How to Build a Credit Risk Management System that Really Works

Putting a B2B credit risk management system for your accounts receivable (AR) is essential for the long-term health and well-being of your company. Without effective credit risk management, you leave yourself open to a host of problems, from cash flow gaps to bad debt.

This guide lays out the key components of a credit risk management system and shows you what you can do to manage risk effectively while maximizing your ability to extend credit to new and existing customers.

What is credit risk management?

The practice of managing credit risk is seen in a number of related fields, including finance, banking, government, and large-scale business operations. But it also applies to any business, specifically B2B businesses, that want to or need to extend credit to customers, including companies offering net terms.

The kind of credit risk management this guide does not cover

In the world of banking, credit risk management guides the decision-making of financial institutions, which must work within regulatory frameworks set by central banks and other organizations.

Lenders use credit risk management to decide what types of financial services they offer clients, and to reduce their aggregate (total) exposure to risk. This affects the pricing of financial services and the allocation of funds, as well as interest rates offered to borrowers. Credit risk management at this scale involves special considerations, like counterparty risk (where derivatives are involved), capital adequacy, and stress testing.

The Basel Committee on Banking Supervision helps to set the standards by which credit risk is assessed.

If all of this sounds incredibly complicated, and you just want to figure out a way to improve the likelihood of repayment when you extend credit to customers, you’re in luck. That’s exactly what this guide covers.

The kind of B2B credit risk management this article does cover

If you’re a business that extends net terms to customers, you’re extending them credit. Extending credit opens you up to risk for a myriad of reasons:

  • The credit you extend to customers becomes your accounts receivable. The more credit you extend, the larger the accounts receivable balance you hold as an asset on your balance sheet, and the more you’re exposed to risk—and the less liquidity and financial velocity you have.

  • Some customers are less reliable than others. Delinquent debt can create all kinds of problems for your business. For starters, if you have to cover credit and loan losses yourself, your business must incur an expense. And, even if you are able to get paid (eventually), the cost (in time and money) of pursuing delinquent AR debt—through follow-up notices, phone calls, other collections methods, and eventually by sending the account to a formal collections agency —is never welcome.

The less credit risk your business is exposed to, the better you’re set up for success.

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What is a credit risk management system?

A credit risk management system is a set of practices you put in place to reduce the amount of risk you take on, while increasing profitability by attracting new, larger customers who expect net terms. Effectively, the number one goal is the mitigation of your company’s risk.

These practices may be carried out either:

  1. In-house, from internal resources and personnel that your company employs specifically to manage your credit risk management process, using a customized in-house workflow. Your internal team may use some external solutions (such as sending requests to credit rating agencies) as part of their credit risk management practices.
  2. By a trusted, third-party service provider (another business that helps you manage your AR and perform credit reviews for a fee).
  3. Technology tools (a digital software solution that can automate and take the process of credit risk management off your hands).

For small to medium-sized businesses, the second and third option is usually favored. It can seem risky to outsource your credit management online, but third-party credit risk management systems and providers can:

  • Function at any scale—whether you have three customers, or three thousand
  • Cost significantly less than having full-time staff manage credit and accounts receivables
  • Offer a host of complementary services, such as online payment processing, invoice financing, credit assessments, credit enrollment, credit decisioning, and collections, in addition to key credit risk management components

Also, streamlining your B2B credit risk management is just complex! Why not outsource to the credit risk experts?

Whichever option you go with, you’ll need a firm grasp of all the approaches used to manage credit risk effectively.

Those are covered in detail in the next section.

The key components of a credit risk management system

Whether you’re strategizing your risk measurement as a whole, or determining the specific amount of risk extending credit to a particular customer could expose you to, there are two key components to every B2B credit risk management system’s methodology:

  1. Accounts receivable (AR) risk assessment: Also called origination, this is the process of identifying which customers are most likely to default on their payments (their level of default risk). This may involve creating a risk profile and risk rating for each customer. For this, you need to take into account their creditworthiness/credit quality or credit score, account balance, financial stability, and payment history.

  2. Collection risk process: The process of assessing current or proposed credit risk, and determining the impact it has on your business.

Checklist: questions to ask before extending credit to customers

When determining the amount of risk that extending credit to a particular customer presents, we recommend that you take these factors into account:

  • Their credit history. What is their credit rating? Has it recently declined or improved? Have you pulled their credit reports from Experian or a company like Dun & Bradstreet? Have they established business credit?
  • Their current financial condition. Anecdotally, how stable is their business? (For public companies, you can determine this by reading financial statements. For private companies, you can ask for financial statements or tax returns).
  • Their payment history. Have they been late with payments before?
  • Their account balance. How much do they already owe your business?
  • The size and nature of the order being placed. How much credit will you be extending? How does this impact your working capital?
  • Are there any shipping terms or terms of their specific sales agreement that could impact the amount of risk to which you are exposed?

Learn more about conducting a company credit check.

How companies typically manage credit risk in-house

Companies that are able to devote in-house resources to running a credit risk management system follow a set risk management process.

The precise steps followed vary from company to company, and not all are necessary for every situation. But understanding the steps to take can get you started on your journey to decrease credit risk, and may help illustrate—indirectly—the benefits of having a third-party provider or solution do some of these tasks for you.

Step 1: Create customer segments Step 2: Minimize bad debt exposure Step 3: Look at the history of unpaid invoices Step 4: Calculate Days Sales Outstanding (DSO) Step 5: Create aging reports Step 6: Identify future cash flow threats Step 7: Measure the impact of payment terms on AR

Step 1: Create customer segments

Sorting your customers into groups helps you assess which types of customers are more likely to pay later than others, and their probability of default or late payment. Knowing the level of risk by segment and/or industry can help inform decisions about which customers you extend credit to in the future.

Criteria for sorting may include:

  • Average size of order
  • Percentage of accounts receivable (AR)
  • Industry or sub-specialization
  • Type of business (eg. online vs. physical retail)
  • Region
  • Size of business
  • Years in business
  • Years as a customer
  • Number of employees

For instance, you may discover—after completing Step 3, below—that companies who have online B2B stores, who carry less inventory on hand than those with brick-and-mortar locations, may have a higher financial risk in paying their invoices on time. Or you may find the reverse to be true. In either case, you can use this data and information to inform you of and proactively recognize financial risk which will inform you on how much credit you should extend to each segment.

Segmenting your customers also lets you identify how risk is distributed across your accounts receivable (AR). For instance, if you have three customers, and they typically comprise 80% of your AR at any given moment, you’ve opened yourself up to considerable risk. If just one of these customers defaults on their debt, or even fails to pay in a timely manner, this could be a significant cost to your business. It’s important to watch out for these types of risk concentrations.

On the other hand, if 80% of your AR is distributed more or less evenly across 30 different businesses (for example), you’re at less of a disadvantage from delinquency as the risk is focused on a smaller segment of customers.

You may wish to create a rating system to measure the volatility of each segment.

Step 2: Minimize bad debt exposure

A variety of security arrangements and guarantees can protect you from bad debt. When auditing your credit risk, consider which tools you currently use and whether there is an opportunity to upgrade to ones that are more stringent or binding. Security arrangements and guarantees for reducing credit losses include:

  • Credit insurance and underwriting
  • AR insurance
  • Lines of credit
  • Bonds
  • Comfort letters
  • Liens
  • Factoring (including reverse factoring)
  • Transfers of assets
  • Transfers of receivables
  • Retention of titles

Step 3: Look at the history of unpaid invoices

Once your customers are broken up into segments, look at the history of their unpaid invoices.

For each one, determine:

  • Why the customer was late to pay
  • Actions you took to collect payment

Then, take into account the rest of the customer’s history.

  • How often did they late pay?
  • How strong was their communication in late payments?
  • Was their reason for late payment usually the same, or did it vary?
  • On average, how many resources did it take your team to escalate the collections process each time?
  • Were the late payments for large or small orders?

This can help you spot patterns and trends in each customer’s payment procedures, and—if necessary—revise how much credit you extend them.

This is another approach we recommend to analyze your entire history of unpaid invoices:

  • Plot all your unpaid invoices over a five-year period (or shorter, depending on the age of your own company)
  • Categorize insolvencies by customer segments (eg. size, region)
  • Determine whether risks are inherent to specific customer segments or just specific customers

Step 4: Calculate Days Sales Outstanding (DSO)

Your days sales outstanding(DSO) is the average amount of time it takes you to get paid once you’ve made a sale. It’s an important metric for your accounts receivable (AR) process.

The lower your DSO, the lower your credit risk, and the more efficient your AR.

Here’s how you calculate DSO:

(AR / Total Sales) x Number of Days = DSO

When you track and reporting on your DSO, you can start to see trends and patterns:

  • How it has changed over time, and (if possible) why
  • How it compares to averages in your industry
  • How effective your working capital is
  • How many customers abide by your net terms, and how many cross the line via late or default payments

Step 5: Create accounts receivable aging reports

An accounts receivable aging report records and reports your AR according to how long an invoice (or total customer account) is outstanding.

When you run an aging report, you see the state of each customer’s account, and your business’s cash position. Running an aging report can help you determine whether you are extending the right credit terms to customers. The longer an invoice or account is aged, the higher the risk for this customer. You can then use this information to make smarter decisions when enrolling new customers or extending more credit in the future.

How do I run an aging report?

Most accounting systems should have a built-in AR aging reporting module built in. Alternatively, different accounts receivable solutions that integrate with your accounting ERP should have reporting modules. This is usually a task for your accountant or AR manager. A third party credit risk management system may be able to generate an aging report for you.

Step 6: Identify future cash flow and risk threats

When setting policies for extending credit to customers, and even when making credit decisions on a customer-by-customer basis, it’s wise to step back and look at the wider operations of your business. A number of factors can affect your overall credit risk, including these factors:

  • Increased sales volume, and with it, an increase in credit exposure
  • Expansion into new regions or industries can increase overall risk
  • New products or services may affect the size and frequency of orders placed, and the types of customers that inquire about opening accounts

Step 7: Measure the impact of payment terms on your accounts receivables

When managing credit risk for a B2B business, it’s important to continually review your net payment terms, determine how the terms impact your accounts receivable (AR) and DSO, and make changes as necessary. Your net terms should be clear and direct, leaving as little room as possible for misunderstanding. At the same time, features like early payment bonuses and discounts, and extended periods of pay, can increase the likelihood that customers pay their bills on time.

When to consider a third party B2B credit risk management system

There are a number of reasons to re-allocate current resources at your company from being over overburdened with credit risk management projects:

  • Depending on the size of your company, you probably aren’t prepared to hire someone dedicated to managing credit risk on a full-time basis.
  • If you did have someone full-time, managing and scaling business credit checks is difficult.
  • Even if you have internal resources, you still take on an element of risk, which exposes you to B2B invoice fraud and a dip in working capital.

Our opinion is that companies should avoid running business credit checks or managing credit risk themselves.

Working with an external credit risk management system is often less expensive than handling everything in-house. Running your business credit reports internally are probably costing you resources and money. On top of that, credit risk management systems like Resolve take advantage of automation and other digital technologies to offer a wide range of tools for real-time management of your credit risk and net terms, including:

  • Credit checks that don’t impact customers’ credit ratings (thanks to our proprietary in-house tools and data)
  • Net terms that can be offered online (30, 60, or 90 days) to customers
  • Automating the entire accounts receivable process to lower DSO: credit checks, invoice reminders and collections, and even processing payments through an online portal

If we’ve convinced you, learn how to select the best B2B credit management system for your company.

To learn how a third-party credit risk management system will benefit your business, read the stories of other companies who done it:

Interested in working with a credit risk management tool? Experience a Resolve “quiet credit check” where we just need the name and address of your customer. Our business credit check provides a full report that is personalized and evaluated by our credit experts with insights just for you. Contact us to learn about our free business checks.


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