Cash flow is critical to any company’s survival and growth.
But unexpected market disruptions or a slowdown in economic activity can create a “cash crunch” that could result in higher borrowing costs, difficulty funding day-to-day operations, or even default.
Effective credit risk management is one way that businesses can enhance cash flow stability.
This article details the importance of credit risk management, shows how credit risk management impacts cash flow, and reveals strategies for improving cash flow through credit risk management.
What is credit risk management?
When most U.S. businesses buy goods and services from a supplier, they do it on credit.
Credit risk management is the process of assessing, mitigating, and monitoring potential risks associated with extending credit to businesses. It involves the identification and review of credit risks and the development and implementation of strategies to minimize and control those risks.
There are several steps to credit risk management that cash managers should be aware of:
- Credit assessment. A first step in a new customer relationship is typically the evaluation of their creditworthiness. Suppliers want to avoid write-offs from bad debt. To mitigate risk, suppliers must evaluate a customer’s financial stability, repayment capacity, and past credit history. Revenues, assets, debt, and credit scores are typically considered in this process.
- Credit scoring and rating. Businesses have too much riding on the credit that they extend to customers to trust their decisions on gut feelings. That’s why businesses use credit scoring models and rating systems to determine the level of risk associated with each customer.
- Credit policies. Clear credit policies and procedures help guide the credit process and ensure consistency in decision-making. Credit policies outline criteria for credit limits and terms.
- Credit monitoring. Avoiding write-offs from bad debt requires businesses to act fast at the first sign of trouble. Businesses must regularly monitor their customer portfolio for warning signals such as missed payments, financial distress, or changes in market conditions.
- Recovery management. When customers default on their payments, a credit risk management team uses recovery strategies to minimize the loss and maximize repayment.
Overall, credit risk management strikes a balance between facilitating sales and mitigating risk.
How does credit risk management impact cash flow?
The way in which a company manages its credit risk can have a big impact on its cash flow.
For starters, effective credit risk management helps ensure timely and full customer payment.
Here are some of the other ways that credit risk management impacts cash flow:
- Bad debt. Poor credit risk management can lead to write-offs from bad debt. Businesses that can’t accurately assess the creditworthiness of customers and set appropriate terms are more likely to experience customer defaults that can make their cash flow stream unreliable.
- Poor liquidity management. Businesses need cash and liquid assets to meet short-term obligations. But ineffective credit risk management can impact cash and deny businesses the liquidity they need to cover operational expenses, debt obligations, and other expenses.
- Costly borrowing. Poor credit risk management can contribute to higher borrowing costs. If a supplier is perceived to be taking on too much credit risk, lenders will likely charge the supplier increased interest rates or require stricter lending terms. Higher cash outflows associated with servicing debt can quickly drain a company’s working capital.
- Obstacles to growth and investment. Cash is crucial for growth and investment. But a business with a risky customer portfolio may have trouble securing additional funding or credit lines at favorable terms. Insufficient working capital can stand in the way of expansion, new investments, and strategic initiatives that can grow the business.
These are some of the ways that credit risk management impacts corporate cash flow.
How to improve cash flow through credit risk management
Effectively managing credit risk can help businesses of all sizes significantly improve cash flow.
Here are six ways cash managers can accelerate cash flow through credit risk management:
- Know where you stand. Conduct a thorough credit assessment of potential customers before extending credit. Evaluate their financial stability, repayment capacity, credit history, and references to reduce your risk of defaults and minimize potential cash flow disruptions.
- Keep tabs on customers. Implement robust credit monitoring systems and processes to identify signs of deteriorating credit quality among customers. Regularly review customer payment performance, including timeliness and credit utilization. Early detection of potential credit issues enables timely intervention, reducing the potential impact on your cash flow.
- Establish limits. Set appropriate credit limits for customers based on their creditworthiness and risk profile. Avoid overextending credit, as it increases the risk of defaults and limits cash flow availability. Regularly review credit limits and adjust them as necessary.
- Be proactive about collections. Work with your accounts receivable department to establish effective collections processes to minimize past-due payments and defaults. Implement automated payment reminders and other strategies for early collection efforts and proactive communication with delinquent borrowers. Timely actions to recover overdue receivables help maintain a healthy cash flow and reduce the need for costly legal proceedings.
- Get on the same page. Ensure that credit terms offered to customers are aligned with your own working capital and are designed to help manage cash flow fluctuations. By optimizing working capital, you can reduce the need for borrowing and improve cash flow stability.
- Never stop improving. Regularly review and assess your company’s credit risk management strategies and practices. Monitor the effectiveness of risk mitigation measures, identify areas for improvement, and adjust as necessary. A proactive and adaptive approach to credit risk management enhances cash flow performance over the long term.
These credit risk management strategies will help drive improvements in your cash flow.
Protect your cash flow
Cash management means more in uncertain times like these. Effective credit risk management can help improve cash flow and reduce disruptions to ensure the financial health of the business.
