There is a better
way to manage your Credit Department, it just hasn’t quite been invented yet
Change is advancing upon us on all fronts, not least in respect of credit and
receivables management. The change referred to is not the sort of ripple
experienced in the past, it is a seismic wave of inconceivable power and
implications. It is the fabled 'third wave' and - as Canute the Great may
have said, when the tide washed in over his feet - “Let all know how empty and
worthless is the power of a credit manager, for there is none able to prevent
the 'tsunami of change' from sweeping away the dearly loved 'status
This article is an appeal to
Credit Professionals everywhere to mount the surfboard of innovation and ride
this wave of change at its leading edge; or be swamped on the beach. The
sandcastles of status-quo-credit-management-methodology carefully crafted day by
day will soon be swept away, despite all protestations that, 'it has always
been done this way', or 'this is the only way to do the job'.
networked economy (is) besieging the old world with the most sophisticated
weaponry ever seen.” 1 In the words of
Prof. Richard Scase, the third wave is a tidal wave … “creating a new
culture of how we do business; a new culture which is based on an
anti-business business approach,
a culture of business which is very much twenty-first century, unlike the
culture of management which we have today, which is often nineteenth century for
many businesses”. 2
Commercial Credit Management - Today
the early 21st Century commercial credit management is still very
much a mixture of art and science. It is almost exclusively focused on the day
to day micro-management of individual customer receivable accounts or individual
Financial Officers and Corporate Treasurers gaze enviously at the retail sector
(mainly credit card companies and retail banks) and long for the day when they
can sweep away their archaic, non-core credit and receivables management
can be no vision of the future, but there can and must be a vision for
the future: a new barbarian vision. A future that isn’t there yet, can't be
discovered. It is created by men and women of vision, who are faced with
the simple choice: to create their own future, or fall into somebody else’s
(and) be at the mercy of another’s whim.” 3
Commercial Credit Management – The Near Future
It is already possible and feasible for companies to outsource
most of the activities traditionally associated with in-house commercial credit
Many corporate or commercial credit managers will be
horrified to think that “credit analysis” could, indeed will be
outsourced. Most have progressed their careers based on expertise in this area,
they love financial analysis, it’s what they do well, it’s what they live
for, it’s what they are …. Hence the changes will not come easily, many will
resist, but the power driving the change will prevail.
Commercial credit managers will be
left with five main areas of activity, namely: 4
1. Developing Credit Policy.
2. Setting Credit Terms.
3. Managing Trade Finance Bank Relationships.
4. Managing Receivables Service Providers.
Working Capital Management.
This will bring a different emphasis to the job, macro-management will become more important than micro-management.
Commercial Credit Management – The
Not Too Distant Future
The new rôle for the commercial credit manager
will be at the heart of the business, managing what for many companies is their
largest single asset, the Accounts Receivable (A/R) Portfolio. 5
Credit managers may look forward to the day when
they take their rightful place on the Executive Committee, as the strategic
manager of the significant investment in Accounts Receivable, and of the risk
profile of that investment.
A/R Portfolio management tools are available, and
others will soon be invented, to enable credit managers to manage the Cost of
Capital, while providing improved transaction-by-transaction Competitive
Cost of Capital
The Cost of Capital is the average cost to a corporation of borrowed funds
(bank loans for example) and equity. In practice it is a function of the
lenders’ and investors’ perceptions of the risk inherent in the business.
In the case of any company that owns and operates a significant investment in A/R, it follows that;
· the higher the Receivable Portfolio risk, the higher the company risk profile, and
the higher the company risk profile, the higher the Cost of
A higher Cost of Capital necessarily leads to lower Total Shareholder Return;
that is poorer performance.
Thus the quality of management of the A/R Portfolio has a direct impact on
overall corporate performance. Of course the quality of management of credit
risk in relation to individual transactions also impacts corporate performance
on a cumulative basis, through its impact on gross turnover figures and bad
debts written-off. However the micro-management of customer accounts does not
have a high profile at CFO and CEO level. How many credit managers have been
promoted to Chief Financial Officer or have a place on the Executive Committee?
None, is probably the answer but that will change when credit managers raise
their status through strategic A/R Portfolio management.
New Credit Management Tools
Two essential tools are needed to make possible the effective management of A/R Portfolio risk, and the efficient provision of Competitive Advantage to the Sales Force in commercial undertakings. These tools are;
1. Trade Credit Ratings of customers, to enable Portfolio Credit Risk analysis, and
a mechanism to separate the Trade Credit Payment Risk from each
transaction or from categories of transactions, to enable the ‘sale’ and
‘trading’ of that risk to and among a large number of investors.
Trade Credit Ratings
The need is for an independent, neutral rating of a company’s ability and
willingness to pay for supplies of goods and services (Can pay? Will pay?).
The most widely known ratings that exist today (those produced by the big
three agencies; Standard & Poor’s, Moody’s and FITCH) are for the most
part designed to provide an evaluation of risks related to money market traded
instruments, such as bonds. They work well for that purpose but are not
appropriate to use in relation to trade credit.
In any event such ratings are not widely available, since they are paid for
by the company being rated, and/or they require the availability of
International Accounting Standards (IAS) compliant, audited financial
The majority of corporations do not issue debt instruments, hence have no
motivation to pay for a debt rating, and the majority of businesses do not make
their financial statements available to the public.
The Lack of Financial Statements should not be a Show-Stopper
It is clear to many experienced credit professionals that the information
available from an analysis of financial statements has very limited usefulness,
as a means of forecasting whether or not a buyer will pay for goods or services
supplied in the future. Competent management, with an effective strategy, will
make a success of a financially ‘weak’ company. However dishonest or
incompetent management will reduce even a ‘strong’ company to ruin.
The third phase of a study by von Stein and Ziegler (1984) “attempted to identify the characteristics and concrete behavioural indications that distinguish failed firms from solvent ones. The qualities found to set failed company management apart (from those in the non-failed group) were the following:
1. Being out of touch with reality.
2. Large technical knowledge but poor commercial control.
3. Great talents in salesmanship.
5. Sumptuous living and unreasonable withdrawals (of cash from the business).
6. Excessive risk-taking.
The management of solvent companies were found to be more homogeneous than
(those of) failed companies and seldom showed a lack of consciousness of
reality. The authors recommend all three components of analysis (balance sheet,
account behaviour and management) be pursued to assess a company.” 6
“Knight (1979) analysed the records of a large number of small
business failures as well as conducting interviews with key persons involved.
Knight (found that) some type of managerial incompetence accounts for almost all
Given these reports and other anecdotal evidence, it would seem that the
gathering and systematic analysis of non-financial information about buyers
could form a better basis upon which to rely when making trade credit decisions,
than pure financial analysis.
In practice today credit managers; analyse financial information with a degree of scepticism; gather payment behaviour information both internally and externally (through credit agencies or direct credit references), and make a largely intuitive assessment of management ability-honesty. This unstructured mixture of science and art then produces an individual credit decision from the alchemy of each individual’s brain - as if by magic.
New Credit Management Tool Number One
What is needed is for this process to be systematically and consistently
carried out by a neutral, independent agency; on behalf of sellers, banks and
investors at large. 7
The Basel Committee on Banking Supervision proposed in January 2001 that
External Credit Assessment Institutions (ECAIs) should be licensed to produce
such credit ratings for banks. This will enable banks to reduce the amount of
capital allocated to higher rated corporate financing, thus increasing bank Risk
Adjusted Return on Capital (RAROC). 8 With this type of motivation,
ECAIs should soon become a reality. ECAI ratings could be used by sellers and
investors, as well as banks.
Payment Risk Trading
day very soon, a salesman will call his credit manager, and ask for a credit
limit on a new account.
The credit manager will look up the quoted price for credit default protection on the new buyer, from his favourite website.
credit manager will grant a credit line with an internal credit charge of say
0.1% per shipment (0.6% / 6 shipments per year).
salesman will factor the internal charge into his quote to the customer.
goods are shipped, the credit manager will purchase credit default protection on the customer, thus hedging his
company's exposure, and transferring the
risk to the credit derivative marketplace.
that the credit manager;
will not read a credit report,
will not consult an in-house analyst, and
will not post a credit loss reserve.
the information he requires about the buyer, will be captured in the market
price for default protection.
process is breathtakingly efficient.” 9
The process described is not only “breathtakingly
efficient”, it provides a means to cover trade credit payment risk that is
flexible enough to enable dynamic
A/R Portfolio risk management.
Unfortunately Credit Derivatives
as they have been structured for use by banks and investment funds –
formalised by the International Swaps & Derivatives Association (ISDA) –
are not appropriate for use in relation to the vast majority of trade credit
(now defunct) realised this and designed a “Digital Bankruptcy Swap” to answer the
perceived shortcomings of the traditional Credit Derivative. However the market
for Digital Bankruptcy Swaps was too illiquid and narrow to meet the
requirements of commercial credit managers generally. In addition
“bankruptcy” is only one of the conditions that a commercial credit manager
seeks to protect against; “late payment” is another important negative
condition. “Late payment” was not covered by a Digital Bankruptcy Swap.
New Credit Management Tool Number Two
needed is a standardised, transferable instrument that enables the payment risk
inherent in individual trade transactions to be carried and/or traded by
participants in the capital and money markets.
‘origination of transactions’ – manufacture and marketing - could be
separated from the ‘bearing of trade credit risk’, in a way which would
enable many investors to compete to minimise the cost of carrying trade credit,
and to spread the payment risk.
The future is created through …
Commercial credit managers should
set aside time to raise their eyes from today’s transactions, to think about
what would make their jobs more meaningful, and to start inventing the future.
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Last Updated: June 28, 2018 18:15 +0100