Credit Risk Strategies To Minimise Bad Debts And Improve Cashflow
Winning sales is half the battle; ensuring you get paid is the other half!
New customers
New customers, new orders from existing customers, and new business opportunities are the adrenalin of every business.
The business usually supplies the goods and services to the customer on credit terms to "win the sale" and to "keep the customer", especially in industries where credit terms are usually given.
Result? Credit risk strategies must be applied to the debt to maintain the cashflow of the business.
Credit risk strategies are simple
There are some simple, cheap and effective credit risk strategies for reducing credit risk for your business, to increase the chances of its collection and to improve cashflow.
Know your customer
Who do you invoice? Who is responsible to pay the bill? Is it a person or is it a company? Is it the company at the place where you deliver the goods or is it the company that asks you to deliver the goods at the place?
Once the customer's proper name is known, why not find out something more about them by asking the customer to complete a credit application form for new accounts?
If a standard credit application form is used, information such as the business office, the names of the directors or principals of the business, names of major suppliers and trade references will be given. In larger businesses, this is followed by a credit check.
Many small businesses do not use credit application forms, do not have access to credit reference agencies, or do not consider the cost of carrying out a credit reference check is justified. That is no longer an excuse!
Searches can be conducted through your country's Securities Commission to gain all the information you need.
Trading terms: Retention of title clauses
Trading terms printed on the front or back of quotations, order forms, invoices and the like are highly recommended for businesses. After all, their purpose is to protect the business from legal liability and to make debt recovery easier.
A basic clause is to specify payment terms of say 30 days, after which time the debt is overdue.
Businesses which supply goods to customers can use a very effective clause in their trading terms, called a retention of title (ROT) clause.
The purpose of the ROT clause is for the business to retain ownership of the goods, until payment for the goods, even though the goods might be sitting in the customer's warehouse. ROT clauses are particularly useful where the customer goes into receivership, administration or liquidation. Why? Because ownership has not passed to the customer, the business can call by the customer's warehouse, showroom or shop and collect any goods for which it has not been paid.
Liens are also useful. A lien is a form of possessory title, available to a business which holds goods belonging to a customer, upon which it has carried out work. The business can hold onto the goods until the debt is paid.
Common examples are the repairman's lien and the warehouseman's lien. The lien disappears once the business loses possession of the goods.
Personal guarantees
Almost all credit application forms provide for the giving of personal guarantees by the directors of a customer if it is a company.
Personal guarantees are not required for customers who are individuals as the debt is in their name.
For company customers, the debt is in the company name. Therefore, if a business wants to ensure that it can go beyond the company to collect the debt, it is necessary to have a personal guarantee enforceable against a director personally.
Most problems with enforcing personal guarantees arise because the credit application form is not correctly signed - it is often signed on behalf of the company. What is overlooked is that the director must sign a second time, for the personal guarantee.
It is a useful precaution to carry out a company search with the Securitites Commission to check that the person signing is a director, and to ask if whether the other directors of the company should also sign personal guarantees.
Credit risk assessment for credit terms
Credit risk assessment criteria should be formulated if credit terms are provided for payment.
Credit risks will depend on an assessment of many factors. Credit risk is heightened where a business's margins are low and where giving too much credit may put the whole business at risk of failing if payment is not received.
The classic example of a business which must be very careful in giving credit terms to its customers, is a travel agency which has a low margin on sales - as low as 5% commission for air tickets; which must pay its suppliers quickly (within seven days) for international air travel; and where the amount of the debt, in terms of a single air ticket or tour can be several thousand dollars.
Each business must carry out its own risk management assessment to establish which accounts it will not give credit upon, which accounts it will give credit upon, and for what time and in what amount, and which accounts require additional security by way of personal guarantees, retention of title clauses and the like before giving credit terms.
Credit card payments
Allowing customers to pay by credit card is a fact of life for most retail businesses. The margins are sufficient in most retail businesses for the credit card fee charged by the issuer/bank not to represent a major expense. If not, the fees can be added to the transaction amount.
For all businesses, receiving payment by credit card is recommended. It accelerates cash flow, and for retail businesses, encourages customer spending.
It is better than receiving a cheque, because payment is guaranteed by the credit card provider's banker, rather than by the customer (except in cases of fraud).
Debenture charges (charges over company assets as security)
While giving credit can be thought of as lending money to a customer, in some cases, a business will physically lend money (by drawing a cheque) to a customer.
The people behind a business can lend money to the business - which may cause problems where one person has lent substantially more money to the business than others.
In each of those cases, the business or person lending the money is acting as a bank, and where the money advanced is substantial, should take not only personal guarantees as security, but also a mortgage over the company, known as a debenture charge (or a fixed and floating charge) over the assets and undertaking of the company.
The procedure is the signing of a debenture charge deed, which is then registered at your country's Securities Commission.
If the customer is a individual or is a business which is not a company, then a trader's bill of sale can be taken out and registered, to the same effect.
The great advantage of a debenture charge or trader's bill of sale is the ability to appoint a receiver over the customer's business and assets, in the case of a default.
The receiver has the power to sell the assets to collect the debt and has priority over all other creditors (except the holder of a registered debenture charge or trader's bill of sale which has priority of registration).
This enables the business to recover the whole of its debt from whatever assets exist at the time of appointment of the receiver.
The fact that banks and finance companies take debenture charges over companies to secure even the smallest of overdrafts, loan facilities, equipment leases and the like means that there is often little left over for the general creditors of a business if it goes into receivership.
A search in your country's Securities Commission will usually uncover all registered debenture charges, to enable a business to assess its risk in dealing with a customer.
Credit management tips
Experience in chasing overdue debts and in writing off bad debts is a great teacher of credit risk strategies. Here are some further comments from my experience:
- Professional debt collectors - namely mercantile agents - are often engaged by businesses for debt collection. They take a percentage of the debt collected (often 30%) on a "no collection, no fee" basis.
They come into their own and achieve success where the business documentation is good, the debt is fresh and the debt is relatively routine and small. They are particularly good for retail and consumer debt.
Many small businesses have debts which do not fit into this description and, thus, do not consider it cost effective to engage a mercantile agent. Lawyers can assist in drafting trading terms, checking personal guarantee and security clauses and preparing debenture charges. They can also assist in debt collection by writing letters of demand, issuing summonses, and negotiating terms of settlement.
- Accepting payment of the debt by instalments is usually preferable to holding out for the full debt. The customer's written confirmation of an instalment schedule is very useful to have. In a continuing relationship, tie the instalments to future delivery of goods and services.
- Beware the trap of continuing to extend credit, or extending further credit to customers which are experiencing financial difficulties in an attempt to recover a pre-existing debt. Often those customers are trading insolvently and go into liquidation, leaving not only the pre-existing debt but also the new debt, unpaid.
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Anthony J. Cordato is a principal of Cordato Partners Business, Property and Tourism Lawyers, Sydney. He is the author of 'How to Collect Business Debts' For more information, email ajc@businesslawyer.com.au or telephone (+612) 8297 5600.
First published: 6 February 2007.
Last updated: 6 February 2007.