Companies face the constant risk that customers will be unable to pay their invoices or may file for bankruptcy protection. Adequately assessing and managing these risks is fundamental in today’s business world. With planning and vigilance, companies can minimize the impact of customer credit problems.
In assessing the credit risk posed by a customer, a company should review its payment experience, as well as the customer’s credit rating (available through services such as Dun & Bradstreet). A company should look for trends indicating the customer has declining financial health. A customer may have financial troubles if they typically paid on time, but lately have taken longer to pay. In addition to a company’s experience with a customer, using credit ratings to assess credit risk is useful because it provides a broader view of the customer’s financial health. A company that is a key supplier to its customer may spot declining payment trends earlier through a credit report because the customer may be paying the company on time, but delaying payment to less important suppliers. Once a customer’s credit risk has been assessed, the steps taken to manage the risk can take many forms. The following are basic steps that may assist in minimizing credit risks:
Establish Credit Terms – the terms of a transaction should include written payment terms, interest penalties for late payments and reimbursement for collection costs (including attorneys’ fees).
Acquire a Security Interest – this may include (a) a purchase money security interest in the goods provided and the proceeds received by the customer’s reselling of the goods, or (b) a security interest that may or may not be subordinate to other secured parties. It is necessary to timely file UCC statements in order to perfect a secured interest, and a company may need to notify other secured parties.
Require the Right of Offset – include in contracts the right for the company to offset amounts it owes a customer, with amounts owed by the customer to the company.
Establish a Lockbox – establish a lockbox in to which all or certain payments by the customer’s customers are received. Through an agreement among the company, customer and the lockbox bank, the company can obtain the right to sweep the lockbox account if the customer is in default.
Sell the Receivables – if properly structured, selling the receivables will pass the risk of non-payment to the factoring company. In order to make the process smooth, a company should include the right to assign payments in its contracts.