At a time when business bankruptcies and interest rates are rising, companies face higher risks of nonpayment for goods and services delivered. Yet many are not managing credit carefully enough to protect their best interests. 

What is credit management?

Credit management is a business function designed to minimize the financial risks a company takes when they extend credit to their customers. It includes evaluating a customer’s creditworthiness, deciding how much credit to extend to them and what payment terms and policies to set, monitoring customer credit and payment history over time, and ensuring the company can successfully collect on customer debt. 

Credit management impacts the company’s profitability, stability, cash flow, and reputation, so it’s important to get it right. And as commercial bankruptcies become more prevalent and interest rates rise, the stakes are even higher. As of September 2023, the number of corporate bankruptcies filed in the U.S. year-to-date were higher than in the two previous years. Between 2022 and 2023 alone, the number of business bankruptcy filings rose 29.9%, from 13,125 to 17,051. 

How to improve credit management

As an invoice factor, AR Funding has conducted credit management on behalf of clients for more than 25 years. Because our business involves buying invoices from our clients and advancing them the cash right away, we need to make every effort to ensure those customer debts are honored. Over time, we have honed our credit management practices to minimize the risk of nonpayment, and while we provide this service to our clients for free, these are things that every company can do to protect itself from credit risk. In this blog post, Kevin Gilbert, AR Funding’s Executive Vice President of Credit Administration, shares five best practices from the AR Funding playbook.

Collect the right information up front

One of the most common mistakes Gilbert sees businesses making is not doing enough due diligence on new customers. Every time you set up an account for a new customer, you need to collect enough information to make informed decisions about how much credit to extend them. 

There are three ways to do this, and ideally, you can use all three to build an accurate and detailed picture of the customer’s financials.

Use a commercial data provider such as Dun & Bradstreet, Experian, or Equifax to collect customers’ financial data. While there is a fee for using these services, the outlay is well worth it if it helps you avoid a nonpayment situation. These providers will not only give you a wealth of business and financial data, but will make a recommendation for the maximum credit facility you should offer the business if they become your customer. 

Request data from the customer, such as audited financial statements prepared by CPA. These statements provide trustworthy metrics that speak to the company’s financial health, such as gross profits, net earnings, revenue, expenses, cost of goods sold, taxes paid, and pretax earnings.

 

Request data from the customer’s bank and trade partners. Banks will give you a range to indicate the balances the customer maintains with them, flag any overdrafts in their history, and provide a list of secured and unsecured loans the customer has taken out with them, along with a list of any collateral used to secure them. 

Calculate your true risk

When you extend credit to a customer, keep in mind that the risk increases every time the payment terms lengthen. For example, if you agree to $50,000 per month in credit to a customer with 30-day payment terms, the maximum debt they can carry with you is $50,000. But if you extend their payment terms to 60 days, that credit facility doubles. If you extend  it to 90 days, that customer could owe you as much as $150,000. 

There is no hard and fast rule when it comes to determining the amount of credit you should extend to new or existing customers, but it’s important to be aware of the level of risk involved when you negotiate these payment terms.   

Monitor changes over time

Credit management is not a one-and-done activity. While you will make a decision to extend a customer credit based on the due diligence you conduct at the outset, a business’s financials can change quickly. You should monitor each customer’s payment habits continually and note when they change, including the frequency of late payments and the number of days by which customer accounts are past due. Your business should also require customers to provide updated audited financial statements annually.

Gilbert also recommended open communication in addition to monitoring payments and requiring updated financials. “Companies need to communicate frequently with their customers to find out what’s going on in their business. If you’re not in frequent touch with them, you could be 60 or 90 days out before you realize something’s wrong, and by then, they could owe you tens if not hundreds of thousands.”

Address issues proactively

Gilbert often sees situations where companies get in trouble because they avoid having difficult conversations with their customers, especially long-term, loyal customers. It’s easy to let things slide when a good customer has cash flow issues and asks for a little extra time to get over the hump. But that’s exactly when nonpayment issues are most likely to arise. 

“It’s better to react quickly to problems, get the full story, and make a decision early in the process than to put it off and let the debt pile up,” Gilbert said. “The further out you push the problem, the greater the risk for your business.”

Consider credit insurance

AR Funding makes use of credit insurance to protect itself and its clients from the risk of nonpayment, and it’s worth looking into, especially if your business offers generous credit facilities and payment terms to your customers. Credit insurance protects your business by paying you a percentage of the amount owed in situations where a customer fails to pay you because of insolvency or other financial issues. (The exact percentage varies depending on the insurance terms.)

Gilbert pointed out that credit insurance can be especially beneficial in cases where a business has a high percentage of business and revenue concentrated with a single customer. 

“If 50% or more of a company’s business comes from one customer, it’s definitely worth looking into this type of insurance,” he said. “No company can afford to lose half its revenue.”

An essential business process

With the economy placing extra stress on businesses of every size and in every sector, it’s more important than ever to know who you’re doing business with and how much credit they can reasonably be expected to manage. Bringing greater diligence to the credit management process can help your company stay resilient, stable, and viable while ensuring that you continue to extend competitive payment terms to your valued customers. 

For more best practices that protect your cash flow, read these blog posts.

4 pro tips for preventing invoice issues and payment delays

How to improve financial resilience for your business 

To learn more about how invoice factoring can help you accelerate cash flow, talk to an expert in your area.