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Credit Risk Analysis in Accounts Receivable: An In-Depth Guide

20 April, 2022
5 min read
Terri Miller, Director of Business Operations
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What you'll learn

  • Learn about credit risk analysis and its significance in mid-sized businesses
  • Explore the steps to perform credit risk analysis for your accounts receivable
  • Get insights into the best practices of credit risk analysis to improve cash flow
What is credit risk analysis?
How does credit risk analysis help to improve your cash flow?
How to do credit risk analysis for your accounts receivable?
Next steps: How to optimize the analysis?
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The sales team closed a huge deal—the customer made a large purchase using credit—the order was fulfilled—the payment date arrived—but the cash never reached your bank account!

What if the customer never pays back due to unforeseen circumstances? You incur heavy losses, and for small businesses or businesses that are dependent on a few customers for a majority of their sales, it could even result in the closure of operations. Credit risk analysis processes help to protect businesses from such potential losses.

With the rise of COVID-19, mid-sized businesses have transformed radically.

Statistics on bad debts in 2020 Source: Gartner

Gartner Finance Research, based on an analysis of 796 financial statements, revealed that bad debts increased by 26% in 2020. The worsening bad debt scenario demands that you conduct thorough credit risk analysis for every customer that requests credit sales.

Estimating the correct credit limits for customers is challenging, especially when the market conditions are volatile. This blog is a complete guide for credit analysts to understand the ins and outs of credit risk analysis and how to perform it accurately to reduce the chances of bad debts.

What is credit risk analysis?

A graphical representation of a credit report

Credit risk analysis is an inspection performed by the credit team of an organization to determine the customer’s ability to repay credit.

The five Cs used for credit risk analysis are: character, capacity, collateral, capital, and conditions. These parameters help assess default risks and better manage accounts receivables.

Let’s dive deeper to see how credit risk analysis helps your business.

How does credit risk analysis help to improve your cash flow?

Cash flow is the most crucial KPI for any business. Disruptions in cash flow affect day-to-day business operations and investments. Credit risk analysis helps ensure a positive cash flow by:

 1. Minimizing bad debts

Invoices might turn into bad debts if adequate measures are not taken to collect the payments. Credit risk analysis enables you to extend credit to reliable customers who are more likely to repay on time, helping you avoid the risk of bad debt.

2. Reducing DSO

Whenever there is a trend of increasing DSO within your business, you must take additional steps, including spending more resources and time to collect the payments. Credit risk analysis helps reduce the hidden operational costs of late payments by lowering the DSO. It also contributes to maintaining a positive working capital that can fund the current operations and future growth initiatives of the company.

3. Mitigating financial risks

Credit risk analysis provides greater visibility into accounts receivable forecasting. It helps your business identify high-risk customer accounts and plan strategically to tackle them. Reducing default risks can improve the financial health of your business.

4. Improving customer experience

Customer satisfaction is vital for a company’s long-term growth. Credit risk analysis enables you to onboard low-risk customers quickly and improve their overall experience. Loyal customers who pay on time also help you utilize your resources to expand your services.

How to do credit risk analysis for your accounts receivable?

Now that you know why credit risk analysis is essential for businesses, let’s explore how you can use it efficiently. There are multiple aspects to consider when conducting credit risk analysis. We’ve compiled a list of the key factors that impact your credit risk analysis based on industry best practices.

1. Assessment of unpaid invoices

The first step toward conducting an in-depth credit risk analysis is to review your customers’ past few years’ invoices. It is beneficial to understand the reasons for delayed payments. You can use the record of unpaid invoices to determine which customer is more prone to default risks or who requires additional payment guarantees. After analyzing the invoices and identifying the default risks, you can categorize the late payment trends and group customers accordingly for dunning purposes.

2. Grouping of customers

The more segmented your customer base is, the easier it is to identify and analyze high-risk profiles and focus accordingly. Thus, it is essential to group your customers based on factors such as:

  • Industry
  • Geography
  • Size of business
  • Payment guarantees
  • Percentage of your receivables the customer represents

Let’s take a scenario in which a few customers exhibit poor payment practices. After grouping customers based on their payment trends, you notice that most defaulters belong to the same industry. It makes you realize that this particular industry might be risky to do business with. You can accordingly reduce your exposure to clients from that industry or take additional precautions when dealing with them.

3. Calculation of DSO

Days sales outstanding measures the average number of days a company takes to collect payment for a sale.

You can segregate customers using this metric and analyze which segments make their payments on time and whose DSOs are higher and more prone to risks.

Calculating DSO in regular intervals helps you to:

  • Keep a check on your cash flow
  • Measure the effectiveness of your receivables
  • Keep track of how the ratio has changed over time
  • Compare the ratio with the industry average to determine whether your payment terms are more/less risky than your competitors

The formula for calculating DSO is:

Formula of calculating Days sales outstanding (DSO)

Suppose during January, Company A made a total of $500,000 in credit sales and had $350,000 in accounts receivable. There are 31 days in January, so the DSO for January would be:

AR = $350,000 , Credit Sales = $500,000 , No. of days = 31
DSO = ($350,000/$500,000) * (31) = 0.7 * 31 = 21.7 Days
DSO = 21.7 Days

4. Review of receivables aging report

Accounts receivable aging report lists the unpaid invoices and their outstanding duration.

Let’s assume a company has $250,000 in its accounts receivable. $50,000 falls under the 0-30 days aging bucket, $150,000 in the 31-60 days aging bucket, and the remaining $50,000 in the 61-90 days bucket.

An aging report gives you a more detailed breakdown of the open invoices. It reflects how long your invoices remain open as well as gives an idea of how many customers delay their payments. It also helps determine whether the current credit limits are suitable or not. If your report shows any deviation from the standard payment patterns, there might be a need to investigate the issue.

5. Periodic credit review of your customer

Periodic credit review assesses your customer’s credit profile at regular intervals. It helps refine credit scores and measure customers’ creditworthiness to decide credit limits.

A higher credit score is a good indicator of creditworthiness. Updating credit scores with periodic reviews gives you a deeper understanding of the customer’s financial health in volatile market conditions.

6. Managing deteriorating payment trends

Your accounts receivable policy should include what actions you’ll likely initiate against customers who default or pay late. Your customer must be made aware of the implications of poor payment behavior; else, they might become accustomed to paying late. Some of the potential steps you might consider to manage deteriorating payment trends are:

  • Regular dunning emails
  • Escalation notices
  • In-person visits
  • Limiting the credit facility
  • Penalties for late payments
  • Legal action

7. Calculation of accounts receivable concentration ratio

The accounts receivable concentration ratio is a metric to determine the risks associated with your accounts receivable. It helps to evaluate:

  • The number of customers who owe money
  • The amount of money owed to your business
  • Relative share of each customer in the total receivables and how that compares to an ideal situation

If the ratio of unpaid receivables to total receivables is high and closer to one, it indicates that even if one customer fails to pay, it will significantly impact your business, and there is a need to reduce it. Let’s look at how to calculate it.

Example : Let’s assume, total accounts receivable balance: $250,000

Breakdown of accounts receivable:

Company 1: $50,000

Company 2: $150,000

Company 3: $50,000

Step 1: Calculate each customer’s percentage relative to the overall accounts receivable balance:

Company 1: $50,000 / $250,000 = 20%

Company 2: $150,000 / $250,000 = 60%

Company 3: $50,000 / $250,000 = 20%

Step 2: Square the obtained percentages and convert them into decimals:

Company 1: 20% * 20% = 0.04

Company 2: 60% * 60% = 0.36

Company 3: 20% * 20% = 0.04

Step 3: Sum up the obtained squares to get the accounts receivable concentration ratio:

0.04 + 0.36 + 0.4 = 0.44

Here, the accounts receivable concentration ratio is 0.44.

This ratio is significantly more than 0.1 (ideal result). Hence, the accounts receivable is more concentrated and therefore risky.

8. Understanding customer industry

It is necessary to understand your customer’s industry well to carry out thorough credit risk analysis. Some of the factors that you should consider are:

  • Financial stability
  • Competitiveness of the industry
  • Government policies relating to the industry
  • Future growth potential
  • Current trends affecting the industry
  • Potential factors that might affect the industry in future

Once you have a thorough grasp of your customer’s industry, you may tailor your services to fit their specific requirements. It also establishes a trustworthy relationship between the customer and the company.

9. Future planning

Predictive analytics tools help you accurately forecast future events and risks associated with your actions (e.g., credit sales). This helps you better prepare your business to mitigate credit risks. Identifying doubtful accounts would help you predict bad debts and help you put in extra payment collection measures when dealing with such clients. To get a sense of your customer’s future financial health, you should also analyze their growth strategies and upcoming projects.

10. Use of technology tools

Technology solutions help optimize processes and improve efficiency. Credit risk analysis can also be streamlined with the right technology. Automation solutions help standardize the process, enable real-time monitoring, and increase the efficiency of detecting potential risks.

Advantages over traditional process :

  • Track changes in customers’ payment behavior with real-time credit risk monitoring
  • Automate periodic credit reviews and stay updated
  • Gain 360-degree process visibility with advanced reporting and analytics
  • Save time and increase productivity of the credit department by reducing manual work with automation

Next steps: How to optimize the analysis?

In this guide, we discussed various actionable strategies for reducing default risks. Conducting a thorough credit risk analysis helps improve the cash flow and reduce bad debt. But, remember to do it periodically rather than conducting it once a year to get the best results and keep up with the constant economic changes in the market.

At HighRadius, we help mid-market companies level up their credit process with the power of automation. With RadiusOne Credit Risk Application, keep a check on your receivables’ health and lower your bad debts like never before.

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