Credit Control

I have done a few blogs on some of the more public tasks and CFO has, such as Investor Relations and Earnings Releases and SEC Reporting (where the results of the process are public). This blog is about a process that if everything goes well will remain private because there is no news to report.

One of the functions that normally reports to the CFO is Credit and Collections. I will discuss collections in another blog to come, this one will focus on credit control. The whole basis of credit control is balancing reducing losses from bad debts while not excessively curtailing the ability of your sales team to sell. There is a very natural conflict point here between Sales and Finance (or Treasury as credit control often is a Treasury function, but Treasury should report to the CFO). Sales is motivated and pressured to increase sales. Credit control is motivated and pressured to reduce losses. In both extremes, you can have either no revenue (all sales are denied) or maximum losses (sales are made to anyone regardless of their ability or desire to pay). Obviously no organization wants either extreme.

Before I detail out what I think is important about Credit Control, this is a reminder of why you need it. If you want to recognize revenue on an accrual basis (when the sale is made instead of when cash is collected), the SEC has listed the rolling four conditions that need to be met (SAB 101):

“The staff believes that revenue generally is realized or realizable and earned when all of the following criteria are met:

• Persuasive evidence of an arrangement exists,
• Delivery has occurred or services have been rendered,
• The seller’s price to the buyer is fixed or determinable, and,
• Collectibility is reasonably assured.”

https://www.sec.gov/interps/account/sab101.htm

The final bullet says that before you can recognize revenue, you need reasonable assurance that it is collectible. The SEC is not often as direct when giving guidance but the four points are very clear. Since then, accounting guidance has echoed those 4 points and all US auditors and most foreign ones use those points. Revenue recognition is a key problem that can lead to either missed quarters or restatements. It is something that a good CFO pays close attention to. It is very damaging to your reputation and the company’s reputation to get this wrong.

The first two things you need to do is to ensure that credit decisions come from a fact based process and that you have a good person with sound judgment leading the team. The two best sources I know of for credit information is Dun and Bradstreet and the credit insurance companies. The other is your company’s experience which is mainly saved by the credit and collection staff but might be in your CRM system as well.
One bad source of credit information is the personal relationship of the sales manager with someone at the client. From the beginning before the credit application goes in to. The. Very end when you do the final rejection as CFO, you will hear a story of what a good guy the client representative and how far back the sales manager goes with them. Sometimes the relationship goes all the way to the top, the sales manager knows their CEO. I have never seen a case where that so called “good relationship” turned a bad credit into a good one. Even if the relationship is real, if the client does go into bankruptcy, the judge can claw back payments made to your company in advance of other creditors. I also have noted that when business turns bad for a company, the CEO is more likely to lie and exploit their relationships than lower level employees.

What is important to know is what the D&B report says and what your collections team says if they have previous experience with them. For example, you may set 30 day terms and the D&B report says that they are often late. If your staff has previous experience with them, they may be able to tell you that they always pay no faster than 45 days but that payment always arrives then. That would indicate that their credit is OK but that you need your pricing to reflect being paid 15 days past your terms.

On average, your credit team should be saying no to cases where there is doubt that the client is trustworthy. If you have 20% gross margin, every bad debt write-off needs to be replaced with 5x the revenue to recover the cost. They cannot say no to everything that is doubtful and there should be some balance struck between an outright no and lower credit limits or a mix of letters of credit, bank guarantees and deposits and pure credit. A good sales manager should be good at negotiating, so they should be able to work something out.

You have to set the right tone with your staff. Some of their decisions will get appealed to you and I have found that the credit team is almost always right. There are times where there is some factor they did not consider, but if you did what I said was important – have a good fact based process and a good leader, then when they say no it normally is justified. Almost always I end up pushing the sales manager to go back and get more security from the potential client. Sometimes I approve the request, but always only when I know something that the team did not know.

A bad reason to approve credit that otherwise would not be approved is because you need it to make the quarter. You’ll just write it off a quarter or two and make that quarter worse plus have people question your judgment.

Credit insurance can help defray some of your risk. If you are exporting, make sure you look into what government supported insurance there is. Many countries have some sort of scheme to reduce risk and will let you recover 70% or more of any loss. Agencies like that also are good sources of credit information and proper practice for the country and maybe even to potential customer. In your home country, you will have to find credit insurance from one of the several that provide it.

When exporting and selling into emerging markets, you need to be very careful when you extend credit. If there is no good rule of law and now ability to enforce contracts or payments, you probably should be requiring an L/C or payment in advance. Many countries have a very bad reputation for paying companies from other countries and in many, you cannot win in court against the “home” advantage your customer has. If you do extend credit, be careful and build up the limit slowly as the customer proves them selves.

As CFO, you have better access to banks and market intelligence than your staff does. Make sure that you communicate with them. A recent example for me was a competitor that also bought our product off of us. I felt that their business model was OK but they were not being run properly and were a bankruptcy risk. I communicated it with our sales leader and our head of credit control. They decided to stop selling to the customer and several months later they did go under. Because I communicated my knowledge, we had no exposure to them.

I wish I was always that good. In one case an Indian customer wanted credit. They were listed in India and not very strong but most of our customers (construction companies) did not have great credit. I had been convinced that extending some credit was OK but our sales leader did not get a good feeling from meeting them in person. He stopped the sale and one of our competitors extended credit and sold to them instead. That company went under and paid no one.

Finally, we were trying to do more business in China where my company’s factories were located. We had a potential customer that was public in China and had a market cap much higher than ours. Typically you get paid by bankers’ acceptances/notes inside China. In this case, the customer offered commercial notes. They were current on their debt and their balance sheet seemed ok. We made a large sale to them and they did not pay the commercial notes off, defaulted on their bonds (pretty much the first in China) and went under. It was an expensive lesson, and we did not makes that mistake again.

And please don’t forget to have your contracts, even your standard sales contracts, reviewed by a lawyer. A poorly written contract can turn a calculated risk into an unexpected disaster.