Guide to successful risk assessment and credit management

If a stranger walked up to you and asked to borrow £100 on the spot with a promise that you would be paid back in 30 days, would you oblige? Thought not. What about repayment and the implications if it failed to materialise? Despite these obvious risks, many organisations need to do business this way.

In the current economic climate, risk assessment and effective credit management for the SME is paramount. Bad debts rarely occur without warning, so if you are pragmatic in your approach and assess your risk at every step, you will minimise the threat of insolvency.

The financial principles of credit management should be applied to small businesses as a sophisticated marketing and cash management tool, however for the SME, no matter how small your businesses is you must ensure you have good risk control, fast payment collection, and a clean sales ledger in order to protect your investment, improve your company’s cash flow and help with the profit level.

Traditionally under the finance banner, the responsibility for credit management has moved to lie somewhere between sales and finance; although essentially everyone should be responsible, especially if you do not have a dedicated finance/sales departments.

By sharing financial information across all employees, your team should be able to work together to help protect your organisation’s bottom line “the profit”. Company credit policies and procedures are essential – creating one and communicating it company-wide is vital, not only in removing the risk of disagreements, but having a dedicated set of ground rules, and responsibilities, will help you maximise profit and support sales.

The objective of a sale is to maximise profit, therefore the sale should not be made until all reasonable efforts have been made to ensure that the potential customer can afford to pay, and will pay promptly.

Remember that the average business loses all profit on a sale if a debt becomes 60 days overdue, and has to work very hard to repair the damage if there is bad debt.

The following key issues must be looked at when managing your cash flow and credit management policy:

Key Credit Management Tips

• Define the scope of the credit function, but remember to be flexible taking into account the changing economic climate and unforeseen changes to the business

• Show who has authority over what and draw up a flow chart of all decision processes, i.e. accepting new customers, changing status of existing customers, exceptions to payment terms, changing credit limits, suspending accounts, using third-party enforcement
• Draw up general selling conditions, i.e. interest charges on overdue accounts, unambiguous payment terms
• Make sure you manage all sources of cash and account for all repayments whether it is investments, loans or money received from a sales ledger
• Maximize your working capital; current liabilities should not exceed current assets, as this could cause a cash flow problem in the future
• Maximise profit; Any interest you pay is a significant cost against your profit. Getting your cash in quicker will reduce this cost and therefore increase your profit
• Minimise the impact of bad debts; Bad debts are a cost against sales. The only positive way to recoup such losses is by additional sales. e.g. £100 bad debt in a business showing 10% profit will require additional sales of £1,000 to recoup the lost £100 profit. (However most businesses lose more profit through day-to-day overdue money levels than through bad debts)
• Support sales: The finance people will have a valuable insight into customers’ payment behavior and should be able to identify which are at risk, reviewing new customers information is key but monitoring your existing customers is equally important
• Every time you make a sale, you have four chances to re-affirm your general sales conditions and specific payment in terms of writing the:
  • Order acknowledgement; An early chance to avoid any confusion over a customer order and eliminate difficulties on collecting payments
  • The advice note; If you don’t have time to issue an order acknowledgement, an advice note can act in the same way
  • The invoice; This should be concise and to the point with essential details of the service/product; charges for the service/product with VAT details; how and when to pay and to whom; full company registered name, place, number and address. (NB Make sure your VAT rates are up to date alongside recent changes - the reduction in the VAT standard rate will become 15%, effective from 1st December 2008 until 31st December 2009.)
  • The statement of account; Useful as a summary of trading activity, the basis for the customer’s inventory reserve, a reconciliation tool, a reminder of payment due date; an opportunity to include a tear off remittance advice to encourage prompt payment

This article was written by Jonathan Strutt, Sage 50 Accounts Product Manager, Sage (UK) Limited