Last month we provided an overview to accounts receivable risk-rating systems. This month, let’s get into the details of credit requirements, due diligence and collateral requirements for each of the ratings. To review, we are using a simple 5-scale system as follows with CR being the acronym for “Credit Rating”:

CR1 = Minimal perceived risk

CR2 = Less than average risk

CR3 = Average risk

CR4 = More than average risk

CR5 = High risk of non-payment

We are assuming that the credit department has a complete application and completed the appropriate rating and credit limit based upon the application, financial statements and credit inquiries already performed. Now let’s proceed.

CR5 Accounts – High-risk accounts tend to be difficult for most credit professionals, yet they shouldn’t be. There are two types of customers in this account rating. The first is those accounts where non-payment appears probable because of financial weakness or prior payment history. These accounts need to be 100% secured. Normally, this means a bulletproof letter of credit provided by a reputable institution. Or, you may take a cash deposit.

These accounts should always be set-up as EFT or draft, to most quickly detect insufficient funds. If a CR5 account will not provide collateral AND agree to be set up on draft payments, let them go to your competitor! CR5 accounts, despite the cash collateral, should be monitored quarterly. Be sure the credit amount is never more than the collateral. It is not uncommon for a CR5 account to agree to cash collateral, and then request a higher credit limit than the cash deposit a few months into the relationship. If this occurs, go through the entire due diligence process again. The only time the credit limit should exceed the collateral is if financial statements show enough positive trends to upgrade the account to a CR4 status.

You may also have CR5 accounts that have solid financials and strong payment history, only ranked 5 because of the very large credit limit required. You will not take collateral, but because of the high potential receivable,set them up into the system for quarterly monitoring. (Also, see this month’s article on receivables insurance. This is an appropriate consideration with large-dollar accounts.)

CR1 Accounts – Any account you think is absolutely golden should still be reviewed annually to be sure they are maintaining their CR1 worthy status. The review will be minimal, just a quick credit bureau report. The exception to this may be extremely small dollar accounts. For instance, you may decide that any account with less than $300 credit limit is not reviewed. Any CR1 that becomes delinquent at any time should always be moved to CR2 status.

CR2 Accounts – No collateral is necessary for a CR2 account. Monitoring frequency is determined by the amount of credit line – semi-annually for the mid-accounts (you define dollar parameters of mid accounts based on your business) and annually on small accounts. Any CR2 that becomes delinquent should automatically be downgraded to CR3. Monitoring will only include a simple credit report. If any credit report is questionable, the account should be downgraded to CR3 where more due diligence will be performed.

CR3 Accounts – These accounts will make up the majority of your customers. No collateral is initally required using the same dollar criteria as CR2 accounts, they will be set up for semi-annual or annual review. With a CR3 account however, at review time and in addition to the credit report review, you will also make at least one bank inquiry and one trade inquiry. If any of the due diligence reveals additional risk or negative trends, the account should be downgraded to CR4 and those procedures followed. And of course, if they are ever delinquent, they are immediately downgraded to CR4 status.

CR4 Accounts – This is where your credit department will earn its keep. CR4 accounts should be collateralized, but you may not be able to get full cash collateral. Outside collateral should always be considered and suggested when regular collateral is not sufficient. Most CR4 accounts began their life with you as CR3 or above, and they have been put into this lower status because of payment problems, therefore they need very close monitoring. Treat the due diligence like a new account.   If they are not already on EFT draft, they need to be moved to draft payments. Financial statements should be required and reviewed for trends. The frequency of financial statement review will depend upon the customer, credit limit, and practicality.

Finally credit ratings should be integrated into your pricing and margin guidelines. The lower the rating, the higher the required margin spread. Anyone who is pricing should have easy computer screen access to each customer’s credit rating.

Like any change, if your receivables staff is not using a rating system, it will take some patience and perseverance to make it an integral part of your system. Once you do, though, you’ll be glad you did!

PetroAnswers Risk Rating Accounts Receivable – Part 2