Credit Risk Strategies for your Business

As printed in ‘My Business’ magazine October 2006

New customers, new orders from existing customers, and new business opportunities are the adrenalin of every business.

But winning sales is only half the battle; win the battle by getting paid! To get paid, effective credit risk strategies must be used.

The best credit risk strategies are made an integral part of the sale. If the sale to a customer starts on the right footing, then the business relationship generally continues that way. If not, then no matter what ‘catch up’ strategy is used down the track, getting paid is always so much harder.

Here are some simple, cheap and effective credit risk strategies for use up front when winning the sale, to achieve a better cash flow for your business. We look at the following:

• Who is your customer?
• Finding out more about your customer
• Up front payments, accepting credit cards
• Structuring progress payments
• Pricing where credit terms are offered
• Credit suspension
• The paperwork
• Retention of title
• Credit risk management
• Some debt collection strategies

Who is your customer?

Who are you dealing with? Who do you invoice? Who is responsible to pay the bill? Take care to find out who is your customer or be left clutching at air!

For business customers, start with the full name and ABN. Are they a person, partnership or a company?

Where goods are ordered for delivery, is it the person accepting delivery at the delivery address who is responsible or is it someone else that is to be invoiced and is responsible for payment?

Finding out more about your customer

Once the customer’s proper name is known, why not find out something more about them?

If a standard credit application form is used, information such as their address, the names of the directors or principals of the business, names of major suppliers and trade references are required to be given.

Whether or not an application form is used, or credit checks are made, for business customers it is essential to log on to the Australian Securities and Investment Commission (ASIC) website, which contains free information on every company and most business customers in Australia.

The web address is: http://www.asic.gov.au/. Input the name and the screen will display the proper name of the company or business, its ACN and ABN, whether it is registered (as opposed to being in receivership, administration or liquidation) and the suburb of its registered office.

If further information is required, click on the ASIC information brokers icon for a paid company search with full details of directors, shareholders, company charges and the like. The full search is available for about $30 and could be charged to the customer as an establishment fee.

A follow up search for business customers is available on the Australian Business Register http://www.abr.gov.au

These public registers will not provide information on creditworthiness. For this information, telephone calls should be made to the trade references, and perhaps a credit check with Baycorp Advantage (available to members only).

Up front payments, accepting credit cards

One off sales to retail customers (businesses and the public) are paid up front, at the point of sale. Nowadays, the widespread availability of credit cards and debit cards has made up front payment for retail simple and convenient using those cards. Giving credit terms such as lay-buys or ‘easy payment plans’ to retail customers has almost disappeared.

For all businesses, receiving payment by credit card or debit card is strongly recommended as opposed to giving credit terms. The merchant fee is a fair trade off in return for the acceleration of cash flow and the fact that the payment is effectively made by the credit card provider. Also, many business customers prefer to pay by credit card to accumulate rewards points personally.

Personal finance is available for retail customers of high value consumer goods, such as furniture, electronics and motor vehicles, and can be supplied by either the retailer or an external finance company. If finance is supplied, it is often reflected in the price – see below.

Structuring progress payments

The easiest sale to make is a ‘pay later’ sale where credit terms are offered to ‘win the sale’. It is also the riskiest form of sale from a business point of view because a product or service is provided that costs the business cash to provide, without receiving cash from the customer to cover the cost. It should not be offered unless it is the practice in the industry, or as a genuine encouragement to a customer to place more orders.

Having said that, ongoing sales to retail customers (business and the public) and sales to business customers, are often made on credit terms, with payments structured as progress payments.

If it is not possible to receive up front payment for the full price, then an up front payment (a ‘down payment’ or ‘deposit’) should be required, and a progress payment arrangement made for the balance.

Progress payment arrangements should be tied to delivery. If the delivery of the product or the services is in stages, payment can be staged. If there is one delivery, then C.O.D. (cash on delivery) should apply. If payment is not available on delivery, in no circumstances should the product be left with the customer. The products should be put back in the van! It is better not to have a sale at all than a sale where collecting payment is difficult and possibly never received.

Some businesses often have dual policies, such as to insist on up front payments where the price is under a set amount, such as $200, and provide credit terms above that amount.

Pricing where credit terms are offered

If it is always cheaper if you are paying in cash, is it always dearer if you want credit? The answer is yes, because the cost of credit (that is, interest), is built into the price. There are two strategies used by businesses.

Retailers may offer terms payments by 24 instalments over 2 years, interest free. How is this done? The answer is that interest is built into the price! This is known as capitalising interest. For example, the price of a lounge suite might be $1,500 if sold for cash (no terms offered). Assuming an interest rate of 20% pa reducible, then the price if it is sold on terms would be more like $1,800, payable by 24 instalments of $75 per month each, ‘interest free’.

In other businesses, where control exists over pricing, the business adds a margin where credit terms are to be offered, such as payment due 60 days after invoice. The business then offers a discount for prompt payment, of say 5%, if payment is made within 14 days. If the price is relatively fixed, add a credit charge or service charge payable of the account remains unpaid for more than 14/30 days. This charge is not imposed where prompt payment is received.

Some retailers of expensive consumer goods introduce their customers to external financiers. If the customer commences principal and interest payments immediately, then the retailer can charge an attractive price, because it is the customer who pays the interest from the point of sale. For example, the retailer may sell a plasma TV package for $5,400. If the retailer introduces an external financier, it will receive $5,400 in payment from the external financier, in the same way as it receives payment if the customer pays by cash (using dollar bills or credit or debit cards).

But if ‘no payment’ or ‘interest free’ terms are offered for a specified period as an inducement to buy, the price must be higher. How is this so?

The cost of any interest free period must be built into the price, because the retailer must pay the interest for the ‘interest free period’ to the external financier. Using the plasma TV package example, if the retailer offers 2 years interest free/no repayments, then instead of a price of $5,400, the price would need to be higher. It might be 20% higher which is $6,999 (which is the advertised list price). The way it works is that the retailer receives $5,400 from the financier (the cash price), the customer owes $6,999 to the financier but pays no interest on that amount for 2 years, and the external financier keeps $1,599 difference representing the interest payable for the first two years.

Credit suspension

Credit that has been given in an ongoing business relationship can be taken away where the customer fails to pay according to the credit terms. Many businesses have a ‘credit suspension policy’ which requires payment to be made up front, on new orders, where a customer is 60 days or 90 days in arrears.

As an adjunct to that policy, many businesses will require payment of the whole of the overdue amount before accepting new orders.

The paperwork

There are two forms of paperwork. The first is a customer details application form, with a Credit Application incorporated into it. The second are the Terms of Trade/Trading Conditions, which are found in the ordering and invoicing documentation.

Credit Applications will contain personal guarantees of at least one director, if the application is made by a company customer. A company search should be carried out at ASIC to check that the person giving the guarantee is a director. The effect of the personal guarantee is that if the company does not pay, then the director who signed the guarantee is personally liable to pay. Personal guarantees are not required for customers who are individuals, as they are personally responsible for the debt.

Some credit application forms go further, and give rights similar to the rights a lender to the business has. For example, the business might have the right to lodge a Caveat upon the real estate of the personal guarantor. In other circumstances a mortgage over the real estate might be considered, or a mortgage over specified goods, which is called a Trader’s Bill of Sale.

Terms of Trade/Trading Conditions are printed on the front or back of quotations, order forms, invoices and the like and are highly recommended for businesses. After all, their purpose is to protect the business from legal liability and to make debt collection easier.

Terms of Trade will contain terms such as passing of risk, retention of title (see below), interest charges for late payment, payment schedules and the like which relate to credit terms.

Signing of Credit Applications and Terms of Trade significantly improves the enforceability of credit terms. The High Court has recently confirmed that ‘A person who signs a document which contains contractual terms is normally bound by them even though that person has not read them and is ignorant of their precise legal effect’.

Retention of title

The purpose of a retention of title (ROT) clause is so that the business to retain ownership of the goods, until payment is made for the goods. Ownership can be retained even though the goods might be sitting in the customer’s warehouse, showroom or shop.

ROT clauses are particularly useful where the customer which goes into receivership, administration or liquidation. Because payment has not been made by customer, then under the ROT clause, ownership has not passed to the customer. The business can call by the customer’s warehouse, showroom or shop with a van and collect any goods which are unpaid. Receivers, administrators and liquidators are none too pleased when this is done, but will release the goods provided proper paperwork containing the ROT clause is produced to them.

Where the business transaction is a service, a lien is available to a business to hold back the goods or materials belonging to a customer, upon which work has carried out work, until payment. Examples include motor vehicle repairers, architects, preparers of reports such as environmental reports and planning reports. A lien is lost, and cannot be regained, once the business parts with the goods.

Credit Risk Management

Each business must carry out its own credit risk assessment to establish for which customers it will provide credit terms, how much the credit limit should be set at, and for what time and on what terms such as additional security by way of personal guarantees, retention of title clauses and the like, it will extend the credit.

Credit risk is heightened in these circumstances:

• Where the customer is a first time or one-off customer.
• Where the product is of little value once it is handed over or are valuable only to the customer. Examples include printed materials, travel (after the trip), building work.
• Where a business’s margins are small and where giving credit may put the whole business at risk of failing, if payment is not received. Examples include the travel industry where profit margins can be less than 5%, and telecommunications.
• Where the credit limit is set too high.
• Where credit terms have been given, and there is already a large amount outstanding on credit.

A senior person in the business should be required to sign off on credit applications. Otherwise, it may well be a case of locking the stable door after the horse has bolted!

Some debt collection strategies

Experience in collecting overdue debts and in writing off bad debts is a great teacher of credit risk strategies.

Here are some debt collection strategies which might assist in obtaining payment and reducing write offs:

• Follow up. Send account reminders – with eye catching stickers, starting with the polite reminder ‘have you overlooked payment?’ and over time, ending with the ‘pay within 14 days or legal action will follow’. Telephone regularly – with the intent of extracting a commitment to pay.
• Review ongoing orders or continuing work to suspend credit, require cash on order and cease work. Beware the trap of continuing to extend credit, or extending further credit to customers which are experiencing financial difficulties, in an attempt to recover a pre-existing debt. Often those customers are trading insolvently and will go into administration or liquidation, leaving not only the pre-existing debt but also the future debt unpaid.
• Send a Letter of Demand or Creditor’s Statutory Demand for Payment of Debt – confer with your lawyer before doing so to ensure that the correct form is being used or have your lawyer do so at an agreed fee. Lawyers are ethically bound in Australia not to take a percentage of moneys collected, unlike their counterparts in the USA, who are able to take a percentage of the amount collected on a ‘no win no pay’ basis.
• Accepting payment of the debt by instalment payments is often preferable to holding out for the full debt. The customer’s written confirmation of an instalment payment schedule is very useful to have as it is an acknowledgement of debt. In a continuing relationship, tie the instalment payments to future delivery of goods and services.
• Engage a mercantile agent to collect the debt. These are professional debt collectors who charge a percentage of the debt collected (often 30%) on a ‘no collection no fee’ basis. They come into their own and achieve success where the business documentation is good, there is a volume of similar debts to collect, the debt is fresh and the debt is relatively routine and small.
• Court proceedings. Statements of Liquidated Claim are able to be issued in the courts. Lawyers and mercantile agents issue Statement of Liquidated Claim, and when they do they add legal costs, court costs and interest to the amount claimed. It is important to decide before issuing a Statement of Liquidated Claim whether the exercise is likely to prove worthwhile. It is not possible to give guidelines to help except to say that the factors to be considered include the amount of the debt due, any dispute concerning the debt, the ability of the debtor to pay and the legal costs of pursuing the debt.
• Lawyers can assist in drafting trading terms, and checking personal guarantee and security clauses. They can also assist in debt collection by writing letters of demand, issuing Statements of Liquidated Claim and negotiating terms of settlement.

The Author: Anthony J. Cordato is a principal of Cordato Partners, Business, Property and Tourism Lawyers, 5/49 York Street, Sydney. He is the author of “How to Collect Business Debts”. For more information, email ajc@businesslawyer.com.au or telephone (02) 8297 5600.

Important Notice

This article provides a summary of the law. It does not cover the whole of the relevant law and is not a substitute for professional advice.

Moreover, because it avoids legal language wherever possible, there may be some generalisations about the application of the law. Some provisions of the law referred to have exceptions or important qualifications.

Your particular circumstances need to be taken into account when determining how the law applies to you.

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