As we continue our deep dive on what business owners need to know about risk management, we’ve now arrived at financial risks. Financial risk is comprised of a few key parts, and we’ll be looking at one per day, this one being credit risk.
While the other risks we’ve covered so far may be a bit foreign to some, especially for those that are new to the business world, credit risk is one that everyone should be familiar with (and most likely one that everyone is faced with as well). Either way, let’s begin with explaining what this risk is, as usual. We can define Credit risk as the risk that another party is unable to repay their debt to you. Whenever we accept payment on credit (or, more generally, on any non-cash basis), we are exposed to this risk. We’ll illustrate this with the following example:
SelfieStix is a plastic moulding company that makes selfie sticks and wholesales them to several retailers across North America. SelfieStix abides by the normal payment terms in this industry, which are “N30”, meaning that sales made on credit are to be repaid in full (net) within 30 days from the transaction date.
Identifying this risk is painfully obvious (to the business owners reading this, you’ve likely already lost at least some sleep wondering when-or if-a customer will actually pay you). SelfieStix faces credit risk since their wholesale customers may not repay them.
Note: As a slight aside, it is worth noting that in this particular case, the credit risk is heightened because SelfieStix’ customers face some considerable strategic risks, namely that the market demand for selfie sticks is difficult to forecast and is susceptible to sudden volatility as customer preferences change - this happens with many ‘fad’ products. So, even though SelfieStix has tried to insulate themselves from this by doing wholesale only, they still face some exposure as if their customers go belly-up, it will eventually turn this credit risk into an actual credit issue as sales go uncollected.
Finally, we have a case study where avoidance is a viable option. SelfieStix can implement a cash-only sales policy, which removes this risk exposure entirely. However, this does come with a cost: if this is not the norm in your industry, this decision may cause your customers to prefer purchasing from a competitor rather than your business. Since we previously mentioned that the usual payment terms in this industry are N30, it’s worth considering other ways to respond to this risk.
In this context, this means that SelfieStix would sell the right to collect cash on their credit sales (known as selling their receivables) to a collection agency. The collection agency would pay SelfieStix a discounted amount to compensate for the agency bearing the burden of the risk associated with not collecting (in essence, this is the quantified cost incurred for transferring the credit risk. This may not sound so bad, but in reality, it can get expensive quick and is not a viable response for a business to make.
Of course, SelfieStix can simply accept this risk, as many businesses often (unknowingly) do. This means that they will occasionally be unable to collect on some sales (this is called a bad debt), which will be chalked up to a cost of doing business. The frequency of this and the financial impact depends on the customer mix. While viable, we can still choose a better response. Let’s move on.
There are several different strategies that SelfieStix can implement to mitigate their credit risk.
One common example is to offer a slight discount to incentivize prompt payment, such as offering a 1% discount for payment within 10 days of the transaction date, with the full/net amount due within the usual 30 days (referred to as a “1/10 N30” term). This can be offered across the board, or only to top customers to strengthen the business relationship while getting good ‘bang for buck’ from the discount policy. Another viable strategy would be to conduct a customer risk assessment before extending credit terms to a new customer. This could involve asking for references (contacting other suppliers to discuss any repayment issues or other notable items in their dealings with that customer), or obtaining a 3rd party risk analysis report from an entity such as Dun & Bradstreet. These procedures can give an idea of the level of credit risk inherent in dealing with a specific customer so that SelfieStix can extend credit terms selectively and manage their credit risk profile/exposure accordingly.
That’s a wrap for our primer on credit risk. If you questions on the above or regarding your own business, feel free to reach out and we can discuss further.
Till next time,