Recently, a credit manager at one of our clients called me about a customer that had become something of a dilemma.
For the last three years, the customer had been submitting orders between $40,000 and $60,000, which fit comfortably within the customer’s $60,000 credit limit. Payments generally arrived between 5 and 14 days after the net 30-day due date. Not perfect, perhaps, but certainly manageable.
Then things began to change.
The customer’s business had been growing, and orders had been increasing dramatically, sometimes reaching two or three times their previous levels. Unfortunately, payment performance didn’t keep pace. The accounts receivable balance continued to climb, and some invoices began approaching 60 days past due.
The credit manager faced a situation many credit professionals will recognize. This was a good customer generating substantial business and nobody wanted to jeopardize the relationship by cutting off credit. At the same time, continuing to allow the receivable to grow was becoming increasingly difficult to justify.
They considered several alternatives, including trade credit insurance and non-recourse factoring. For various reasons, however, none provided quite the solution they needed.
So, my client and their customer came up with an unusual idea of their own.
With each new purchase, the customer would pay an additional 10% that would be placed into a separately tracked risk reserve. For example, a $100,000 purchase would require an additional $10,000 contribution to the reserve.
As additional invoices were paid, the reserve would gradually grow. Assuming everything went well, the parties could later agree to leave the reserve in place, return some or all of it to the customer, or modify the arrangement as circumstances changed.
It wasn’t credit insurance in the traditional sense. Rather, the two companies were essentially creating their own financial safety net.
I thought it was a creative solution, but I also cautioned my client that the existence of a reserve should never become an excuse to allow the receivable to grow unchecked.
First, I recommended that the customer bring the existing past-due balance current before beginning the new arrangement. Whenever possible, it is better to start a new credit structure with a clean slate rather than carrying yesterday’s problems into tomorrow’s solution.
Second, we discussed establishing firm limits on the total accounts receivable exposure. A customer purchasing $100,000 a month can quickly create a much larger exposure when invoices aren’t being paid according to terms.
Third, I emphasized that the reserve itself would take time to accumulate. If the customer suddenly defaulted after only a few months, the money in the reserve might cover only a small portion of the outstanding receivable.
That leads to what I think is the most important lesson from this story:
A safety net should reduce your risk — not give you permission to take more of it.
A reserve like this should complement the fundamentals of good credit management, not replace them. Credit limits still matter, payment trends still matter, and financial information still matters. And when a customer that historically paid 10 days late suddenly starts paying 30, 45 or 60 days late, that change deserves attention regardless of how valuable the customer may be.
Any company considering a similar arrangement should also have its legal and accounting advisers review how the reserve is documented, accounted for and ultimately returned or applied. Both parties need to understand exactly how the arrangement works before the first dollar goes into it.
There are times when saying “no” to additional credit is absolutely the right decision. But there are also situations in which a good customer is worth working with, provided you can find a reasonable way to manage the additional risk.
Good credit management isn’t always about deciding whether to say yes or no.
Sometimes the real challenge is figuring out how to say yes and do it safely.
Your thoughts and comments (nseiverd@cmiweb.com) are most welcome!
Nancy Seiverd, President
CMI Credit Mediators, Inc.
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