Cash Flow Management

How to reduce Business Risk

Business Risk can be reduced in the following ways:

1. Part Payment
2. Stakeholder Accounts and Other Forms of Secure Deposits
3. Legal Expenses Insurance
4. Special Payment Terms
5. Discount for Early Settlement
6. Prompt Payment Rebate Scheme
7. Third Party Guarantees
8. Retention of Title
9. Contra and Offset Against Payables
10. Trade Credit Insurance
11. Factoring
12. Exporting
13. Setting Credit Limits

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2. Stakeholder Accounts and Other Forms of Secure Deposits
Businesses can generate customer confidence and reduce credit risk by using a neutral body such as a bank to hold the funds until the buyer is happy. There are many forms of trusteeship, secure deposits and escrow accounts to achieve equitable arrangements.

In building work and related contracting there are problems of credit risk, quality disputes and cash flow. But the contractor needs working funds. A Stakeholder Fund can generate client confidence, keep the contractor up to the mark and encourage a bank to advance money for the work.

For example, where the contract terms are 'one-third on contract, balance on satisfactory completion', the client is asked to deposit the initial third into a nominated bank account held for the seller. The stakeholder bank will only release the funds on the written instructions of the purchaser or an agreed arbitrator. The seller will be keen to satisfy the client to obtain payment. If the seller is at fault, the advance may be refunded by the stakeholder bank.

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3. Legal Expenses Insurance
In the building/contracting industries and others where technical disputes often delay payment, the fear of large legal costs deters many firms from suing for their money. Some debtors are suspected of keeping disputes running if they think a supplier cannot afford litigation.

Insurance cover can be available for legal expenses if your client has a good case. A broker's help is advisable for negotiating terms. The building industry, for example, has an insurance scheme at Lloyds for members and non-members. Details from LRM on 01903 884663.

It is important that unpaid sellers feel confident of having disputes settled in court if needed. If debtors are told that legal costs are not a barrier because they are insured, disputes may well be settled quickly without going to court.

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4. Special Payment Terms
If your client has a risky customer, you may suggest that they reduce their payment period from the standard 30 days to 7 or 14 days.

Accounts on special terms should be grouped together in the ledger for constant collection attention. Any default after agreement of special terms should lead to 'cash terms only'.

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5. Discount for Early Settlement
You may wish to advise businesses that this is an expensive inducement to obtain payment from their customers and needs to be treated with caution. It is only viable when the business's net margin is high and you have the staff to control unauthorised deductions. If only bad payers are offered cash discounts, all the good payers will want the same benefit.

Terms of '2% 10 days, net 30 days' should produce fast payment because a customer would be silly to ignore the effective lower net price. The annualised cost is huge (36% pa for the example above) and more expensive than waiting an extra 2 months for payment. Also, it is difficult to recover deductions from payments made too late to qualify.

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7. Third Party Guarantees
This is a written undertaking by a third-party to be legally liable to pay if a customer does not. Since the wealth of individuals is uncheckable, limited company guarantees are preferable. Sole traders and all partners in partnerships are personally liable for their business debts anyway. Directors are not liable for their companies debts.

Parent companies are not liable for their subsidiaries debts unless they issue guarantees. 'Comfort letters' which confirm the shareholding, are not guarantees and should be rejected.

Banks sometimes guarantee payments to suppliers when the debtor is under-capitalised, e.g. in a start-up, where the bank has lent initial funds and wants the venture to succeed.

Wording of guarantees can be obtained from solicitors, credit insurers and credit management books. Guarantors may insist on limiting the amount and expiry date. Give the wording to your debtor who should ask the guarantor to issue on their own headed paper.

About half of all newly-formed businesses do not last two years! It makes sense to restrict initial credit and, for large orders, to get payment guarantees.

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8. Retention of Title
If a businesses' goods (not services) remain easily identifiable as supplied by it, then the business should have a condition of sale which ensures the goods remain its property until paid for. It may then recover them at any time, but especially when a customer is in difficulty.

The business should notify customers of the new clause and make sure it is simple but clear. An 'All Sums Due' clause allows the business to recover its goods against any monies owed, not just the debt for the goods recovered.

Retention of title clauses are not appropriate if the goods are to be processed or incorporated into something else. They also need very careful wording so they are appropriate to the business. It is advisable for a business to seek legal help in drafting.

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9. Contra and Offset Against Payables
If a business has a customer that is also a supplier, it is not acceptable business practice to withhold payment to them for their goods/services as a way of offsetting an unpaid debt by the other party.

The two contracts are quite separate. For example, the Receiver for an insolvent customer can require a business to repay amounts already offset.

A simple written agreement with common customers/suppliers that debts may be offset, and any excess paid by the party concerned should be considered.

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10. Trade Credit Insurance – see separate page on this – link below
Trade Credit Insurance – see separate page on this – link below
For all businesses, extending credit to customers involves a certain amount of risk. The risk can be minimised by insuring against the possible default and insolvency of customers.

Trade Credit Insurance can be an important tool in credit management and can help to minimise the risk of potential problems with late payment and bad debts. It can also provide much needed replacement working capital if customers fail to pay within the agreed credit period.

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11. Factoring
Factoring is a credit management, plus finance, service which enables businesses to improve their cashflow and provides an alternative source of working capital finance. Factoring companies work closely with businesses and will usually offer a credit management service to their clients.

By providing finance which is secured against unpaid invoices factoring allows businesses to expand without exhausting cashflow as finance is made available in line with the level of its sales.

Invoice Discounting is an alternative confidential form of factoring whereby invoices are funded by the factoring company without the use of other credit management services.

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12. Exporting
Selling overseas is one of a number of paths open to enable growth. Sustained success in exporting can bring a business a wide range of benefits including:

• Higher turnover and profits;
• Economies of scale due to increased volumes; and
• A more competitive edge

As with the UK market there are risks associated with exporting, although it is not necessarily more difficult to get paid. However, it is important that all businesses minimise their exposure to late payment and bad debt and seek out specialist advice. (www.export.co.uk) or (www.sitpro.org.uk)

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13. Setting Credit Limits
It is important that your clients have a 'credit limit' established within their credit policy. This credit limit can be set following consultation with you. Alternatively a business can buy an opinion from a credit agency, get a decision from a credit insurer or make their own calculations.
The two heading below are ways to find out how to set a credit limit.

1. To set a Credit Limit, there are two approaches:

i) A Credit Limit to support sales levels. If references are good enough, the Credit Limit equals twice the monthly sales figure for that customer.

or

ii) A maximum amount the business is prepared to be owed, regardless of current sales levels. A popular calculation is the lower of 10% Net Worth or 20% Working Capital (Net Current Assets).

Method i) needs constant revision as sales increase but is a useful trigger for re-checking the risk at intervals.
Method ii) is better as sales staff have the authority to sell up to the Credit Limit, which needs less frequent revision.

2. Risk Code
As well as the amount of credit, a risk code can indicate the likelihood of being paid late and therefore how closely the business needs to watch the account. For example:

Code 'C' identifies persistent slow payers, county court judgments, markedly worse solvency. Insolvencies will then come as less of a surprise and all should be from the 'C' category.

Despite the risk, a business may have to take on some 'C' accounts if it can't get enough business from 'A's and 'B's. There is good profit to be had from 'C's if monitored carefully and risks are minimised.

If 'C' customers can be identified, extra sales effort can be put into the 'A's and 'B's in future to put the business on a sounder footing. These codes should be reviewed over time.
Staff must be made aware of customer credit limits.

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