By Sam Fensterstock, AG Adjustments
As a 3rd party collection agency, CMA exclusive partner AG Adjustments has heard it all when it comes to why once good paying customers that were easy to work with are now past due, no longer ordering and unresponsive to your attempts to contact them. What went wrong? Why did a customer with whom you have been doing business with for quite some time and thought you had a good relationship with start slow paying and now is not paying at all? Is there anything you can you do to reduce the likelihood of this happening?
When you extend credit, one of the costs of doing business is the fact that some percentage of your receivables (2% to 5% in most industries) will become delinquent (one or more days past due) at some point during the year. The question is, what type of processes and tools can be put in place to increase the probability that your customers will pay you on time, almost all of the time.
So, with this in mind, let’s look at the various components necessary to manage customer credit risk and increase the likelihood of getting paid on time.
FIRST STEPS – ONBOARDING YOUR CUSTOMER
The credit application is one of the major tools for controlling credit risk. It is a contract between the seller and the buyer. A good credit application will benefit the seller, a bad one the buyer. Therefore, it is important that a company be certain that their credit application contains all the safeguards and guarantees available to reduce customer credit risk. Unless you have the critical information on a potential customer, mentioned below, the only way you should sell them is on a cash basis.
What Do You Need to Know to Control Credit Risk?
The credit application is your first step in gathering information about your potential customer. The more you know, the better off you are. And remember, you are not going to just assume all the information on the application is correct. You are going to verify as much of it as you can before you grant credit. Therefore, it is important that the sales department arrange for potential customers to submit their application as early as possible so that you have sufficient time to do a thorough review.
The information provided by the credit application will also be used to enter the customer into your basic accounting, Enterprise Resource Planning (ERP) or Order to Cash (OTC) system. So, you must be sure it is complete and correct or system errors can occur that will affect your relationship with the customer. A typical credit application requires that at least the following information be provided:
- Name and address of the applicant
- Name and address of any parent company
- Type of entity (i.e., corporation, partnership, proprietorship, etc.)
- Names of principals/directors/officers
- Bank references
- Trade references
- Applicant’s Social security number or tax ID number
- Availability of financial statements
- Credit limit required
- Applicant’s agreement to payment terms
- Applicant’s agreement to interest on past-due amounts
- Applicant’s agreement to pay for legal and collection costs
- Applicant’s agreement to seller’s venue if legal action is required
- Applicant’s personal guaranty(s)
- Right to verify data on application from external sources (banks, trade references, credit bureaus, etc.)
- Signer(s) is an officer and can legally bind the buyer
A credit application serves two purposes: It is a data gathering tool and it is a contract. As a contract it specifies the rights and obligations of both the buyer and seller or debtor and creditor. As you are writing the application it should be to your advantage rather than the buyers.
Verifying the Credit Application
Once you have the credit application in hand you need to verify the information it contains. At least three trade credit references should be contacted and all of their banks. You need to be sure that all of their references are legitimate. If for some reason you can’t contact one – be sure at least that they exist. Any false information on the credit application is a valid reason for not doing business. If the buyer is looking for a substantial credit line make sure you review their financials, audited if you can get them. If they are operating in a negative cash position you need to be sure that they will have enough cash available to pay you. Limit their credit line if it looks that they may have a cash flow problem.
How Much Credit Should You Extend?
If you have properly evaluated your customers’ credit risk, most of your accounts will not become collection problems. However, no credit risk evaluation system is perfect and even the most sophisticated companies have customers that don’t pay. In general, what is the best approach to take for evaluating credit risk for new and existing customers? Well the first thing is that you need to have 2 separate credit processes for evaluating risk, one for new customers and one for existing customers. Given that you have no history with a new customer your primary source of data will be the customer and the credit bureaus. However, with an existing customer you have your historical payment history data to add to the mix, data that has proven to be the most predictive when trying to assess future customer payment performance and that data should be heavily relied upon in your ongoing risk analysis process. No matter what methods you use to evaluate new and ongoing customer risk, it should be documented and consistently applied on an ongoing basis.
MANAGING YOUR ACCOUNTS RECEIVABLE
No matter how good you are in evaluating customer credit, some accounts that you have extended credit to will not pay you on time and others will not pay you at all. You need to be prepared for this eventuality and have a policy in place to handle it. Collecting your accounts receivable as quickly as possible is important for your financial success, so having a documented collection strategy is a major requirement. The three critical factors in such a strategy are: (1) What is your collection strategy, when do you contact your customer, how frequently do your collectors follow-up and how do you handle broken promises to pay. (2) When should you consider an account severely delinquent, and (2) What are you going to do about it when it occurs?
Here are some specific customer account characteristics, regardless of the size of the account (large, small to medium size, or mom and pop) that indicate you may have a collection problem:
- Your terms are net 30 and the account is over 90 days past due.
- You have called the account several times and they haven’t returned your calls. Additionally, they haven’t responded to your emails or your collection letters.
- A review of their AR shows very erratic purchasing activity.
- The account has stopped buying.
- All recent payments, when they have paid you, have been from different banks.
- You get negative information from an independent credit reporting service or you belong to a trade group and one of the members provides you with negative information on the account.
- The account refuses to settle certain disputes which you feel should be easily settled.
With the above in mind, you need to be sure that the problem is not self-inflicted. As such, the following are key questions that need to be answered before collection activity is initiated:
- Is it easy for your customers to pay you?
- Can they pay online by credit or debit card?
- Can they access their invoices and statements online?
- Is your customer aware of your procedure for handling billing disputes, deductions and charge backs?
If the answer to any of the above is no, you may have a communication problem rather that a collection problem.
If It Is a Collection Problem
Typically, the Credit & Collection Department is responsible for performing your internal collection activity. This can mean collection letters/emails supplemented with telephone collection calls. For you to maximize your internal collection effort, sales need to work with credit. When there is a problem with one of their customers they should help in collecting past due monies owed. Additionally, if the situation escalates and you’re still not getting paid, the sales rep who handles the account should visit or communicate with the customer. Perhaps payment arrangements can be made. In any event, if the customer is seriously past due, they are not responding to your calls, and communication attempts fail, there should be no further shipments until acceptable payment arrangements are in place.
It’s the responsibility of the Credit & Collection Department to determine if they have exhausted all their internal collection efforts and what to do once they have. Most uncollectable accounts are still operating businesses, and if they are refusing to pay it is time to bring in a 3rd party collection agency (called a 3rd because they were not a party to the original transaction), or simply “collection agency” to help in your collection efforts. Collection statistics indicate that once an account goes over 90 days past due, to maximize the probability of collection, it should be turned over to a collection agency as the probability of collecting in-house significantly decreases once your customer is 90 days or more past due.
A Word About Software
If you, operationally, can’t keep up with your growth you won’t be able to provide the necessary level of customer service and your business may very well fail. Growing businesses need to continuously evolve to meet their future system needs and that means making sure that your accounts receivable system can keep track of your expanding business.
Let’s assume that you have a basic system installed, it may even be considered an Enterprise Resource Planning (ERP) system by its provider, but as your business grows, the number of sales transactions may eventually overwhelm your existing basic system, and your collection operation. This is a problem that many growing businesses have had to deal with and a wide variety of computer system suppliers have developed various solutions to the problem. They call their solution Order to Cash (OTC). Essentially, it’s a set of integrated programs that allow a company to efficiently manage their cash flow from the time they take the order to the time they receive the payment. Fully integrating order entry, fulfillment, billing, and payment processing eliminates the possibility of human error and can cut days or weeks off the order to cash process. A typical OTC system consists of the following modules:
- Customer master file
- Order entry (creation of order / booking of order)
- Order fulfillment (order is physically picked and entered into the computer system)
- Distribution (delivered to customer)
- Customer payments
- Cash application
- Credit Analysis
- Deductions (If invoice short paid by customer)
- Collection (strategy, calls, emails, letters, etc.)
Lack of cash control has put many companies into bankruptcy. You cannot let your growth bring your business to a standstill if orders are not quickly paid. By prioritizing and refining the Order to Cash system, you are setting your company up for long-term success.
Why and When to Use a 3rd Party Collection Agency?
When a customer becomes a payment problem and your internal collection efforts have been unsuccessful, what should you do? Most companies will either turn to a collection agency or to a collection attorney. While at some point an attorney many need to be engaged for the purposes of litigation, we believe that once you have exhausted your internal efforts your first stop should be with a collection agency.
There are at least three good reasons to use a 3rd party collection agency to help collect past due accounts:
- A collection agency will collect from accounts that you could not. Your past due accounts won’t talk to you, but they will talk to an agency or the collection agency’s attorney. The agency knows that to collect they must contact the account and they won’t stop trying until they do. A good collection agency will make 10 to 15 attempts to reach your former customer in the first 30 to 45 days they have the file. This is typically about 3 times the number of attempts your internal staff will make. As their fee is based on what they collect an agency will be more persistent and assertive than your internal collectors are at this stage of the customer life cycle. Just remember this, collection agencies don’t get paid unless they collect your money and collection agencies do not want to work for free.
- Using an agency frees up the time and resources needed to manage your current active business.Collecting money is very time consuming. You need to send letters, emails, possibly make customer visits and make phone calls, lots of phone calls. This takes time away from the things you and your employees need to do to manage and run your business on a day to day basis.
- A collection agency utilizes technology that you do not have. This makes them far more proficient at collecting money than their clients. They possess advanced tools that help them find and contact debtors. This technology is costly and unless you are in the collection business you won’t have it. Additionally, their personnel are professional debt collectors. That is what they do and it’s the only thing they do.
We have tried to cover a wide range of topics in this blog. The most important thing to remember is that for you to maintain a healthy customer base and get paid on time your business needs to be under your control. You need the systems and processes in place to provide the information required to make intelligent decisions about your customers. We have provided some basic information and specific guidelines in certain areas which should help you implement what you need to manage and control customer credit risk and future growth.