May 08 National Newsletter   ASSESSING THE CREDITWORTHINESS OF CLIENTS Malcolm Poslinsky BAcc CPA MICM Director, Brilliant Credit Management Pty Ltd   Learn more about Malcolm

 

 

Your clients are the key to your success - the more you have and the greater the fees, the more successful you are. But what happens when those clients don’t pay you on time or at all? It’s easy enough to say you’ll sue them for the overdue debts, but how often do you recover the money owed, and at what cost to you and your time?

 

By granting credit to creditworthy clients, you will maximise your cash conversion rate.

 

WHY DOES CREDIT RISK MATTER?

 

All clients have a level of credit risk. There is the risk that that may not pay you at all, or the risk that they will pay you, but it will be beyond your trading terms. Both of these have a direct impact on your cash flow.

Credit risk of any transaction is an expression of the probability of financial loss after taking into consideration as many influencing factors as possible.

 

There may be many reasons why a client does not pay their account. One of these reasons that may be overcome by a good credit assessment is the risk that their business will fail or the individual will have no capacity to pay the account when due.

 

Delayed payment is a financial burden that may also be overcome by a good credit assessment. An example where this may occur is where your client is a large company such as one of the commercial banks. You may be confident that the bank will not collapse and you will be paid, but they may have processes and a track record that indicates they pay their creditors outside trading terms.

 

Determining the level of risk that a client poses to your cash flow should not necessarily restrict business or reduce your fee income. With the knowledge and understanding of the risks involved, you can consider various options available to reduce that risk. Credit risk may not always be zero, but it should be at a level you are comfortable to bear. In this regard, different law practices will have different tolerances to risk, and different practice groups may be viewed differently. For example, where the matter requires significant third party disbursements or other cash outflows, you may be at a cash flow disadvantage if you are required to pay the disbursements before you are paid by the client.

 

CREDIT RISK ASSESSMENT PROCESS

 

Checking the credit worthiness of a client is an important process to gain the knowledge necessary to make an informed decision on their level of credit risk. The decision process should be undertaken for new clients before work commences and for existing clients before a new matter is undertaken. Periodic reviews may also be required.

 

What is the process to assess credit risk?

 

1. Gather the required information
2. Analyse, review and assess the information
3. Make an informed decision

 

INFORMATION GATHERING

 

The primary source of information necessary for the credit aspects of a new client engagement can be from your New Account or New Client Form but it may be necessary to review your New Account Application Form if your forms do not request all the relevant details.

If you are dealing with individuals your terms and conditions should address the privacy obligations under the Privacy Act 1988. You should get the form signed by a representative of the entity or the individual authorising you to carry out the credit checks.

 

The minimum information that should be obtained from a prospective client includes:

 

• Registered Name and Trading Name
• ACN or ARBN number (may differ per state)
• Applicants Status, i.e. Company, Sole Trader, Partnership, Individual, Trust or other
• Registered Address and Primary Business Address
• Trade references including the Company Name, Contact Name and Telephone Number
• Date of birth or drivers licence number if the applicant is a Sole Trader, Partnership or Individual

 

Additional information that may be requested from clients and used in the credit assessment includes:

 

• Incorporation date or time in business
• Number of staff
• Financial data (refer note below)

 

Relevant information from Sole Traders, Partners and Individuals would include a Statement of Assets and Liabilities.

 

Special care should be taken with Trusts, and requesting a copy of the Trust Deed may be required to understand the credit risks.

 

Financial Data

Analysis of recent historical financial data will provide a good indication of the financial strength of a business, and when the amount of credit granted is significant, this information should be requested.

 

Other information that may be sourced from credit reporting agencies include:

 

• Parent and associated companies
• Line of business
• Directors names, background and other boards
• Registered charges
• Court actions, insolvency notices
• Number of trade reference and other enquiries

 

This list of information is not exhaustive.

 

ANALYSIS, REVIEW & ASSESSMENT

 

When you have the information you can assess it.

 

In the first instance, you need to confirm the information that has been provided is complete and accurate. The Registered Name, ACN or ARBN number, Applicant Status, Registered Address and date of incorporation or date business started should match exactly to ASIC or the relevant state authority records. The reason is to ensure you are contracting with the correct entity or persons in the event you need to begin recovery proceedings. The information can be checked directly with ASIC, the ATO and the relevant state authorities like the Department of Fair Trading in NSW. Credit reporting agencies accredited by ASIC also provide access to this information.

 

If the entity is deregistered or any data is unmatched, the application should be held until you clarify the status and have the correct information.

 

Entities that are under administration or other external control require special care.

 

The information gathered should be used to assess the credit worthiness of the entity or individuals. Does the information indicate there is a high or a low credit risk?

 

The date of incorporation or the start date of the business is a good example. Statistics gathered and published by credit reporting agencies and government regulatory authorities over many years show that there is more likelihood that a business will fail in its first few years than if it is established a long time. The date of incorporation or date the business started can be used to calculate the years and form part of the decision making data.

 

The number of staff will assist in evaluating the size of the business, on the basis that a small business has a higher risk than a large business. Part of that premise is that bigger businesses are likely to be more established with more staff in various capacities with more controls and less single dependencies.

 

The age of individuals gives a guide to their years of business experience.

 

Directors, and their link to other companies, are very important.  The correlation of failed directors to failed companies is alarmingly high.

Trade references are an effective way to ascertain an entity’s payment history and patterns with other credit providers, noting however that you may only be given ‘good’ referees.

 

The financial data of a business is the best source of information on its financial strength. In most instances, financial duress is evident long before the business fails. Information such as the growth in turnover, the profitability, the gearing and the asset base are good indicators of financial strength and can be measured using financial ratios. Accurate historical data should be available from the company accountants or auditors and management should provide forecasts. Care should be taken with financial information that is not current or not prepared by reputable sources.

 

Personal financial information, if accurate, gives a real assessment of an individual’s financial strength. The information can be gathered from a personal assets and liabilities statement, and some assets such as real estate verified easily. Credit reporting agencies provide access to land titles and other assets and encumbrances such as mortgages.

 

If there is any adverse information such as Court actions or insolvency notices, you should consider the credit risk high.

 

DECISION MAKING

 

Now that you have gathered, analysed, reviewed and assessed the information, its time to decide on the client’s credit worthiness, i.e. the probability that you will get paid or paid on time if you extend credit.

 

Based on an accumulation of the information, you should be able to make a judgement. If all the information is positive, accept the client and grant credit. If a lot of information, or important elements are negative, e.g. there are court actions, decline credit. If there is some negative information, assess its impact on the creditworthiness of the client and then decide.

 

To assist you to process all the information, credit reporting agencies offer credit scoring. Credit scoring is a process whereby each element or predictive factor is allocated a numerical value and benchmarked against historical outcomes and averaged.

 

The result is usually presented as a percentage risk.

 

Law practices with a number of new clients each month would benefit from tailored Trade Score software to improve decisions. Taking control of the information and building a database of your own clients will deliver the best assessments. Credit risk evaluation is an ongoing process. You could also profile your existing clients so credit assessments are carried out each time a significant new matter begins or if you become concerned when an account falls into arrears.

 

The amount of credit granted will differ from practice to practice and is a function of each individual practice’s credit risk tolerance. A small practice could be affected significantly by a large credit exposure. A large practice may consider managing many high credit risk clients a drain on their administrative resources.

 

Understanding the credit risk of each client will enable you to increase fee income safely.

 

Where the risk is elevated, strategies to reduce the risk should be explored before turning the client away. Credit assessments are not an exact science. Common sense should always prevail.

 

Disclaimer
This article is for general knowledge. It is not a guide to grant credit. The goals, benefits, result improvements or expected cost savings are not guaranteed as acceptance of recommendations, process and other changes are all decisions that remain with the individual business or law practice in its sole and absolute discretion.