In this volatile economic environment, you may find that tightening credit lines or collecting more aggressively is needed to keep your customers current. There is a delicate balance between aggressive collection, risk management, and customer care. This is particularly true with major customers when both parties want to have a long-term relationship. One way to approach this is to obtain some form of collateral, that if liquidated, can presumably offset what the customer owes your company.

Collateral can protect your firm against payment delays, defaults, and even bankruptcies. For those of you who might be new to this term, collateral refers to an asset that a creditor accepts as security for extending credit. The most frequently used collateral includes inventory, fixtures, equipment, vehicles, accounts receivable, stocks, bonds, and negotiable instruments. In some cases, it could be a lien on the property, a personal guarantee or you can ask for a Standby Letter of Credit. With this last option, the customer's lender has adequate collateral to guarantee payment to your company for a given amount. It can easily be liquidated if certain conditions spelled out in the text are met. There are also advantages to your company in a bankruptcy situation. The bank, not the customer is guaranteeing payment.

These various forms of collateral can protect your firm against payment delays, defaults, and even bankruptcies. There are some key things to understand in advance to determine if the liquidated collateral will have sufficient value to offset your company's credit exposure.

1. Will the asset's value increase over time? At the outset, you should calibrate the volatility of the collateral's value. Will the value increase or decrease widely over time? There should be a strong likelihood it will increase in value or at least be stable in a time window allowing you to determine that action is necessary and to liquidate the collateral to pay down what is owed to your company.

2. Is the collateral correlated to the underlying debt? If the collateral is already related to an underlying liability, you might not be able to liquidate it and clear what is owed.

Let's say your company takes as collateral customized and specialized equipment. It is only of use in the production of a product that is exclusive to your customer. Maybe the technology involved is out of date and undesirable for purchase by another party. The value of the equipment is contingent on your customer's continued financial health and ability to produce a specialized product. If the customer fails, or you otherwise need to liquidate an outstanding balance, the collateral is likely to have minimal liquidation value.

3. Will you have access to the asset? It is essential to have the first possession of the collateral or be certain that if the collateral is liquidated, the secured creditors will be satisfied with enough value left over to pay your company. Legally, creditors who are first in line to perfect a security agreement will be in the first position to take ownership of the assets along with any liquidation proceeds.

With that said there are ways for a trade creditor to take a Purchase Money Security Interest (PMSI) on products shipped to the customer. If done properly, this lien will take precedence over other secured creditors, such as a bank. Banks typically have a blanket lien on all assets, including inventory. Once your product is sold it becomes very difficult to obtain payment for your secured product. If your company is a highly valued supplier, you can try to work with your customer and the bank to obtain a Blanket Lien on all the customer's assets, along with a Subordination Agreement. This can put your company next in line for all assets aside from your PMSI or others in place. That will ensure you are first in line after the bank if your PMSI does not satisfy the debt.

4. How long will it take for liquidation, and at what expense? Let's say you have a lien on a specialized facility or equipment. You have to consider the time and expense involved to liquidate the secured assets. Compare this with the revenue and profit potential for your company if a credit line is approved.

Are there any other factors that you evaluate while collateralizing your risk exposure? Feel free to share your thoughts in the comments.

If you are looking for alternative strategies to mitigate risks during these difficult times, watch this free training video by Robert Shultz to find 18 strategies on how to reduce portfolio risk concentrations.