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!


Sherry Miller said...


Great insight on establishing a strong credit function. I would like to share a couple of comments on this subject:

1) Always check the credit references listed on the credit application. They should mirror the trade experience on the credit report. If they do not, it may indicate that the company is preferencing payment only to those trade references. Must look at the whole picture for complete view to determine credit worthiness.

2) Paydex score will also help predict if/when an account is giving all the indicators for filing bankruptcy. For example, studies show that companies sustaining a 10-point decrease in paydex score during the 18 month prior period, filed bankrupcy. Also, the average company that filed bankruptcy was 14 points lower than the industry average.

3) Finally, after the account is set up, established with a credit line and terms, it is important to follow up for payment as soon as the account becomes past due. It reinforces with the customer you are not donating material or services and expect timely payment as per agreement. We have a credit hold option available within our system that reads credit line and past due status. If either one of those controls is exceeded, the account will go on credit hold. This creates an ideal opportunity to call customer and inquire about payment. If needed, new orders can hold to leverage payment on past dues.

Just some thoughts I wanted to share. Thank you.

Sherry Miller
Credit Manager
Bonsal American, Inc.

Don Downey said...

Thank you very much to your contribution. I appreciate your insight regarding changes in Paydex and conferring with references. As always the management of receivables is difficult, more so now with global economics indicating a slow down. I hope others will take away from your contribution, which I feel will have a definite positive impact on their receivables.