Article
Written by Alice Payne
Posted on 22/07/2016

How to reduce credit risk

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The modern day credit manager has many responsibilities, but one of the most pressing is to reduce credit risk. When extending credit, there is always an element of credit risk which needs to be carefully balanced to avoid falling victim to late payment or bad debt. However, there are a number of ways credit managers can reduce risk effectively.

Determining creditworthiness

Accurately judging the creditworthiness of potential borrowers is far more effective than chasing late payment after the fact. Indeed, chasing late payment can waste valuable financial and human resources that could be invested in generating new business. And there’s always the additional risk that late payment will become bad debt.

This makes it especially important to determine which customers are worthy of credit – and there are certain fundamental best practice procedures to follow.

Know Your Customer

Know Your Customer is a type of regulation that is imperative in specific sectors, such as financial services. But its principles extend to everyone: don’t offer business to customers unless you have conducted sufficient due diligence. At the very least, verify the identity, profile and financial conditions of a client before doing business with them.

This principle shouldn’t just apply to prospects – you should implement periodic checks on your existing clients throughout the customer life cycle. In today’s business world, a company’s outlook can change swiftly and if you wait for bad news to reach you, it could be too late to recoup your losses.  

Conducting due diligence

There are certain due diligence procedures that can significantly strengthen your credit control function. When determining the creditworthiness of a customer, always check their business profile on Companies House and examine any financial statements. It’s important to compare the previous three years of financial statements to identify how their performance is currently faring. You can also learn a lot about a company and its culture by conducting a director check.

Leveraging expertise

Using a reputable credit reference agency for more in-depth due diligence can give you invaluable insight and alert you to any potential red flags. You’ll also be able to use the credit report to create a business profile and segment the client appropriately in terms of risk and credit allowance.

It’s wise to consult your industry contacts and check the business’s reputation – especially regarding payment behaviour. And, of course, leverage your in-house resources: your sales team will have a closer relationship with the client and will likely sense if there’s a change in financial health. So make sure your credit control and sales teams work together.

Setting accurate credit limits

To set credit limits accurately, you’ll need to spend time examining the customer’s finances. Look at the previous three to five years’ reports and question whether sales are trending up or down. How about the company’s profits, net worth and shareholders’ funds? These are key indicators of financial health. And make sure to assess the business’s working capital ratio, which indicates its liquidity and ability to meet short-term financial obligations.

It’s also important to take a wider sector view when setting credit limits. Learn about the sector’s behaviour to reduce your credit risk, making sure you understand the growth prospects and future challenges of the sector.

With this combined information, you should be able to score your customers effectively, minimising your credit risk and setting profitable credit limit.

For more information, read the four steps you need to take to avoid credit risk.