Credit Risk Management: Protecting Your Accounts Receivable

Credit risk isn't just about bad debt—it's about cash flow, working capital, and the resources you spend chasing payments. A customer who pays 60 days late may eventually pay in full, but they've consumed your capital and collection resources in the meantime.

This guide covers how to build a credit risk management program: evaluating customer creditworthiness, setting appropriate credit limits, monitoring the portfolio, and managing collections when customers don't pay.

Building a Credit Policy

A credit policy establishes guidelines for extending credit. It should balance sales objectives (customers want terms) with financial protection (you want to get paid). Without a policy, decisions are inconsistent and often err toward accepting risk.

Credit Policy Components

• Standard payment terms: Net 30 is typical; longer terms require justification
• Credit evaluation requirements: What due diligence is required before extending credit
• Credit limit guidelines: How limits are determined and approved
• Exception approval process: Who can approve non-standard terms
• Collection procedures: Escalation process for past-due accounts
• Hold and release criteria: When to stop shipping to delinquent customers

Standard vs. Non-Standard Terms

Evaluating Customer Credit

Before extending credit, assess the customer's ability and willingness to pay. The depth of evaluation should match the credit exposure—don't spend hours evaluating a $5,000 credit line.

Information Sources

• Credit applications: Basic information, trade references, bank references
• Credit reports: D&B, Experian Business, Equifax Commercial
• Financial statements: For larger exposures, request recent financials
• Trade references: Contact other vendors to verify payment history
• Public information: News, legal filings, ownership changes

Credit Evaluation Levels

Red Flags in Evaluation

• Recent payment delinquencies or collections
• Tax liens or judgments
• Declining revenue or profitability trends
• High leverage or negative working capital
• Refusal to provide financial information
• Recent ownership or management changes
• Industry in decline

Setting Credit Limits

Credit limits should reflect both the customer's creditworthiness and your risk appetite. A credit limit is the maximum outstanding balance you're willing to carry.

Credit Limit Methods

• Percentage of sales: Limit = Expected annual purchases × 10-15% (adjusts with relationship growth)
• Working capital method: Limit based on customer's working capital and your share
• Credit agency scores: Use D&B or credit bureau recommendations as starting point
• Industry standards: Some industries have established limit norms

Credit Limit Guidelines

• Start conservative and increase based on payment history
• Review limits annually or when circumstances change
• Set limits relative to your ability to absorb loss
• Consider aggregate exposure (parent company and subsidiaries)

Ongoing Credit Monitoring

Credit evaluation shouldn't be a one-time event. Customer financial health changes, and early warning signs allow proactive risk management.

Monitoring Activities

• Aging reports: Review weekly; flag accounts sliding past terms
• Payment pattern changes: Previously prompt payers becoming slow
• Credit report alerts: Subscribe to monitoring services for key accounts
• Order pattern changes: Sudden increases or decreases in orders
• Industry news: Customer layoffs, management changes, competitor issues

Early Warning Signs

• Increasingly slow payments (DSO creeping up)
• Partial payments instead of paying in full
• Check/payment issues (NSF, stop payments)
• Disputes filed to delay payment
• Difficulty reaching AR contact
• Requests for extended terms

Collection Procedures

A systematic collection process ensures consistent follow-up and escalation. Without defined procedures, overdue accounts fall through the cracks.

Collection Escalation Timeline

Collection Best Practices

• Document everything: Keep records of all communications
• Be professional: Firm but courteous—you may need the relationship later
• Verify disputes quickly: Resolve legitimate disputes; don't let customers use them to delay
• Offer payment plans: Partial payment may be better than no payment
• Know when to escalate: Don't waste time on accounts unlikely to pay

When to Use Collection Agencies

• Account is 60-90+ days past due with no progress
• Customer is unresponsive to collection attempts
• Customer disputes validity without basis
• Internal resources are better spent elsewhere

Trade Credit Insurance

Trade credit insurance protects against customer non-payment. It's particularly valuable when you have concentrated exposures or sell to customers in volatile industries.

How It Works

• Insurance covers typically 80-90% of invoice value for covered accounts
• Insurer evaluates creditworthiness and sets coverage limits per customer
• Premium typically 0.1-0.5% of covered receivables
• Claims filed after collection efforts exhaust or insolvency declared

Benefits Beyond Insurance

• Access to insurer's credit evaluation and monitoring
• Enables extending credit to customers you might otherwise decline
• Protects against catastrophic loss from large customer failure
• Can improve borrowing capacity (insured receivables may qualify for higher advance rates)