Credit Risk Mitigation Tips and Tools
January 23, 2020
In this fast-paced, interactive presentation, you will learn the best methods to manage the two most important types of credit risk – slow payment and nonpayment.
What You’ll Learn:
- Methods to improve collection results immediately.
- Tools to better measure and assess credit risk and assign appropriate credit limits.
- The use of various credit enhancement tools including:
- Liens
- Letters of credit
- Guarantors (personal and intercorporate)
Video recording:
Webinar slide deck:
About the Presenter: Michael Dennis
Michael Dennis is a partner in DC Associates, a consulting company helping clients to manage credit risk and to limit payment delinquencies.
Michael has more than 25 years of credit management experience with a number of Fortune 500 companies.
Michael is the author of 7 books related to credit risk management including Credit and Collection Handbook, Credit and Collection Forms and Procedures Manual, Happy Customers Faster Cash, and The Credit and Collection Manager’s Concise Desk Reference.
Credit Risk Mitigation Tools and Tips transcript
Good morning, everyone. Thank you for joining us for Credit Risk Mitigation Tools and Tips. Joining us today is Michael Dennis. Michael is a partner at DC Associates, a consulting company helping clients to manage credit risk and to limit payment delinquencies. Michael has more than 25 years of credit management experience with a number of Fortune 500 companies.
Michael is the author of seven books related to credit risk management, including Credit Risk and Collections, Credit and Collection Handbook, Credit Collections Forms and Procedures Manual, Happy Customers–Faster Cash, and The Credit and Collections Managers Precise Desk Reference.
My name is Tom Barrett; I’m with BARR Credit Services. During today’s presentation, if you have any questions, enter them into the chat room window at the bottom of the screen on the right-hand side. We will have time for questions at the end of the presentation.
Michael, welcome.
Thank you very much. I would like to welcome the attendees. Just a little housekeeping. We’ve committed to begin and end right on time. As Tom mentioned, we’re going to save ten minutes at the end for questions. So as they occur, please write them down. We’ll certainly try to answer as many of those questions as we can.
Let’s jump in. The good news: There are a lot of very practical things that credit pros can do, starting today, without technology, without a lot of change. Those practical things will have a big impact on your company’s ability to limit credit risk. My perspective is this: There’s one best time to manage credit risk. It’s when you’re evaluating credit applications for the very first time. When you’re making the decision whether the applicant company qualifies for open-account terms. But it’s more than just yes they do or no they don’t. We then must decide how much credit they quality for in open-account terms. Is it $10 thousand or is it $110 thousand? What is their credit limit?
We then have another question: Do we require any additional collateral as security? Let’s just take $100 thousand. Do we require a personal guarantee, a corporate guarantee, a security interest, a letter of credit? These are examples of some of the things we would consider when establishing a $100 thousand credit limit. So we manage risk most effectively when we do it upfront.
The next best time to manage credit risk is when you’re in the process of periodic updates on your customers. Whether every five years, every three years, every year or every three months. Look at active customers and say, “Does this customer still qualify for open-account terms? Do we require any other changes to the relationship? Are we going to shorten the payment terms, or now require collateral or security?
Reducing two different kinds of risks:
- The risk of slow payment
- The risk nonpayment
Every single open-account sale that we make includes these two risks.
The problem I see is that companies do a fantastic job in the initial credit review of the credit application. Where some companies have a need of improvement would be in the updates. Everybody wants to manage risk, but they may not have the time or resources that they would need in order to make better-informed decisions as to whether an active customer still qualifies for the credit limit that’s been established.
RISK MITIGATION TOOLS
There are common tools that many companies across the U.S. use every day to reduce the risk of bad-debt losses.
Common tools are credit insurance, mechanics’ liens, personal guarantees, inter-corporate guarantees, letters of credit, pledges of collateral as security and factoring of accounts receivable. The least frequently used in the U.S. are probably credit insurance and factoring of accounts receivable. These are all techniques that will make it more likely that your customers will pay their invoices when due.
Do any of these tools eliminate the risk of non-payment? I wish they did. Take credit insurance. Anybody who says credit insurance eliminates credit risk is wrong. Let’s say you have two accounts: K-Mart and Walmart. You decide to insure your accounts receivable to eliminate the risk of bad-debt losses. You go to your credit insurance company to cover the two accounts. The reality is, you’re not likely to get all the coverage you want for K-Mart because the insurance company recognizes that Walmart is a fantastic credit risk and K-Mart is not. So you’re not likely to get all the coverage you want for higher-risk customers.
What if you use all the tools? You would be much closer to eliminating risk, but no one of these tools can do that. You’re not going to convince the customer to provide you with every form of security you want. Nobody has that kind of leverage. You need to maintain positive working relationships with these customers. “If there’s no money, there’s no money.”
CREDIT INSURANCE
Credit insurance has a reputation for being a silver bullet. No, it’s a tool that reduces the risk of non-payment. If I have a million dollars of credit insurance coverage for Walmart, I can be very confident that I’ve eliminated the risk of a million dollars of losses from Walmart. Credit insurance is a very popular product in Western Europe. A credit insurance policy can be written to include every single customer you have in the world. And they can be targeted to cover only certain customers.
Credit insurance covers certain kinds of losses, those that are within the direct control of the debtor company. If we have a customer in Iceland. They don’t have control over the volcano that blew up 15 years ago and disrupted business in Iceland. But they do have control over insolvency, bankruptcy, protracted payment default, and refusal to pay for goods received.
Some credit insurance policies also cover one or more political risks. For example, if the government of Iceland declares that creditors in the U.S. can only be paid if the payment terms are greater than 150 days. I’m not saying Iceland would ever do that, but that’s an example of a political risk that would prevent a customer from paying you.
So why not just identify only your high-risk customers for insurance coverage? Companies have that option. The insurance company has the same option. Using the Walmart/K-Mart illustration, if the only account I offer them is K-Mart, I’m not sure how attractive my application is going to be to the insurance application underwriter. If you only want coverage for the “dogs,” it’s going to be expensive and you’re unlikely to get the coverage you want. If you offer a mixed basket, you’re more likely to convince the insurance company to provide coverage for more accounts.
This is an overview. We could spend an entire hour just discussing credit insurance. Credit insurance policies include a specific dollar coverage limit for your customers. There are specific sub-limits for each customer. They might give you $100 thousand in coverage for K-Mart and $10 million in coverage for Walmart.
There are also discretionary coverage limits for customers that are relatively small. This limit might be $50 thousand for customers whose credit limit is between zero and $50 thousand.
These policies also include annual deductibles that have to be met before the insurance kicks in. Also per-loss deductible. For instance, after you’ve met your annual deductible, insurance will only pay a percentage of the loss.
There’s also an annual cap on the total amount the insurance company will pay for a covered loss. So we have to know all these elements that relate to the credit insurance: credit limits, annual and per-loss deductibles, and the annual cap.
With regard to the annual cap, let’s say you have a cap of $2 million, but you have a $500 million portfolio. Suddenly that $2 million becomes vanishingly small. In that scenario, you’d be very happy to have a $20 million annual cap on claims paid.
There’s also a clause that says the insurance company has the right to terminate coverage for any covered debtor company. So is credit insurance magic? Maybe not as magic as many people think it is.
Can a credit insurance company terminate coverage at any given time? And what happens to the balance owed by the debtor company?
No, they need to give you notice; often they can only cancel at the end of the policy year. Coverage cannot be canceled retroactively. Whatever that debtor company owes you today that’s covered by the insurance company, if the debtor defaults, the insurance company is still on the hook, even if they cancel coverage.
The cost of credit insurance, the annual premium, varies. It primarily varies based on the factors that the insurance company underwriter is looking at as it relates to your company purchasing coverage. Such as your customer’s bad-debt losses to your company. They’ll also evaluate your customer’s perceived credit risk. And also the type of insurance requested, as well as the size of the annual deductibles. Also the size of the dollar cap on total paid losses, and policy exclusions.
Why don’t we use credit insurance more in the U.S.? It’s customary in Western Europe, and in the U.S. we haven’t gotten into that habit. My best answer is, it’s not the norm here.
MECHANICS LIENS
Mechanics liens can be filed by companies that provide materials or labor to a construction project. For instance, a sink manufacturer. These liens are used to ensure that the people who provide goods and labor are paid. They’re used by contractors, subcontractors and suppliers. The property owner receives a lien release when they make payment. If they don’t, then a lien attaches to the real property. When they try to sell the property, they must resolve the issue first to have the lien released.
The problem with mechanics liens is that the laws are different in each of the 50 states. Another problem is the paperwork required each and every time you provide something new to this construction project. You must prepare and submit the required paperwork in order to ensure that, if you desire to enforce your lien rights, you have the legal right to do so.
PERSONAL GUARANTEES
A personal guarantee says that I want someone to offer me an assurance that if this company does not pay me for whatever reason, that the individual will do so. Every creditor can request that every customer sign a personal guarantee at any time during the business relationship. But the best time to request a personal guarantee would be when setting up a new account.
For example, if you extend credit to my company, if my company doesn’t pay you, then I will. The guarantor has personal liability for those debts.
The personal guarantee should include no dollar cap and no term limit; it should be ongoing and unlimited.
What if the personal guarantor does not have the ability to pay the debt?
That comes back to what I was saying—even if you use every one of these credit tools, there’s no magic. It does not eliminate risk. So if the personal guarantor ignores your request for payment, you’ve got to sue the individual. These are separate and distinct; there’s the debt that’s owed by the corporation and then there’s the debt that owed by the individual. If the corporation pays you, you dismiss the lawsuit against the individual; if the individual pays you, you dismiss the lawsuit against the corporation.
Personal guarantee benefits: reduces risk of bad-debt losses, demonstrates individual’s commitment, creates ongoing individual obligation regardless of changes within the debtor company, makes it easier to get paid by the debtor company. For instance, companies may prioritize debts where the decision-maker (e.g., company officer or owner) is personally liable. People do what’s in their best interest.
INTER-CORPORATE GUARANTEE
Like the personal guarantee, the inter-corporate guarantee is a contract where the guarantor company is jointly liable for the debtor company’s debt. In the event of the debtor company’s default, the guarantor company agrees to pay. There are various types of inter-corporate guarantees: upstream (when subsidiary company guarantees for the parent company), downstream (when parent guarantees for subsidiary—which is more common), and cross-stream (when company guarantees for an affiliate).
But parent companies are often reluctant to sign inter-corporate guarantees for subsidiaries because it undermines their reasoning for creating the subsidiary in the first place: to limit their liability.
LETTERS OF CREDIT
At their very basic, a letter of credit is an agreement to pay made by an issuing bank to an applicant company that is otherwise not credit worthy. For instance, if a debtor company in Iceland is not credit worthy, you’re not going to sell them an account with $100 thousand on open-account terms, but you might sell them $100 thousand if somebody else guarantees payment, namely, the issuing bank. It’s a guarantee of payment not by the debtor company, but by the debtor company’s bank.
The issuing bank in Iceland will pay you a specific amount of money if and when you provide them with specified documents in connection with a shipment that you’ve made, within a specified time period and at a specified place. The documents must conform to specific terms and conditions described in the letter of credit.
Probably the single most important thing to recognize is that, if you don’t do it right, you don’t get paid. It’s an undertaking by the bank never to pay you unless you provide the specified documents, within the specified time, and at the specified place. About 50% of the time there’s a “discrepancy” within the documents, which means you may not get paid because you did not conform to the rules under the letter of credit.
The issuing bank is only concerned that the documents conform to the requirements in the letter of credit.
We don’t demand letters of credit from all active customers; it’s limited to those with unsatisfactory credit ratings. The creditworthiness of the bank is substituted for the debtor company’s lack of creditworthiness.
What’s the difference between a documentary letter of credit and a stand-by letter of credit? A stand-by letter of credit simply allows the creditor to go to the issuing bank and say, “I shipped; I didn’t get paid by the debtor; now pay me.” There aren’t all the document requirements.
PLEDGES OF COLLATERAL
Also known as security interest, companies obtain security interests much the same way as banks. Any creditor company can become a secured creditor by having the debtor company sign a Security Agreement which pledges a tangible asset as security. For instance, a debtor company’s inventory could be used as collateral.
To “perfect” the pledge of assets as collateral, you must submit certain types of documentation to record the fact that you are a secured creditor and that the debtor company has offered specific assets as security.
The biggest hurdle is convincing a debtor company to grant you that collateral as security. For instance, it may already be pledged to the bank.
FACTORING OF A/R
This is the least frequently used tool to mitigate risk. It’s a process by which a third party buys your A/R. You’re selling your right to payment to this financial institution. The A/R can be purchased with or without recourse. “With recourse” means that if the financial institution doesn’t collect the money from the debtor, then you must repay the money that the factor paid you. “Without recourse” means that if the factoring company doesn’t get paid, it’s not your problem. You get to keep the money that the factor paid you when they purchased those invoices from you. The creditor is paid a lesser amount when factoring without recourse.
Factoring A/R is very expensive—maybe five points. Not many companies have an extra 5% that they can give away in terms the after-tax profitability.
PERSPECTIVES ON PAYMENT DELINQUENCIES
The more flexible you are with customers, the wider you open the door for abuse of payment. You must be certain that customers know what you expect from them. Customers must know as soon as their credit is placed on hold. Never re-negotiate a payment plan. Customers and creditors are business partners and should be treated as such. The “two and up” rule when calling for payment: Don’t leave more than two messages for the same person for the same past-due balance. Use two messages and then move up, all the way to the company president.
Don’t be too flexible. You need to be reasonable and realistic.
Past performance is not a perfect predictor of future payment behavior. Calling customers is more effective than correspondence. It requires give and take.
Don’t be arrogant when calling, but be confident. You want realistic and reasonable commitment for payment. Always ask for immediate payment in full. Refer all uncollectible account balances to a reputable third-party commercial collection agency.
When should creditors call for payment? As soon as the invoice is past due. How often should creditors call for payment? However often your company has indicated that calls should occur. Prioritize your collection calls into descending dollar value. You’ll get the most dollars collected sooner.
Michael’s contact information is on the screen. Reach out to Michael or call anyone at BARR Credit Services.
Questions:
Q: What if the person who signs a personal guarantee leaves the company? Can you still go after them?
A: Sure. It’s a contract, and a contract doesn’t talk about their employment status. It doesn’t talk about whether they are young or old, male or female. It just
states that, “I agree that if the company defaults on payment, I will be liable to you to repay that debt.” Typically when a person leaves the company, he says that he’s cancelling the personal guarantee. But provided the guarantee is in effect, the obligation remains with him.
Q: Can you incorporate a personal guarantee into a credit application?
A: Yes, lots of companies have personal guarantees that are built in to their credit applications. I’m not a lawyer, and I encourage you to talk to your lawyer. But my lawyer says the personal guarantee should be included with the application but should not be on the credit application. It should be a separate document.
In answer to Jennifer’s question, we will make a transcript available along with the video version of our recorded webinar. We will email that to you after today.
Q: With regard to letters of credit, do you have to go to the physical location of the bank to collect the payment?
A: No, you must send the documents to the location. It’s the delivery of the specified information to the specified place that is required.
Q: Do you need a spouse’s signature on a personal guarantee?
A: That is a legal question. I’m not a lawyer. But my perspective is, yes. In community property states, people are pledging assets that are subject to community property laws. If the individual is married, the spouse needs to agree that the community-owned assets are subject to the demands made under personal guarantee.
Q: What is your experience with customers who keep incurring late payments on their accounts? Do you think it is better to let them go, or is there some more specific technique that has worked for you?
A: In many companies, there is something on the invoice that says: “Invoices paid late are subject to 1.5% per month interest charge.” If your company regularly does that, then you can have a bunch of these charges stacking up. Are they collectible? What do you need to provide a customer in order to collect? A P.O. number, a copy of the invoice, and a proof of delivery. You don’t have a proof of delivery (this is a late fee, a service charge), a purchase order (nothing was purchased), or an invoice (just a debit for 1.5%). Whether it’s collectible depends on the amount of leverage you have with that particular customer.
What many companies do is use the stacks of late fees as a bargaining chip for future negotiations. For example, if a debtor company typically pays invoices 15 to 20 days past due and has 400 late payment penalties on the A/R totaling thousands of dollars, you could offer this: If they agree to pay invoices within 10 days of the due date, then after they’ve done so for a specified period, we’ll write off the thousands of dollars in late payments that have accrued over the last year. So it’s a tool you can use to negotiate with the customer.
It looks like we’re out of time for questions. There are still a few unanswered questions, so we will respond to those individually afterwards.
Michael, thank you very much for your time.
