Are you using risk-ratings in your credit process? If not, you should. Risk rating is a key, critical component to avoiding bad debts plus streamlining credit processes. Risk-rating your accounts helps you spend less time and less work on low-risk accounts, while insuring you perform maximum due diligence on high-risk accounts. Here are guidelines for instituting an effective risk-rating system.
Simplicity. Your system needs to be easy to understand to be effective. A five-point system based upon risk of non-payment is best:
1 = Minimal perceived risk
2 = Less than average risk
3 = Average risk
4 = More than average risk
5 = High risk of non-payment
Even the largest, most complex banks use only five ratings. Any system with more than five categories is cumbersome and not as effective as a five-category system.
Clear criteria. Written definitions of how risk-ratings will be determined is essential. Use a criteria matrix that is a combination of your selling profit margin, the expected credit limit, the customer’s industry, and the customer’s ability and willingness to pay. Let’s look at each area in detail.
Margin – The lower your gross profit margin, the higher the potential risk. For instance, if a 75-cent-per-gallon gross profit lube customer doesn’t pay their bill, it will only take you a few paid orders to recoup the loss. If a one-penny-after-freight fuel customer doesn’t pay, however, it will take over 100 loads of paid fuel loads to make up for the one gone bad. Using your own typical margins, define your specific margin levels for each of the five risk ratings.
Amount of credit – Using your five-point risk-rating scale, also assign dollar credit limits to each category that make sense to you. For instance, for some marketers, any credit limit below $5,000 might not be worth spending much time on and would automatically be given a “1” ranking, while anything over $100,000 would given a “5” rating. For a smaller business, though, these limits might be $1,000 and $25,000 respectively. The amounts should be dictated by your company’s capacity to absorb bad debts.
Industry – How risky is the customer’s industry? Are there any industries you serve that, because of concentration of receivables dollars, should be ranked as risky? There are likely at least one or two industries you serve that should automatically be ranked as “5” risk. Most banks, for instance, label all general contractors as “5” risk until they have a multi-year, proven track record that warrants a higher rating. Yours might be lumber or mining, or whatever industry is unique to your area.
Customer’s Ability to Pay – We will use two categories of risk ratings in ability since it is so crucial. One will be a company’s short-term ability to pay measured by available cash. Credit personnel should always remember that what pays accounts is cold hard cash, nothing else. Available cash is a company’s cash balance plus cash available through lines of credit. For instance, a company with $25,000 in cash, a $1,000,000 credit line, and $950,000 drawn on the credit line, would have available cash of $75,000. If they are requesting a $100,000 account, they just became a “5” risk for this category (and possibly a COD account!).
In addition to actual available cash, a company’s length of time in business should always be considered into the payment ability rating. (Some companies use time in business as a separate matrix item, but we find it can be factored into the cash rating.)
The best indicator of long-term payment ability, especially under duress, is net worth (total assets minus total liabilities). If a company is short on available cash, but has good equity in it’s assets, then it has low danger of bankruptcy. Take the net worth calculation one step further to an equity percent by dividing net worth by total assets. Banks use a 25% equity as a benchmark, so you might consider companies with 25% equity a “3” ranking. Anything under 20% should be a “4” and anything 15% or less is a definite “5.” Anything 50% or more is a “1.”
Willingness to pay — Unfortunately, a company can have the ability to pay creditors, but not the willingness. This is best detected from reviewing how the company is handling current creditors from credit reports such as D&B or Experian. Always require trade references on your application, but remember that most companies will not provide a reference to someone they paid slow or didn’t pay at all!
Have your credit department utilize checklists for all accounts. Each component should have a risk rating and then an overall risk score assigned. Remember that accounts below a certain dollar limit will not require the full checklist, but any account above your minimum level must have a completed matrix and overall score. The overall score should be posted and available directly in your computer software.