Balancing Credit Sales and Profits:
How to Sell Profitably on Credit Terms to Customers that Are Financially Vulnerable

By John Salek

Some companies are fortunate to have financially strong customers who account for most of their sales. This reduces the risk of bad debt and delinquency loss substantially, along with the cost of Credit & Collections activity required. Even in this fortuitous state of affairs, it is imperative that you confirm that perceived financial strength and check it at least annually.

Most companies, however, are in a position where they need incremental sales volume from higher-credit-risk customers to break even and achieve profitability. How can this be optimally executed?

Fortunately, there are a number of devices you can employ to facilitate sales to higher credit risk companies on a profitable basis. To do that you will want to consider your pricing policy, insurance options, credit extension and risk mitigation protocols, as well as collection efforts.

Risk-Based Pricing

The first option is to charge higher prices to customers with higher credit risk. Doing this will compensate your firm for:

• The additional administrative cost incurred in closely managing and controlling these customers’ accounts receivable balances.
• The increased risk of a significant bad debt loss that your firm bears.

Credit Insurance

Another option is to obtain Credit Insurance. This will likely involve blanket coverage for your entire AR portfolio, but with the help of a good broker you may be able to get coverage on appropriate customer segments. Purchasing Credit Insurance, however, will only solve this problem if:

1. The policy covers financially weak, higher-risk customers. Credit Insurance policies often exclude individual, named accounts. However, if the customer is a public company, you may instead be able to purchase a Put Option Contract as protection.
2. The policy cost is acceptable. Insurers want to be paid for the risk they bear.  If your high-risk customers are very risky and numerous, the insurance premium may exceed your average yearly bad debt losses.
3. The other policy conditions (deductibles, co-pays, etc.) are acceptable and make economic sense.

On the positive side, Credit Insurance may help you get a higher credit line and a lower interest rate if you are pledging your receivables as collateral for a bank loan or line of credit.

Tightly Manage the Credit Extended

If Credit Insurance is not a viable solution, you’ll have to manage the credit risk and exposure yourself. This involves setting lower credit limits (considering customer requirements, economic order size, etc.), then closely monitoring these customers supported by aggressive collections. If you go this route:

1. Ensure you thoroughly review your financially marginal customers paying particular attention to financial strength (profitability), cash flow and leverage. Those that are too weak for you to extend credit will require upfront payments — find the way (COD, Cash-in-Advance, down payment, etc.) that is most compatible with the customer.
2. Try to get a guaranty from a financially strong related party who will pay the AR if the customer defaults. This reduces the credit risk substantially and can lead to a higher credit limit. Make sure with Personal Guaranties that you both vet the person making the guarantee as well as the property laws for their state of residence - an individual guarantee in a joint property state can be essentially useless.
3. Look at other risk mitigation instruments such as bonds, liens, and UCC security filings.
4. When you have established a credit limit, explain it and your expectations to the customers. A key element is to encourage truthful communications because there will be bumps in the road.
5. Ensure that every order from these customers passes through a credit check. An automated order approval system is best if you have significant order volumes. If the customer account is in an acceptable state in terms of available credit and terms status, the order can be released. If not, the customer must be contacted. Typically a payment (or strong promise) will be required before the order can be released.

Flag Higher Risk Accounts for Aggressive Collections

The order hold routine will control AR exposure and trigger collection activity. However, substantial additional Collection activity may be required. More Collection activity, effectively administered will accelerate receipt of cash from these customers. These customers will require more intense follow up of past due invoices (e.g., every few days vs. weekly), and collection follow up (e.g., at 4-7 days past due vs. the two weeks or more that is typical).

If the additional collection activity looks like it will require adding staff (even part-time), there are AR automation solutions that are both low-cost and efficient. These can be easily implemented to increase and improve the AR management effort, thereby increasing cash flow with existing staff levels.  These automation solutions also facilitate “work-from-home” which has become very important in retaining and attracting employees.

A Case in Point…

International Paper Company (IP) produces a wide variety of paper products. One of their legacy products was the paper stock used to produce manila file folders and tickets for toll roads (for those of you who remember). As electronic storage of documents and EZ Pass type toll collection proliferated, the demand for this paper declined substantially. IP had one old paper machine that manufactured manila stock. It was very old and too costly to convert to manufacture other grades of paper.

Consequently, IP continued to sell this paper (in declining volumes) to a few distributors whose sales volume and financial condition deteriorated over time. IP used the Credit and Collection strategies described above to continue to serve these customers and collect the AR incurred. It finally ended when these few customers went out of business, but the bad debt losses (which were fully reserved for) were far less than the profits the company earned while keeping this product line alive. A clear example of the astuteness of the policies described in this article!

Final Thoughts . . .

Even if you implement risk-based pricing, you will still want to adjust your credit and collection policies in regard to those accounts. The increase in price should be calculated so that you still realize a profitable sale when calculated against the additional administrative credit and collection cost as well as any subsequent increase in bad debts. Credit Insurance, in contrast, eases the burden of credit, collections, and bad debt.

Implementing a more conservative credit and collections policy for financially vulnerable customers will unavoidably require more time and effort. Managing tight Credit limits to financially weak, slow paying customers requires a lot of communication and analysis, and almost daily monitoring of the account status. Improved Collections results is simply a “numbers” game.  More customer contacts, properly executed utilizing accurate AR information, results in higher cash collections. You might also want to consider collection training, which is not costly and often available for free, to increase the effectiveness of whomever is assigned that task.

Selling profitably to high credit risk customers on credit is possible and often necessary. With the way events are trending — stock markets in correction, saber rattling from Russia and China, and supply chain disruptions to name a few — the number of higher risk customers may soon be increasing. Follow the steps described above and you will be able to reap profits and increase your cash flow from these customers.

Editor’s Note: This article was originally published January 25, 2022, in Your Virtual Credit Manager and is reprinted here with the permission of the author and publisher

About the Author: John Salek is President of Revenue Management Associates, an Accounts Receivable & Order to Cash consulting company.  He is a highly experienced financial professional with proven performance in the Order to Cash process, having worked in a broad range of industries with over 250 clients for more than 40 years, most recently with Genpact. He holds an MBA in Finance from the Amos Tuck School of Business Administration at Dartmouth College and is the author of “Accounts Receivable Management Best Practices,” (Wiley). John can be reached at jgsalekrma@aol.com.