Mitigating Risk of Trade Credit – Part 1: Developing and Evaluating an Effective Credit Policy       

The following article is part one of a two part post on mitigating the risk of selling goods and services on credit. This topic is of particular significance given the effective shut down of the Canadian economy resulting from the COVID-19 pandemic, and these posts are aimed toward assisting creditors with managing risk in these uncertain economic times. This post addresses steps creditors can take now to improve their credit policies and ensure compliance and prompt payment by their customers, and part two will address options available to creditors when a customer defaults or becomes insolvent.    

Many types of businesses supply goods and services to their customers on credit. These types of credit relationships can arise informally, such as where a business supplies goods or services and then invoices or collects on the invoice at a future date. They can also arise through more formal, structured processes whereby customers will complete an application for credit through a trade supplier or co-operative and open a credit account. In both cases, the result is the same – the business is advancing something of value on a promise to pay at some point in the future, which results in the business assuming some of the risk that the customer may not be able to pay.

Now more than ever, it is important that creditors take proactive steps to ensure that their credit policies are sound and to ensure that the proceeds from these sales will be realized. The following article outlines some of the best practices that creditors should adopt when granting credit to customers.

Benefits vs. Risks of Granting Credit

There are both benefits and increased risks associated with extending credit to customers in uncertain economic times. Granting short term credit may help to boost sales and bring in new customers, but there are also considerable risks associated with supplying to customers who may not be able to meet their financial obligations in the short or long term. A summary of some of the benefits and risks of supplying on credit are outlined below.

Benefits:

  • Provides customers with more flexibility, which may enable them to better weather the economic impacts of COVID-19;
  • Provides customers with an increase in purchasing power, which may lead to an increase in sales;
  • May generate goodwill and buyer loyalty; and
  • Provides an opportunity for additional revenue in the form of interest.

Risks:

  • Late or missed payments may lead to uncertain cash flow on the part of the seller;
  • Costs associated with managing credit and administering accounts;
  • Costs associated with collection of accounts;
  • Costs associated with bad debts or insolvent customers; and
  • No priority of claims vis-à-vis other creditors such as secured creditors or statutory claims of the government

Some of the ways to manage the risks associated with granting credit include being proactive in creating and implementing good credit policies and regularly reviewing your credit accounts to ensure any delinquent accounts are being addressed promptly.

Be Proactive in Evaluating Credit Policies

Good credit policies are part of a good overall risk-management strategy. Credit policies, when done correctly, assist a business with retaining existing customers, bringing in revenue and mitigating the risk to the business. Companies with written policies have the advantage of streamlining credit decisions and enforcement, resulting in consistent and efficient accounts management.

The following are some key points to consider when evaluating your organization’s credit policy:

  • Complete adequate customer assessments prior to granting credit, and periodically re-evaluate the customer’s credit worthiness on an ongoing basis.
  • Steps that creditors can take to assess a customer’s creditworthiness include:
    • Checking references
    • Obtaining credit reports
    • Reviewing banking and trading history
  • Carefully draft your credit application to include terms and conditions that are comprehensive, unambiguous and valid in law.
    • Consider obtaining legal advice when drafting a credit application to ensure the agreement you are entering into is enforceable and reflects the terms you wish to impose on customers.
  • Ensure terms and conditions are applicable to all customers, with limited exceptions.
    • Require complete credit applications for new customers.
    • Set and enforce credit limits.
    • Ensure employees are consistently following the credit policy.
    • Identify and rectify any issues with customer accounts prior to default. Ensure each customer account has a complete application on file, and that you have written confirmation of acceptance of your terms and conditions
  • Periodically evaluate the impact your credit policy is having on your bottom line, and, if necessary, revise the policy. Consider the following:
    • What percentage of debts incurred are ultimately written off as “bad” or uncollectible debts?
    • What costs are you incurring as a result of granting credit? Are there ways you can reduce these costs?
    • Is the benefit of granting credit worth the cost to your company?
    • Are there other ways you can reduce your exposure, such as by taking additional security?
  • Consider which items need to be included on your invoices and statements
    • Detail who is being billed and the date they are billed;
    • Clearly explain what you are billing for (do not use abbreviations or codes the customer cannot understand);
    • Include invoice and reference numbers; and
    • Clearly indicate the amount due, payment terms and due dates.

What should be included in a good credit granting policy?

  • The company’s objectives for extending credit
  • The information required from new customers to extend credit
  • The terms and conditions to be set on every credit account, including:
    • Credit limits
    • Credit terms
    • Deposit requested
  • Billing process and procedures
  • Policies and procedures for dealing with delinquent accounts

Remember, there is no one perfect approach that works best for every organization. Each policy must take into account what business the organization is involved in, its cash flow, what is common in the industry, economic concerns and the level of risk associated with lending.

Managing Delinquent Accounts

Finding an appropriate way to handle delinquent accounts is an important part of effective credit management. If your extension of credit policy addresses how delinquent accounts will be dealt with at the outset, it will be easier to implement those policies in the event that delinquencies occur.

Even if your organization has not implemented these considerations into its credit policy, they can be implemented on an ongoing basis to deal with the collection issues that may occur in relation to the current economic downturn.

  1. Regular monitoring is the best way to keep accounts in check and manage payment.
    • Monitor your receivables on a regular basis.
    • Keep track of what payments are overdue.
    • Monitor for signs of trouble paying an account.
  2. Follow up on overdue accounts immediately, and continue to follow up regularly until payment is received.
    • Call clients to politely and respectfully remind them that the payment is due.
    • Confirm a date that payment will be received by, preferably in writing.
    • Follow up with a polite and professional letter requesting payment and confirming any commitments made, if applicable.
  3. Work with clients and provide options for repayment, while still ensuring your interests are protected.
    • Provide reasonable grace periods to clients with good credit histories.
    • Use defaults as an opportunity to rectify any issues with paperwork on accounts.
    • Obtain additional security in exchange for deferring on enforcement.
  4. Develop payment plans with your customers.
    • If the customer seems genuinely willing to pay, set up a plan.
    • Be flexible – voluntary payments made over time will cost less and may be more successful than moving straight to enforcement.
    • Be creative – the payment plan could involve instalments, partial payments, additional security, or a combination of any of these things.
  5. Learn to recognize signs that your attempts at collection are not working, and know when to resort to enforcement.
    • Debtors will often start to default long before they are fully insolvent. Early enforcement greatly improves your chances of success.
    • Part 2 of this post will address this subject in more depth.
  6. Ensure that interest rates and late payment fees are detailed in writing in your credit policies, and that you have evidence that your customers have accepted these policies in writing.

Remember, the squeaky wheel gets the grease! Many customers who are having financial or cash flow issues will refrain from paying suppliers who aren’t following up and engaging with the customer or demanding and enforcing on accounts. Staying on top of delinquent accounts with a consistent communication policy and knowing when to resort to enforcement options will improve your rate of collection and assist with mitigating any losses you may face in these uncertain economic times.

If you have any questions relating to how best to continue your lending practices at this time and how to mitigate the risk associated with extending credit, please reach out to MLT Aikins for assistance. We are here to help you and your business navigate these concerns and mitigate your risk going forward.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.