Wednesday, July 30, 2008

Time to Ride

Over the last several weeks all of the pieces to an effective credit policy were formulated. By now, the astute person would have this framework awaiting approval. Policies are essentially useless unless they are put into action to initiate change. The beginning of change comes with the collection policy and related efforts.

The collection policy essentially outlines the systematic steps that must be applied to manage the accounts receivable. Recall that the credit policy established the guidelines on which the organization will manage their client relationships. The collection policy starts the moment accounts receivable is generated in the relationship. If you are following this process closely, the question you should have is, “How is inventory (work in progress) managed?” The management of inventory is defined in the assessment of client risk, as it is the sum of inventory and accounts receivable that designates the investment in the client relationship.

After years of research into the reasons for delinquent accounts receivable, the causes can be reduced to: relationship, billing and/or economic. To the credit/collections professional, these issues can all be resolved. The easiest issue to resolve is that of billing. A simple flow audit through the organization will unearth some of the issues surrounding billing. For a bill to be accepted, it must conform to the terms of the engagement. i.e. meet the terms of the Purchase Order, or engagement letter. The bill must clearly outline what goods and services are being billed for, with identification of the timeframe the bill covers. Most importantly the bill must identify a specific recipient, date, when payment is due and any supporting documentation. One of the faux pas with professional services firms is the use of the caption ‘payable upon receipt’. Turning to Webster for clarification, payable can be defined as, “capable of being or liable to be paid’. Sounds a little illusive, how about “payment due upon receipt”, which removes any ambiguity!

Delinquent receivables are the result of client related economic issues, and this is a tremendous opportunity for the organization to establish client good will as well as solidify a long term relationship. Economic misfortunes may or may not be the result of client actions. It is the astute firm that can use the situation to complete or continue the engagement while ensuring payment is forthcoming. This is where the savvy collection sense of the credit department can leap in to action. In so doing, provide payment options for the client so as to maintain the relationship.

The most difficult issue surrounding delinquent receivables occurs when there is a relationship breakdown. When this occurs, the client has essentially professed their position with their check book by silently stating, “I am not paying you!” At this point, firms have options. They could simply walk away from the receivable, otherwise known as a write off. The firm could turn the account to an outside firm that may litigate and possibly recover some of the amounts. This option brings a significantly reduced payment and the possibility for counter claims. Therefore, the firm must be sure that they did everything according to the original engagement. Can you see why it is so important to get the relationship off the ground correctly? The last option is for the client representative to go back to the client and attempt to rebuild the relationship. Rebuilding the relationship isn’t negotiating a settlement, it is accepting that a relationship has two sides and it took two to break up the relationship.

What ever the cause of the delinquent receivable, it is the task of the credit department to flush it out and get the cash flowing. There has been much written in this area, sadly much of it unprofessional. The best piece of advice in this area is to become familiar with the credit/collections laws in your jurisdiction. In the United States credit/collections falls under the, Fair Debt Collection Practices Act. Keep in mind that there are or could be laws for local jurisdictions based on your type of business. A good layperson’s resource written for the US market is The Credit & Collection Manual (CCM), put out by the Credit Research Foundation. This text packs a tremendous amount of resource information in a small handy text. It is a definite must have for any credit department desk.

Regardless of the cause of the delinquent receivable, the first action is to flush out its root cause. The best way to do this is by way of monthly statements of account. For many organizations the sending of monthly statements is deemed to be a waste of time and postage. However, the recipient of a statement can quickly identify what they owe and discrepancies in the billing; whether they choose to act on it or not. For a publically traded company this information is paramount, as a reconciliation of payables is one of the areas investigated during the annual audit. Sending statements is even more important for law firms’ clients. For clients who require an annual audit, information as to the involvement in a lawsuit is paramount, and a statement from the law firm makes it clear to the auditors.

In addition to the monthly statement, the credit department must make contact with the client. According to the CCM, computer generated form letters provide substantial saving in time and expense while being marginally effective. Keep in mind, in light of an economic or relationship distress a ‘nasty-gram’ letter won’t open a dialogue to getting the issue resolved and receiving payment. The text goes on to say that individually prepared collections letters only give the recipient evidence that someone is monitoring the account, but the results are somewhat the same. Collections letters will only generate payment when the recipient simply hasn’t received the billing or truly wants to pay the account but has simply fallen behind. This means of communication isn’t really aimed at problem resolution, it is simply and audit trail toward litigation.

The best approach to flushing out an issue and begin problem resolution is direct telephone contact. This approach is heavily encapsulated in laws; therefore it is only for those well versed in collections laws. Ed Poll in his book, Collecting Your Fee, refers to this time as dial and smile. When done correctly credit professionals will flush out the root cause of the nonpayment, relationship or economic, and thereby begin to formulate a resolution.

There is no mystery to getting your bills paid; it all comes down to having a plan. The plan begins with understanding your affinity for risk, then building a policy for managing the risk. From there, gauge every client relationship against your risk profile while making sure both sides knows what is expected in the relationship. Do the best job you can to fulfill your obligations and have a procedure for managing those few accounts that become delinquent.

To most organizations, the concept of change seems like hiking Mt. Everest. Firms can continue along doing what they have been doing and expecting the same results – that is insanity. Change takes courage, vision and determination. The fork in the road must not be an obstacle, but the chance for a new beginning – choose a direction and let’s ride!

“Insanity: doing the same thing over and over again and expecting different results.” Albert Einstein

“When you get to a fork in the road, take it!” Yogi Berra

"When you look for excuses not to change...they will be found. It takes courage, determination and fortitude to get off the merry go round." S A Miller

Tuesday, July 22, 2008

Want GiGo free Accounts Receivable?

The last few weeks were spent building the foundation of a credit policy. If one were meticulous and honest in working through the steps, you would be close to a policy that now reflects the organization’s affinity for risk and one that would form the basis of a collections policy. Although the organization owns the client receivable and work in progress, certain individuals must accept responsibility to ensure the inventory is maintained according to policy. This final contribution on building a credit policy focuses the client and the inventory custodian; the credit department.

Contrary to what may be said, people show their likes and dislikes by how they spend their money. Essentially, they buy from people they like. If the bond doesn’t exist, a sale, no matter the price, isn’t forthcoming. Ed Poll in, Collecting Your Fee, sums it up very well with: You can judge the quality of a relationship by the way it ends…a client who genuinely respects you and the work you did will pay your bill in a timely manner. For me, that statement says it all, barring extenuating circumstances on the client side. There are two ways to achieve and maintain that respect, in order to facilitate payment by establishing the foundation for a good relationship from the very beginning, the first meeting. Then once the relationship is established, open regular communication is essential for maintaining trust.

It is during the very first meeting that the professional must establish the foundation for the relationship. Here is where information is exchanged, including costs, fees, terms of payments, and terms of engagement which must all be discussed and documented. It is also the time in which the professional must seek information about the prospect. PROSPECT. The person on the other side of the desk is a Prospect until such time as they meet the organization’s criteria of acceptance into “client-hood”. It is for this reason that he professional must obtain a completed credit application during the meeting, as this is the only means by which the organization can assess where the Prospect fits regarding the firm’s affinity for risk. At the end of the meeting, the professional should have explained the nature of the engagement and provide all discussed to the Prospect, either as an engagement letter or proposal; which must be signed and returned. The professional should have a fully completed and signed credit report.

The credit report form provides core insight into the Prospect’s business; their inherent risk. At this point, the firm must quantify the risk and compare it to their affinity for risk. The process by which this is done was discussed earlier in Crystallizing Goals. The part of the organization that is responsible for making this determination is – the credit department. This responsibility must be clearly documented in the credit policy. Depending on the size and complexity of the organization this section may involve a varying degree of detail. By way of example, here are a couple of options that will seed thought:

The credit department establishes credit limits for all prospects and active clients. These limits are based on D&B or TRW ratings, credit references, financial statements, security, or other information obtained directly from the applicants. The credit department must review large client investments on a periodic basis. All limits are subject to revision, based on changing levels of credit worthiness. Only executive management has the authority to override limits established by the credit department. All overrides must be fully documented and the requesting professional is fully responsible for their collection.


Professionals will obtain a completed and signed firm designated credit application from each prospect. This will contain bank reference and three trade references. Through due process, the credit department will determine the prospect’s ability to pay and the level of risk they pose should they become clients. Should the prospect be accepted as a client, a credit limit will be assigned through the use of scoring tools and techniques. Where the professional determines the credit limit is insufficient for the engagement, the prospect must provide 2 years of financial statements or must maintain, on deposit, the equivalent of 1/3 of the expected cost of the engagement. Only executive management can override this policy.

Having a clear delineation of responsibility for the credit department, the professional and the executive officer ensures that the credit policy is adhered to. With the sign off on the entire policy, all people in the organization will act to ensure a consistent approach for dealing with clients. Your AR is a direct reflection of your organization, if it is full of delinquent garbage AR, you put it there through your practices. Only you can stop the build up of garbage AR – build a garbage-free client portfolio!

In closing,

"When you look for excuses not to change...they will be found. It takes courage, determination and fortitude to get off the merry go round"

Organizations are not the victims of their delinquent clients. You and your organization cause your collections problems by not telling your clients from the beginning what you expect from them. Ed Poll

Monday, July 14, 2008

Who’s on First?

To continue with the series of building a credit policy, identifying who is on first is the initial step in beginning to gel the entire policy into a workable procedure. Previously, we outlined the mission of credit within the organization, and then we examined risk and the organization’s affinity to risk. This exercise has set the foundation for what is to follow, integrating the foundation into the structure.

Identifying and empowering the group who will transform the written policy to a way of life within the organization is the most important part of the credit policy. How the responsibility and authority is divided will either produce a highly effective credit department or a serious cost burden on the organization. Senior management, at this point, must clearly define the credit authority and responsibility of the chosen individual or group. Once established, management must uphold the decision of the credit group throughout the entire management infrastructure. If the credit responsibility and authority is not held steadfast by senior management, the credit function will be riddled with squabbling, poor morale, and horrid results.

Ideally, the credit function should report to the most senior of management; treasurer and / or finance committee. At this level of authority, the decision makers have already established the organization’s affinity for risk. Therefore, they must be the body that determines if the organization should accept an engagement for a client which poses a higher than acceptable amount of credit risk. Following are examples of how the credit responsibility section of the credit policy can be worded.

The credit department reports to the office of the treasurer (managing partner); it includes all functions relating to the extension of credit, collections and cash application. The credit manager establishes all credit limits, has final authority to hold or release all engagements when credit problems exist, decides when credit privileges should be revoked and decides when formal credit activity should be initiated.

Recognizing that certain engagements can be beneficial to the organization, the policy could carve out sections that cap credit limits to the credit department and permit management some slack in accepting the engagement. An example for which as follows:

The credit department reports to the office of the treasurer (managing partner). The credit manager may establish credit limits up to $ XX,XXX, and the manager may delegate up to $X,XXX of authority to other credit personnel. Higher limits MUST be approved by the office of the treasurer (managing partner). Those parties requesting higher credit limits than established by the credit department must submit a comprehensive business model as the amount of credit requested, terms of payment and means by which the credit risk is mitigated to firm established limits. In the event an engagement is being withheld because of credit problems, all parties including the office of the treasurer (managing partner), must meet to gain consensus on a solution.

The clarity and authority by which this section of the policy is written will determine the effectiveness of the credit function in the organization. Organizations need to realize that they needn’t accept every engagement. It is interesting to witness the number of organizations that accept engagements from clients who have a higher probability of default than making payment terms. Organizations fail to internalize that doing work for which no payment will be received is known as ‘charity’. As mentioned previously and will be again, the suggestion isn’t to shun these engagements, but rather build a payment arrangement, through retainers, COD etcetera that will allow the organization to accept the engagement through the mitigation of risk to an acceptable level.

There are many tools available to the credit manager and the organization that will allow them to mitigate credit risk while accepting less than sterling engagements. However, the first step is to relinquish any ambiguity of credit responsibility and know definitively ‘who’ is on first!

Tuesday, July 01, 2008

Crystallizing Goals

Continuing on the theme of building a credit policy, once the firm has a feel of their affinity for risk the next step is to understand the client dynamic. As was presented in the last contribution, clients bring to the firm a certain level of inherent risk. For the most part, the amount of inherent risk is unknown to the firm. However, there are tools in the market that will give insight into the nature of the client. Although your client profile may appear like:

In reality, each of the above bands hides carries with it the probability of default as given by:

With the firm’s understanding of its affinity to market and inherent risk, the goals of the credit policy can be established. Miller, in How to Write a Credit Policy, contends that one can establish true numerical goals or more fluid goals, but I believe the true numeric goals bind the organization to a dedicated practice of receivables management.

A true numeric type goal is as follows:

Our goals are to limit bad debts to X% of billings, Days Sales Outstanding to Y days, and receivables agings to no more than Z% beyond 60 days.

Alternatively, the more fluid type goal is as follows:

The credit department strives to meet goals, established by senior management, that relate to bad debts, receivable agings and Days Sales Outstanding.

Although goals change, having a clear numerical definition for the credit department and the firm will establish a clear commitment to the credit team and the entire firm. Once this goal is established, the firm should undertake to build a credit application. The credit application is the first means by which the firm obtains financial insight into the client – the inherent risk. There are a plethora of examples on how to build a credit application. Ed Poll, in Collecting Your Fee, provides a very simplified yet very functional client intake/credit application form. The information to be captured must include, at minimum: Full legal name, address, telephone/fax, type of company, tax id, owner/manager information, SIC number, trade references, Bank References and signature of the prospect/client to accept financial responsibility of invoices. For professional services organizations, this information should be included in the engagement letter. This letter must fully document the type of relationship, firm policies on billings and when payment is due, firm contacts, who will be working on the file, and billable rates.

With this information in hand and concurrent with a conflicts check, the firm should undertake a credit check of the prospect. The credit check will determine if the prospect’s ability to pay is in alignment with the firm’s goals and ultimately the firm’s affinity for risk. The first step in gaining insight into the prospect is by way of a credit report. The credit report is a very powerful tool that will give the firm insight into the prospect. The three key credit reporting agencies in the North American market are: Dun & Bradstreet (D&B®), Experian, and Equifax. Although these companies use different algorithms to arrive at their metrics, the metrics you receive are very close amongst the three companies. Using the Dun & Bradstreet system, the following information will be included.

Paydex Score

The Paydex® score is a unique, dollar-weighted indicator that provides an instant overview of how a prospect has paid bills in the past, and how they are likely to pay bills in the future. This is a very important score when it comes to being approved for credit terms or financing. The Paydex® is a 1-100 dollar weighted numerical score of payment performance, calculated using up to 875 payment experiences from trade references reporting into D&B®. Following is the scale and legend.

Therefore if the prospect is slow 90 days and the firm’s policy is 60 days, the first red flag should go up. It doesn’t mean that the firm should not take the prospect on as a client, but rather alter the terms of engagement understanding the client’s past behavior. This may include a larger retainer than normal or more frequent billing with the stipulation that all invoices are due immediately.

In addition to the Paydex information, all credit reporting agencies will provide information on the prospect's collections history, financial statements and if it has ever suffered any liens or judgments. This information will provide the firm a good understanding of how they should anticipate the client behaving when faced with the firm’s billings. One of the pieces of information that most corporate environments find most helpful is the overall rating. This information essentially ties together all of the information provided by the prospect into an overall rating. The overall D&B rating is as follows:

If Dun & Bradstreet has current financials on the prospect, a rating anywhere from 5A to HH will be provided. The 5A to HH ratings reflect the prospect’s size based on Net Worth or equity. If the prospect has supplied financials that show it has a negative Net Worth then the company will not be rated, but will have a – where a rating should be. The second half of Dun & Bradstreet’s rating on the prospect is D&B®’s Composite Credit Appraisal. This is a number from 1 to 4 and follows the 5A to HH rating. The Composite Credit Appraisal reflects D&B®’s overall assessment of the prospect’s creditworthiness. This assessment is based on the financial statements supplied (using financial ratios) in the report and payment history. A 1 is the highest credit assessment you can receive and a 4 is the lowest.

With the crystallizing of the terms of engagement, a result of the firm’s affinity for risk, and some due diligence, firms can essentially mitigate their collection woes and will have the cash flow they expect. With simple tools and structure, firms can mange their cash flows, instead of the clients managing it for them!