lot of talk of outsourcing of services but credit management is a strategic process, not a pure cack office function. By all means outsource some processes but business leaders need to set their own strategy and policies.
Once that is done there are many support services available to help businesses trade safely and profitably on credit. All of these services should be assessed on the bottom line impact, not on cost alone. The range of services include:
To ensure you offer the right level (if any) of credit & therefore the greatest chance of being paid on time.
Outsourced management of your sales ledger - from invoicing to debt collection - to experts you may not have in house and/or at a cheaper cost.
To ensure you offer the right level (if any) of credit & therefore the greatest chance of being paid on time.
Payment of what you are owed if your customer fails.
The option for debt collection to be included.
Credit management, trade and country risk advice.
Finance from your invoices.
Outsourced management of your sales ledger to experts you may not have in house and/or at a cheaper cost.
Finance from your invoices.
No. However, you are required if you are a Director of a Company to ensure you have safeguarded the Companies assets. Best practice risk management should certainly include considering this as an option.·
No, but it can help in that situation as well. Invoice discounting is now very much in the mainstream of finance options for businesses, including those who are financially sound. Optimising your balance sheet, freeing up cash to re-invest or provide a higher return is an important business process.