![42
Credit Risk Control - How
" Work closely with sales to determine the expected
level of sales to each customer.
• Work proactively to try to qualify customers for the
credit limits they require - and when you are unable
to extend amount of credit requested make sure that
the salesperson knows both the credit limit and the
reason[s] for your concern about their customers'
financial health and/or payment problems.](https://image.slidesharecdn.com/creditrisk-management-170503100731/85/Credit-Risk-Management-42-320.jpg)
![43
Credit Risk Control - How
f) Insist/require/demand that your collection staff report
to you any problems they encounter including:
" If an account becomes seriously past due [for example
more than 30 days past due], do not return to
"business as usual" once the past due balance is paid.
v This situation should automatically trigger a
review of the customer account before a decision
is made about whether or not to continue to offer
open account terms and at what credit limit.](https://image.slidesharecdn.com/creditrisk-management-170503100731/85/Credit-Risk-Management-43-320.jpg)
Uploaded byFarouk Nasser
Credit Risk Management
This document discusses various aspects of credit risk management. It defines different types of credit like trade credit, export credit, and consumer credit. It describes the roles and responsibilities of a credit manager in evaluating risk, monitoring performance, and collecting payments. It also provides details on credit evaluation processes, credit policies, credit limits, and methods to control and mitigate credit risk.
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Credit Risk Management
- 1.
- 2. Credit Risk isprobability of loss of the investment as a result of default by the borrowing party to meet their commitment of repayment, willingly or unwillingly… Credit Risk Management 2
- 3. 1. Trade Credit: is an agreement where the supplier or seller delivers goods or services with the understanding of receiving the payment at a future date (usually after a specific time, 30, 60 or 90 days from the signed delivery note date or invoice submission date. • purpose is to maximum sales volumes • Improve customer relationships • To decrease slow moving inventory Credit Categories 3
- 4. Credit Categories 2. ExportCredit : offered by financial institutions (government export agency-ECA) to domestic companies for international export operations including insurance cover to mitigate political as well as commercial risks of overseas investments. • ECAs act as intermediaries between government & exporter for financing • ECAs do the prequalification process for the prospective local vendor seeking the credit facility 4
- 5. Credit Categories 3. ConsumerCredit : is a debt that a person incurs when purchasing goods or services (non – investment services consumed or tangible goods with high depreciation rate) usually obtained with credit cards, lines of credit and some loans. 5
- 6. Credit Risk –The Manager 6 ü A credit and collections manager establishes policies and guidelines that help subordinates collect data and evaluate risk factors associated with credit applications. • Reviewing risk-factor calculations and evaluating credit applicants' financial histories to make final decisions on credit approval. • Planning, evaluating, implementing and continuously improving credit & collection functions and processes including but not limited to KPIs, Collection Targets, professional Ethics
- 7. Credit Risk –The Manager 7 ü Credit Managers must follow up on overdue accounts (delinquent) by instructing their employees on ways to contact, inform and negotiate repayment. • Write, Call and Email clients to discuss payment plan options, decide when to send final demand notices, close accounts and contact outside collection agencies, or use legal action to address delinquent borrowers. • Communicate with billing, operations and sales managers to discuss how overdue accounts are being handled.
- 8. Credit Risk Management Know Our Customer Credit Evaluation process Structure theOfferClose Deal Monitor Performance 8
- 9. Credit evaluation andapproval is the process a business or an individual (applicant) must go through to become eligible for a loan or to pay for goods and services over an extended period.. • Also refers to the process businesses or financial institutions undertake when evaluating a request for credit Credit Risk Management 9 ü Collect Customer data~Business References ü Financials ~ Customer Master Data File ü Credit History ~ Credit Score/Report
- 10. Prospective Customer’s CreditProfile ! Purpose of Credit and sources of repayment ! Current Risk Profile (nature & risk amounts) : this determines the debt size as creditors will always consider debt to Asset ratio plus other financial statement reports 10 Credit Evaluation
- 11. Prospective Customer’s CreditProfile ! Borrower’s repayment history & Current capacity to repay (historical financial trends/future cash flow projections) ! Borrower’s economic sector status, their expertise and standing in said sector. 11 Credit Evaluation
- 12. Prospective Customer’s CreditProfile ! Length of commitment : Lenders accept additional risk as the time horizon increases. • To cover some of the risk, lenders charge higher interest rates for longer term loans ! Corporate Social Responsibility Alignment : Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. • low-income housing projects or business incubator programs. 12 Credit Evaluation
- 13. Economic Sector Index(Construction) 13 Credit Evaluation Orders Source: IHS Markit, Emirates NBD Research
- 14. Credit Terms :2/15, net 40 • This means the supplier will allow a 2% discount if paid within 15 days, or the regular payment in 40 days • Usually an incentive for the buyer to pay the Accounts payable earlier (Cash Flow issues) • Determine the discount period, percentage paid to keep the money based on a 360 Day Financial calendar year 14 Cost of Credit - Discount
- 15. Credit Terms :2/10, net 40 (Discount Offered %) x ( 360 ) 100 – Discount % Credit Period – Discount Days 2% x 360 100% - 2% 40 – 10 (2/98)% x (360/30) 0.0204 x 12.0 = 24.48% per Annum 15 Cost of Credit - Buyer
- 16. The Sales Ledger isyour record of sales revenue, and whether or not you have received the money, and how much you are still owed as recorded for each individual customer transaction. • Sales (Cash & Credit) made by date & customer A/C • Accounts Receivable (A/R) : is the amount owed to a business from its customers at a point in time • Net credit Sales : net amount of gross sales revenue on credit minus the sales returns, allowances, and discounts pertaining to the sales on credit.
- 17.
- 18. Altman’s Formula (probabilityof Default) The original Z-score formula was as follows: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5. X1 = Working Capital Total Assets Measures liquid assets in relation to the size of the company X2 = Retained Earnings Total Assets Measures profitability that reflects the company's age and earning power… Credit Risk Assessment 18
- 19. Altman’s Formula (probabilityof Default) The original Z-score formula was as follows: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5. X3 = Earnings Before Interest and Taxes Total Assets Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability Credit Risk Assessment 19
- 20. Altman’s Formula (probabilityof Default) Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X4 = Market Value of Equity Book Value of Total Liabilities Adds market dimension that can show up security price fluctuation as a possible red flag X5 = (Sales/Total Assets) Asset Turnover ratio (efficiency of using assets for revenue) Altman found that the ratio profile for the bankruptcy fell at -0.25, and non-bankruptcy at +4.48. Credit Risk Assessment 20
- 21. 21 Credit Policy A writtenpolicy (always kept current) provides a step by step approach to risk management and debt collection process. • Ensures consistent & fair credit decisions • Can be used as a performance measure by senior management of the credit department’s operations (inline with company goals) • Can be used as a training tool in policy & processes.
- 22. 22 Credit Policy –what for? ü Will a credit application be required? ü Must it be signed? If so, by who? ü Will the application include a personal guarantee? ü When must it be signed? ü Will the guarantor be required to provide personal financial statements? ü How will the creditworthiness of the guarantor be confirmed? ü What are the company's standard terms of sale?
- 23. 23 Credit Policy –what for? ü Under what circumstances will extended dating be considered? ü Who must approve requests for extended dating, and what form will this approval take? ü What is the credit manager's authority limit? ü What are the consequences of exceeding this authority limit? ü Who in management can override credit decisions? ü What form does that override take?
- 24. 24 Credit Policy –what for? • How frequently will customers be contacted about past due balances? How soon will the customers be contacted after the fact? • What is the process of dealing with uncooperative debtors? All the way to legal… • At what point may orders be placed on credit hold? Who authorizes credit holds? • Who must be informed of the credit hold? How will this notification take place? • Who can authorize an extension?
- 25. 25 Credit Policy –what for? • Who will review the information, and what constitutes an unacceptable credit risk? • Who has the authority to withdraw open account terms? • Who has the authority to place accounts for collection? • What methodology will be used to calculate bad debt reserves? • When will accounts be considered eligible for write off?
- 26. 26 Credit Policy –Dos & Don’ts Ø Share it with your sales department & senior management. Ø Do not make your policy so rigid. Must adapt to changing business conditions Ø Do establish a specific hierarchy within the credit operation. Make certain that everyone with credit granting authority knows his or her credit approval limit. Ø Do hold your subordinates accountable for disregarding credit policies and procedures without providing a written explanation
- 27. 27 Credit Policy –Dos & Don’ts Ø Update your credit policy so it does not become obsolete Ø The policy should state that the credit department is 'pro' sales. Make certain you are looking for reasons to release orders, not excuses to hold orders. Ø Do include policies and procedures intended to minimize credit risk and the potential for bad debt losses. Ø Do include instructions about how confidential information will be kept (code of conduct) Ø Do include examples of actual or potential conflicts of interest.
- 28. 28 Credit Policy –Past Due Accounts Ø Should describe the grace period before the initial call – if any… Ø Describe a specific and disciplined process for follow-up Ø Mention in detail how to address disputes and customer deductions Ø Explain the credit hold process Ø Indicate who can propose and who can accept a payment restructuring procedure
- 29. 29 Credit Limits Ø Givingthe customer what they need but at the same time protecting the organization from high credit exposure (total amount of credit risk extended to which lender is exposed incase of default by borrower)… • Bank will allow higher exposure to a lender with good credit rating but lower to one with bad ratings o Some considerable options; 1. A Credit Limit to support levels of Sales. If references and credit scores are good enough, Credit Limit = monthly sales figure x 2
- 30. 30 Credit Limits The Networth of a business is also known as its book value, or as its owners' (stockholders') equity. Net worth = Total Assets – Total Liabilities 2. Credit Limit Calculation can also be the lower of 10% Net Worth or 20% Working Capital (Working Capital is a measure of both a company's efficiency and its short-term financial health). Working Capital = Current Assets – Current Liabilities 3. Credit limit equivalent to and extended on invoice by invoice basis…
- 31. Trade Credit insuranceis a policy and a risk management product (safety net) offered by insurance companies to business entities wishing protection from loss due to credit risks like; • Payment defaults • Insolvency or Bankruptcy • Foreign Buyer risks (Forex Volatility, political unrest… Credit Risk Mitigation 31
- 32.
- 33. Letter of Credit:also referred to as a documentary credit, is a contractual agreement whereby the Issuing bank (importer’s bank), acting on behalf of its Customer (the importer or applicant), promises to make payment to the Beneficiary (exporter) through Importer’s or intermediary bank (advising/confirming) up to a stated amount, within a prescribed time limit and on receipt of “LC complying” documents. Credit Risk Mitigation 33
- 34. Exporter/Beneficiary Importer/Applicant 1.Proforma 2. LC Application 3.Notification Advising/Confirming Bank Issuing Bank 4.LC Confirmation 5. Goods Shipped 6. Original Document Flow 9. Payment Flow 7. Original Docs Flow 8. Payment Flow 10. Original Docs Flow 9. Payment Flow Letter of Credit 34
- 35. Letter of Credit: (Types) • Revocable Letter of Credit : can be void or reversed without the consent of the Exporter • Irrevocable Letter of Credit : can not be cancelled or amended without the knowledge or consent of all parties • Sight Letter of Credit : dictates that payment is made to the seller immediately after the required documents have been submitted as per stipulation • Term (Deferred Payment or Usance) LC : payment by the Confirming bank is made at a future fixed time from presentation of the documents by Exporter. • Confirmed Letter of Credit : extra commitment topped up by the confirming bank (located in Exporter’s country) in addition to that of the issuing bank to pay the Exporter 35 Procurement : Risks & Remedies
- 36. Letter of Credit: (Types) o Revolving Credit : applicable on partial deliveries of the ordered goods at specific intervals (installments shipments/ documents) o Transferable Credit : Beneficiary (Exporter) in the LC can use it as a means of paying their own suppliers or a security for payment o Standby Credit : drawn only in the event of a contractual default, including the failure of an importer to pay invoices when due. o Red Clause credit : LC with advance payment to seller for manufacturing or procuring goods stated in LC. 36 Procurement : Risks & Remedies
- 37. 37 Credit Risk Control Credit risk is managed through a framework that sets out policies and procedures covering the measurement and management of credit risk, approvals, credit exposure, monitoring and mitigation. • clearly segregating the duties between transaction originators in the businesses (sales) and approvers, collectors in the Risk function.
- 38. 38 Credit Risk Control- How a) Increase your department's participation in industry credit groups to gain additional insights about existing customers as well as potential new customers. b) Create an internal credit scoring system based on client industry, probability of default formula and submitted financials. c) Request or require that customers provide financial statements more frequently than once a year…just to be sure that debtor’s credit worthiness is still intact
- 39. 39 Credit Risk Control- How d) If you are selling to a subsidiary of a company, and the subsidiary's financial condition or payment pattern is "disturbing”, request or require the parent company to sign an inter-corporate guarantee. e) Increase the frequency of calls relating to past due balances, and eliminate grace periods before making the first of these collection calls.
- 40. 40 Credit Risk Control- How f) Insist/require/demand that your collection staff report to you any problems they encounter including: " Disconnected phones " Customers that will not accept their calls " Customers that do not return messages " Unrealistic payment commitments " An outright refusal to make a payment commitment " Customers that refuse to pay large past due balance because of small Dirham disputes.
- 41. 41 Credit Risk Control- How " Be more willing to use order holds as leverage to extract payment from a customer that has not made a payment, or even offered a reasonable payment commitment. " Consider using credit insurance to help prevent catastrophic losses - but remember that credit insurance is not a cure-all. Usually, there are a number of customer accounts for which coverage will be denied in full or in part by the credit insurance carrier.
- 42. 42 Credit Risk Control- How " Work closely with sales to determine the expected level of sales to each customer. • Work proactively to try to qualify customers for the credit limits they require - and when you are unable to extend amount of credit requested make sure that the salesperson knows both the credit limit and the reason[s] for your concern about their customers' financial health and/or payment problems.
- 43. 43 Credit Risk Control- How f) Insist/require/demand that your collection staff report to you any problems they encounter including: " If an account becomes seriously past due [for example more than 30 days past due], do not return to "business as usual" once the past due balance is paid. v This situation should automatically trigger a review of the customer account before a decision is made about whether or not to continue to offer open account terms and at what credit limit.
- 44. # What are ourdepartmental goals? Identify KRAs? A Key Result Area (KRA) is an strategic process region either internal to the organization or external, where strong positive results must be realized for the organization to achieve its strategic goal(s), and therefore, the organization's longer term vision of success… # What metrics are used to evaluate the performance of the credit department • What do we do with the results of these performance metrics? 44 Credit Department
- 45. KPIs (Key PerformanceIndicators) are quantifiable measures (metrics) against which a company defines & evaluates it’s progress towards achieving set strategic and operational goals… “You Can Only Manage What You Can Measure” 45 Credit Risk Management
- 46. Goal : Increasingcash flow! • Accounts Receivable performance indicators • How these KPIs interact with each other • What those interactions (departmental, company-wide and Customer) mean for your bottom line. Accounts Receivables : KPIs 46
- 47. Accounts Receivable TurnoverRatio (ART) measures how many times your company turns accounts receivable into cash during a period; usually over one year. ART= Net credit sales/average accounts receivable • A higher ratio means you are turning A/R into cash more frequently; if, for example, your ration is 2, you collect average A/R twice a year, every 6 months. The more frequently you are collecting, the higher your cash flow and liquidity therefore the stronger the company’s bottom-line… Accounts Receivables : KPIs
- 48. Days sales outstanding(DSO) or Average Collection Period or Days’ Sales in Receivables : is a measure of the average number of days that a company takes to collect revenue after a credit sale has been made. • This calculation shows the liquidity and efficiency of a company's collections department • Can be calculated on monthly or annual period DSO = Account Receivables x Period Total Credit Sales Accounts Receivables : KPIs Note : Accounts receivables are reported on Balance Sheet (Financial year) while Credit Sales (Revenue) on Income statement
- 49. • Standard DSO= Account Receivables x Period Total Credit Sales Ø For example (June Month), if your accounts receivable totaled AED. 20,000 but you sold AED. 10,000 on credit in a 30-day period, you are taking an average of 60 days to collect on your invoices. • Best Possible DSO = Current AR x Period Total Credit Sales Ø If your current accounts receivable is AED.3,000 and you sold AED. 10,000 on credit in a 30-day period, then your current debtors are taking an average of 9 days to pay. This should serve as a benchmark to aim for in your standard DSO. Accounts Receivables : KPIs
- 50. Average Days Delinquent(ADD) or Delinquent DSO: measures the average time from an invoice date to the date it’s paid. • Shows the average number of days your invoices are past due and will give you a good idea how well your collection efforts are working. Delinquent DSO = Standard DSO – Best Possible DSO Accounts Receivables : KPIs
- 51. Collection Effectiveness Index(CEI) : measures the % of your A/R that are closed or paid within a time period. • used to determine the quality of your collections (amounts received), not the time it takes to collect them. The nearer to 100 %, the better results you are achieving in your collection efforts. If it begins to drop, you should re-evaluate your credit policies. Accounts Receivables : KPIs Ending Total Receivables Receivables balance at end of 12-month period being reported. Ending Current Receivables Por>on of domes>c open accounts and notes not yet due as of end of 12-month period.
- 52. DSO provides insightinto collections during one point in time, usually periods of less than a year. • DSO also is a measurement of time, how long it takes for you to collect on an invoice once it is sent. CEI measures the effectiveness of your collections performance over a longer period of time. • CEI differs from DSO because it is not a measurement of time, it measure the overall quality of your collections processes. KPIs : DSO Vs. CEI
- 53. Credit Risk Management þ Identify the end goals of the department inline with the vision of the company þ Prioritize those that are achievable with available resources, in the short term but with incremental benefits þ Draw out a process flow of how to get to the goals… þ Review the approach…understand teh current state þ Make a note of those process steps that really work þ Start building a set of procedures and policy against the proven process steps.. What now?...
- 54. « Invoicing & AccountsReceivables