Selling on credit exposes businesses to similar financial risks as banks. Both suffer cash flow problems and lost profits if customers miss payments or default on accounts. Banks, however, specialise in managing financial risk, whereas businesses specialise in their core operations and controlling risk is an adjunct responsibility. As such, businesses can benefit a great deal by thinking like a bank when it comes to credit sales.
Banks anticipate and prevent cash shortfalls
Banks need to manage their cash inflows and outflows to ensure they are always solvent. The consequences of failing to do so can be severe. Banks will lose some customers if they don’t have funds available for them to make withdrawals. Additionally, failing to make interest payments on their own loans will damage their credit score which raises their cost of capital and reduces profit. Like businesses, the responsibility of managing cash flow arises from their many customers who fail to pay on time and default on debts. Developing policies to mitigate liquidity risk — the risk of failing to pay short-term debt obligations — is one of the most fundamental elements of banking. Banks have many methods to generate short-term funds to pay these liabilities, however, they must balance these methods with their relative costs.
The most effective strategy for minimising liquidity risk balances the acquisition of funds with the cost of capital. For instance, banks could quickly raise funds by offering term deposits with interest far above their competitors. Despite the probability that this would meet their short-term debt obligations, it would be excessively expensive. Instead, banks will develop a strategy which may use multiple sources of funds to prevent default at the lowest possible cost. Intuitively, banks can’t do this if they leave fundraising to the last minute. If they did, they would need to raise the necessary capital with little regard for the cost. This is why banks continually monitor their upcoming receipts and obligations to implement strategies ahead of time.
Businesses can benefit from implementing the same proactive approach to liquidity risk management. By frequently and objectively analysing expected receipts, they can determine whether it is likely they will have the necessary cash to settle liabilities when they fall due. This involves understanding customer behaviour and forming a realistic forecast for receipts that accounts for expected late payments. Upon identifying a probable cash shortfall ahead of time, businesses can implement a strategy to ensure funds will be available to pay upcoming bills. Further, the strategy can be formed in such a way that the cost of obtaining these funds is minimised. For instance, a business might begin asking for partial upfront payment from some customers in the short-term, chase outstanding invoices more diligently, offer discounts for early payment and/or borrow when necessary. It is likely that such a multi-source strategy will be cheaper than borrowing money, such as through invoice finance, at the last minute. Therefore, managing liquidity risk like a bank increases the probability that businesses will have the funds to meet their obligations at the lowest possible cost.
Banks assess customer credit risk objectively
Banks don’t have the same relationship with borrowers that business owners do with their customers. This is both an advantage and disadvantage for banks and businesses. Businesses usually know their customers well and have an intuitive understanding of the risks they pose. This can enable them to set judicious credit limits and adopt reasonable policies. However, these personal relationships may lead them to assume they can take a relaxed approach to selling on credit. Such an approach would overlook leading indicators of financial difficulty that materially increase risk, or to imprudently give customers the benefit of the doubt.
Banks need to compensate for the absence of personal relationships with their borrowers. This forces them to evaluate the creditworthiness of applicants objectively rather than subjectively. They do this through thorough business and credit analysis before granting loans. Such analysis usually incorporates economic, industry and borrower-specific risks that provide a more holistic assessment. This approach occasionally fails to identify some unquantifiable factors that indicate low risk, such as a reputation for being reliable. However, broadly it results in banks adopting relatively risk-averse lending practices compared with businesses who may encounter losses due to their assumption of customer solvency or lack of analytical rigour when providing credit. Thinking like a bank motivates business owners to implement thorough analysis that can further reduce credit risk.
Banks protect their profit margin
Banks generate most of their profit from the difference between what they charge customers for loan products, and the interest they pay on deposits and borrowings. Despite highly publicised profits in the banking industry, most come from the volume of their loans rather than the size of their net interest margin. In fact, the net interest margin for Australian banks has fluctuated between just 2–2.5% over the past decade. Understanding that slim margins mean losses have an outsized impact on profit leads banks to vigilantly control their risk. Businesses in many B2B industries similarly operate with slim profit margins, often between 2.5–7.5%. Losing accounts worth 1% of annual sales to bad debt results in 40% and 13% lost profit for businesses with 2.5% and 7.5% margins, respectively. Thinking like a bank involves understanding the damage even deceptively small losses can cause and protecting your margin accordingly.
Banks compete with businesses to recover losses
Businesses compete with banks to recover assets if their customers go broke. This occurs when businesses try to recover unpaid invoices while banks try to recover unpaid loans from the same insolvent debtor. Banks usually have an advantage over businesses in these events due to the contracts and associated security interests they put in place when lending money. The same resources are available to businesses to secure their assets, such as with the PPSR. However, business owners are often not aware of security interests, how to register and enforce them, or of the liquidation process of insolvent customers’ assets. This lack of knowledge and implementation can ultimately result in banks receiving liquidated assets to which businesses with the same securities in place would have been entitled. Businesses that think like banks implement systems that prevent banks from outflanking them when attempting to recover security interests.
How Tradex can help
Tradex provides specialist credit management found in banks and financial institutions to small businesses. We work with clients to develop credit sales policies that balance risk and cost reduction with their specific business needs. We then implement these policies day-to-day through active credit analysis and receivables management. If you would like to find out more about how Tradex can help your business, you can book a 30-minute discovery call with our managing director here.
