Four Questions to Ask When Evaluating Customer Risk

If it wasn't for risk, companies would not need credit managers. This is truer than ever given that the types of risk, about which corporate executives and investors are concerned, are expanding.

Twenty-five years ago, and beyond, credit executives were solely focused on financial risks. The question was: will this account pay us? The ability of an account to make timely payments (delinquency risk) and the risk of default were the primary issues.

Now that we have moved from a consumer-driven industrial society to an information-driven service-oriented economy, a host of new risks are trickling down into the credit function. The Gramm-Leach-Bliley and Dodd-Frank acts have brought us regulatory and compliance risks. Mass digitalization has ushered in cyber-risks. I don't know if it is fair to blame climate change, but certainly greater awareness of the impact of natural disasters has fueled concerns about supply chain disruptions, as has the Covid-19 pandemic and the near-collapse of the financial system in 2008. Lastly, the more the economies of the world are integrated globally, the more the risks.

Within this still emerging socio-economic framework, it's constructive for credit executives to re-examine from a holistic perspective how they manage risk. To assist you along this path here are four questions to ask about your AR portfolio:

1. What are the risks?

As mentioned above, to understand the totality of the risk of doing business with a specific account, we now need to look beyond the financial statements and credit reports. Additional questions to ask in order to identify the risks involved include:

• Are they who they say they are? You need to be able to identify the business and the business agent, and then be able to confirm that the business and the agent are in fact associated. This has “Know Your Customer” (KYC) and anti-fraud implications. Accordingly, you also need to determine if the company or its officers are on any government sanctions list such as those maintained by OFAC (Office of Foreign Asset Control)
• What are the risks associated with the account's location? These can involve political risks if you are exporting goods and services, hazard risks (likelihood of natural or man-made environmental disasters), and economic risks (80 percent of small business success is determined by their local economy).
• What is your firm's level of exposure to this account? This should be evaluated with respect to the level of exposure of their peers as well as including related entities. Related to this you also need to quantify the opportunity, not just in sales, but also in profits and the impact on your competition.
• Are they secure? If they don't meet your standards of cyber-security, you need to beware of sharing information with them. For example, they may want to pay via ACH, but do you want to let them store your bank account number in their systems?
• What does the sentiment data say? This includes what customers are saying about the business as well as positive or negative coverage in the press. There is a lot of information on the Internet, especially about mid-size and larger companies, that can provide insights into their stability.

2. How have the risks been changing over time?

Too often customer risk is viewed based on current circumstances. Plotting risk trends is much more informative and is more useful in identifying accounts whose situation is deteriorating.

As the above chart illustrates, different credit scores for a specific customer can move in different directions, and will also vary trend-wise compared to the averages for your portfolio. In this case, the delinquency risk score has been increasing, while the default risk score has only moved above the portfolio average in the last two quarters. Experience will be informative in helping you recognize if a trigger point is near and the chance of default increases. Plotting other risks (see question #1) will provide additional insights as well as plotting AR balance and payment trends along with the risk information. A holistic view of risk over time for individual customers as well as your entire AR portfolio will be very informative.

Note: Don't worry about different scores being on different scales. My preference is to convert everything to a 1-100 scale for easier plotting.

3. Why is the total risk level what it is?

Answering this question requires you to dig into the details. For example, financial risks do not occur in a vacuum. In some cases, they will result from a structural problem in the business model, such as being undercapitalized or over-leveraged. On the other hand, financial risks will sometimes emerge due to external events such as the loss of a key customer, supply chain constraints, or a natural disaster. And sometimes, the combination of multiple events can be the cause of a heightened risk level.

Knowing what is causing the risk level with any particular account provides insights into the future evolution of an account's risk environment as well as informing your best course of action in dealing with that account. Is the risk level what it is due to a business interruption event that the account will be able to navigate successfully? Is the risk level the result of growing pains the account will likely overcome over time? Or, is the risk level likely to increase?

4. How does the risk compare to industry peers?

Its common knowledge that how a customer pays other suppliers in your industry is key to understanding how a customer is likely to pay you. By the same token, it is valuable to compare your customers to their industry peers in terms of the risks you monitor. In the above chart, the average delinquency and default scores for a specific customer can also be compared to the average for your entire AR portfolio, as well as the average for other accounts in the same industry.

Ranking risk by account across your entire AR portfolio is a very valuable exercise. That shows you where any individual account stands in terms of risk against the rest of your portfolio as well as their industry peers. Are they in the top or bottom quartile or somewhere in between? The ranking then allows you to look at your dollar exposure for low, medium, and high-risk accounts, which will inform you whether your AR portfolio is taking on more risk or not.

Final Thoughts…

The focus of much credit executive training is on the credit evaluation of individual accounts. That is all well and good, but a holistic understanding of risk across an entire AR portfolio requires the comparison of one account relative to another and ultimately to every other account. That is best done by ranking your entire AR portfolio based on a single quantitative score. When that has been done, it is much easier to see where a new customer fits into the mix, which is your AR portfolio. Ranking, along with segmentation, is also your gateway into more sophisticated portfolio risk analysis insights.