Seasonality and weather create further challenges for McCoy's. "People don't buy two-by-fours for Christmas, so in December we see some decrease in sales and we have to look for the risk in our credit portfolio there," says Neal. "And weather is always an issue in our business—hurricanes, hail storms, events like that. We have to pay attention to everything that puts our customers' receivables at risk."

Understanding the nature of both your business and your customers' businesses is a crucial first step in mitigating A/R risks. "It's important to evaluate all types of risk associated with cash flow, since accounts receivable is one of the largest sources of cash flow for most B2B companies," says Mike Kresse, chief operating officer for the receivables and payment services business at FIS.

Are you differentiating between credit and collection risk?

One of the best practices that FIS recommends to customers is to look separately at credit risk and collection risk. In this paradigm, credit risk management involves evaluating the financial viability of a customer or prospective customer, and projecting the organization's future financial stability. Credit risk managers must answer questions such as: Will this prospective customer be able to continue its operations successfully? Are any upcoming events likely to throw off its projected cash flows? And how long can we expect this customer to be doing business? "It's very important to understand these aspects of credit risk," Kresse says.

Collection risk has similar drivers, in terms of the business issues impacting customers' ability to pay, but collection risk evaluates risk to cash flow in the current period and the near future. In other words, it's the risk inherent in the invoices that are already out the door. "You have to ask: What's the risk that certain invoices that are current will become past-due, or will be in a protracted-pay situation in the next six months?" Kresse says. "By understanding which current accounts have the highest probability of going past-due in the next six months, a company knows how best to align its credit and collections resources."

Whether a company places more emphasis on credit risk or on collection risk depends on the nature of the business—in particular, on the sensitivity of the business to changes in cash flow. "You have to concern yourself with the risk of default, but also the risk of slow payments, which can have a significant impact on your cash flow," explains DS Services' Ball. "With regard to collection risk, a customer may be deemed a low risk of default, but they may become a chronic slow payer unless you stay on top of them."

Companies that have ample cash flow and have customers that run larger account balances tend to be more concerned about credit risk. For example, Future Electronics, a privately held electronics distributor with around $4 billion in annual revenue, is much more concerned about credit risk than about collection risk. "Our collection risk primarily stems from PO issues with stable companies," says Joe Prudente, vice president of worldwide credit for Future Electronics. "The price might not be right, or something else might not be right. It's a paper problem. Payment might be slow, but we're going to get paid eventually. We view collection risk as something we want to manage but something we can live with. But we're very averse to credit risk, to taking bad debt. So we go through elongated steps of credit scoring and really understanding what we're getting ourselves into with each new customer."

DS Services takes the opposite view. "Our business is in a rapidly growing industry," Ball says. "We are able to limit our exposure due to the small average open balance for our customers and our automated processes for suspending service when they don't pay."

Does your credit policy keep you awake at night?

The first line of defense in mitigating both credit risk and collection risk is to establish policies that are appropriate to the organization's business model and customer base. Top-performing companies have a thorough and well-vetted credit policy that staff can refer to in making decisions about whether and how to do business with a particular customer.

A corporate credit policy needs to define parameters for determining how the company will engage with new and existing customers. It needs to address how the company sets the credit limit for each specific customer. It also needs to establish how the company will determine which payment options and payment terms it will extend to each customer.

"The credit policy has to have well-defined rules that standardize how the company sets credit limits, as well as how they decide when to offer a customer credit under restricted terms," says Bryan DeGraw, senior director in the finance advisory services practice at The Hackett Group. "The terms may limit a customer to purchases paid by cash in advance. Or they may require payment by credit card, depending on the size and volume of transactions. Policy is critical."

For companies that work with a small number of high-volume customers, credit managers may devote substantial resources to making the right credit decision based on the risk posed by each prospect. Future Electronics pulls extensive financial information on each new customer, including financial statements, bank loan and balance information, and reports that the electronics distributor obtains from an industry group which aggregates trade references. It integrates this information into a portal-based scorecard that automatically rates a prospect's credit risk based on its financials.

"This gives our collectors and analysts a good sense of where we should be," Prudente says. "We know that for accounts with good scores, we can be a little more aggressive in granting a credit limit as a percentage of the customer's net worth." Prudente personally approves some customers' credit limits, but only when the scoring model indicates that his approval is necessary. "I don't just approve everything over some limit, like $3 million," he says. "Whether a customer requires my approval depends on the risk of the customer. If it's a poor-scoring customer, I may need to approve it down to dollar one. If it's an account with a very good score, I may give my regional managers the ability to set a $2 million or $3 million credit limit because we know there's very little credit risk."

For businesses with a much larger number of low-spending customers, the best practice is generally to make determinations of credit limits or terms based on the customer segment into which a company fits. That's how credit management works at DS Services. About 60 percent of its 1.5 million customers are commercial, and about 40 percent are residential. "We segment customers into credit score ranges, then we establish certain criteria based on those segments," Ball says.

For commercial customers, the depth of information Ball's team acquires depends on the customer segment and the requested credit limit. "Our retail and key customers buy in much larger quantities than our standard residential or commercial customer," he says. "As such, we perform a more diligent up-front credit review of these customers. With regard to our smaller commercial accounts, we're periodically looking at our mix of risk overall for our portfolio, and whether we should adjust our credit policy."

Do you have an established collection policy?

While corporate credit policy determines how the credit team evaluates, and mitigates, the initial risk posed by each customer, corporate collection policy needs to establish guidelines for the frequency with which the customer's creditworthiness is reconsidered. According to FIS' 2015 credit and collections global benchmarking study, 65 percent of companies score their portfolio less often than once per month. Infrequently evaluating customers' creditworthiness can make it difficult to monitor and manage credit risk effectively.

What should companies be doing to mitigate this risk? Companies with many low-balance customers may find that reviewing existing customers' credit once a year is adequate. But businesses that have more exposure to each customer will likely want more frequent updates.

At Future Electronics, an automated collection management system re-scores a customer's credit every time it receives new information. For example, "As soon as a public company posts its financials, the system will re-score that customer," Prudente says. "We get a ping anytime a score has changed, and we re-score our entire portfolio daily. Our analysts have access to a portal that shows the current score for each customer. We also run a quarterly report of any customer that changes by 25 percent or more. This gives us the opportunity to consider whether to change the credit limit, or to be more proactive about collections. The process effectively boils a six-figure number of customers down to a couple hundred that I need to look at each quarter."

When re-scoring a customer's collection risk, companies should take into account whether the customer's payment performance is meeting expectations on an ongoing basis. "Once you have a customer, your greatest information about how they're performing is how they are interacting with you," says Hackett's DeGraw. "The biggest shortcoming we see in organizations' credit and collections is that they perform that initial pass but don't continue to evaluate. You need to be doing ongoing credit analyses and making changes to their terms and limits when necessary."

Future Electronics also considers several economic and geopolitical factors in its credit re-scoring process. "Where a customer is based is important," Prudente says. "For example, we have a fairly large customer base in Brazil, where the real was devalued by 40 percent last year. Customers can't convert their reals to dollars in order to pay us because the valuation has changed so much, which obviously causes problems for collections. In other countries, the government doesn't allow outgoing payments. Another issue related to geography is cultural risk. In India, for instance, it's just common to pay late. We also have to look at political and cultural factors in determining whether a customer is likely to be able to refinance with their banks when their loan agreements expire.

"When you've done this for a long time, you have a good sense of whether a particular customer will be able to refinance, and whether there will be cultural issues or a problem with the currency," Prudente adds. "That's why the credit and collections staff is so important. You need a well-rounded person to make that analysis, rather than just looking at a credit score."

The goal of a corporate collection policy is to keep current as large a proportion of the portfolio as possible. Companies should make sure that their customer segmentation is appropriate, and that new customers are slotted into the right segment. They also need to make sure that their approach to collection management is appropriate for each segment. 

"You don't touch every customer in the same way," DeGraw says. "You need rules around how the collections team should manage the portfolio they've been assigned. Collections staff need to know how they're supposed to reach out, and when to escalate issues: If the friendly email or fax does not get a response, when do you actually call the customer? They also need goals. Down to the individual collector level, they need to know what their targets are for average days delinquent and percentage current. And they should be tracking payments within their own portfolio—customers' promises made versus promises kept. This all ties in with credit policy, but you need to make sure the collection policies and procedures are also in place."

One further advantage of using rules that draw on clearly defined corporate policies is that it gives credit and collections managers a guideline for making tough decisions about long-standing customers. "In 2008, we had customers who had been great customers for 10 years, but when the housing market dried up, they began to present a huge collection risk," Neal says.

To mitigate that risk, McCoy's automatically recalculates all customers' credit scores once a month. "Once they're in our system, we grade them on their average days to pay, what their gross margin is, what their sales are, and how long they've been a customer," Neal says. "We put all that into a model, and it drives our collection process the next month. Anybody whose score falls more than 10 percent is put on a watch list automatically, and we scoot their collections up." This automation enables McCoy's collections managers to maintain good relationships with customers, yet not allow those relationships to impact decision-making around necessary collections activities.

Does your team collaborate with other departments to resolve disputes?

Another aspect of the credit and collections process that requires solid policies is dispute resolution. According to the FIS market study, disputed invoices result in increased days sales outstanding (DSO), disruption to automated processes, and a negative impact on customer relationships in 89 percent of organizations. Moreover, 43 percent of respondents said this issue is exacerbated in their company because the collections team allows each dispute to hold up the entire invoice, as opposed to segregating the disputed element of the invoice and pursuing the remainder for payment.

Every company faces customer disputes over billing, and the faster those disputes can be resolved, the faster the organization will get paid. But DeGraw says The Hackett Group doesn't recommend that organizations strive to be world-class in dispute resolution.

"The goal is to work on them diligently, to reduce the volumes," he says. "Sometimes the issue is internal, sometimes it's external. Root causes don't always align with reason codes. Sometimes you'll find that the invoicing process is working right but you have breakdowns in customer data management and the customer master file that's feeding your invoice isn't accurate. It's really important to look at the process holistically, including looking at your data sources, and to make changes internally, if necessary, to reduce the volume of disputes."

Disputes and deductions affect some industries, such as retail and consumer packaged goods, more than others. For companies in these sectors, DeGraw recommends pulling together a cross-functional team to analyze where the bottlenecks are in the company's collections process. Often companies find that most of their deductions revolve around pricing. Other times they find that the problem is operational—that they're making mistakes in their shipments, for example.

"Having a well-described process for assigning, tracking, and responding to disputes and deductions is key," DeGraw says. "It's also important to have a workflow tool. Organizations that struggle in this area are trying to do things via email, and information ends up going into a black hole. Software can provide a clear path for escalation of issues, and provide access to information about how a dispute is being handled. Some applications also provide reporting, provide a look at the recurring issues so the company can take steps to drive them down."

The best practice for building an effective dispute-resolution process involves oversight by a cross-functional team. That's because functions outside of accounts receivable may have to make changes to their standard operating procedures. "You may find you're dipping into sales or dipping into operations and asking them to resolve a problem," DeGraw says. "They need to understand what disputes mean to the company overall, and to their function in particular. If you can translate the issue into dollars—into what it means to the business from cash flow and working capital perspectives—that usually gets them more interested in helping."

Another reason to involve other departments is that they may have information about the reasons for disputes that the finance and A/R teams don't have. "We capture reasons for customer disputes in three areas of our business," says DS Services' Ball. "We can gather information about short payments from remittance details when applying customer payments. We may find out about a dispute during a collection call, or our customer service team may capture a reason for non-payment when a customer calls into our new customer care center."

DS Services gathers information about disputes and deductions wherever it can. For the retail business, the company identifies reasons for deductions and tracks them systematically to target the largest offenders and aggregate trend data. Because of the small average balance of the company's invoices, a focus is placed on examining the issues at a holistic level. "We have processes to address the small individual deductions." Ball says. "But we also address the root causes through a cross-functional team—with representatives from sales, credit, finance, and operations—that looks at the top reasons for deductions, takes ownership of them functionally, and then drills down into their causes."

Is technology the glue to hold it all together?

For dispute resolution, as for all aspects of credit and collections management, workflow and documentation are key. The system at Future Electronics streamlines credit approvals and logs all A/R activity on each account. "You approve it, you reject it, or you put it to the side to look at later," Prudente says. "Approvals are online, so I can be in London, I can be in Hong Kong; I can just go back to my hotel room and do the approvals. And the system date-stamps everything, which satisfies a number of needs. It satisfies a credit insurance requirement that we annually update them on customers at a certain level. It satisfies a bank securitization program, where we use our A/R as collateral for bank loans."

At Lafarge, a leading building-material company, the credit, cash collection, and A/R policies are documented by global process owners as part of an internal control framework. "Our policies and procedures are published and accessible in our system," says Jean-Claude de Vera, Lafarge's VP of global shared service. "We have regular performance and compliance reviews with management and internal control and auditing."

Implementation of an A/R workflow product can be a great way to build documentation of corporate policies. "In configuring the software, you're recording the specifics of the company's credit, collections, dispute management, and cash application controls," says FIS' Kresse. "When you set up the system, you document your policy, and then the system essentially enforces that policy and brings to your attention any exceptions to the policy, whether through work queues or reports or dashboards."

Credit and collections automation solutions can also help a company review whether it's chosen the optimal policies. A couple of times per year, McCoy's looks back over recent credit and collections activities. "We'll go back and review why certain decisions were made," Neal says. "We have so many variables—for example, maybe we took a risk on a customer because the local manager had a relationship with the customer and we were trying to lure them away from another dealership. So we go back and look at what caused a certain account to go delinquent. Then we apply any lessons we learn through that exercise to how we make decisions going forward."

At DS Services, regular reviews led to a change in the corporate credit policy a few years ago. "Our data suggested that there was an increase in bad debt for customers with certain credit scores and indicated that we may need to increase our minimum credit requirements." Ball says. "We knew that doing this could reduce the number of new customer starts because it would require certain customers to pay deposits or cash in advance." Knowing that this decision could have ripple effects both upstream and downstream from A/R, DS Services used a collaborative approach involving other functional teams, similar to the deduction committee, and implemented the new credit thresholds only after getting input from all affected departments.

How can you take charge and develop the appropriate policies for your business?

Establishing the right policies is key to mitigating A/R risk. The following best practices can help a company take credit and collections to the next level:

Know your business.  First, creators of A/R policies need to understand the business inside and out. They need to understand the company's goals and objectives, as well as its overall level of risk tolerance. Policies that are too stringent may limit the company's ability to close sales. On the other hand, policies that are too lenient will lead to the company unintentionally providing financing to customers.

A/R decision-makers also need a solid understanding of the company's customer base. For one thing, they need to establish where they draw the line between a customer that is considered a slow payer (but still a payer) and a customer that has gone bad and needs to be written off. For another, they should understand the industries in which their customers operate.

"You really have to be intimate with your customers and the industries they play in," DeGraw says. "Are they part of the same supply chain that you work in? Or do they actually touch and work with other customers? You really need to understand the full dynamics of that supply chain in order to understand what your potential risk is and how your policies need to align with that."

Lafarge's de Vera adds: "In credit management, the one major component is what industry you're in. In the construction industry, we use specific account analysis, mostly based on the market segmentation of our customers. For example, the risk is very different when you are talking about commercial projects versus when you're talking about government projects. On commercial projects, you likely face both credit risk and collection risk. On the government side, your credit risk is usually low, but your collection risk is fairly high because it's not unlikely that you will be paid late. We need to adapt our policy to the types of customers and the country where we're operating."

Build sophisticated models.  Developing credit-scoring models is a crucial step in the development of effective credit and collections policies. Models associated with new customer selection should incorporate data from credit bureaus; financial statements, especially for customers that are privately held companies; and the customer's payment behavior with other companies, if that information is available. Models designed to evaluate collection risk of existing customers should emphasize the customer's payment behavior with the company doing the scoring.

Using this information, the models should provide recommendations to credit and collections managers about the credit limit, terms, and payment options to offer each customer and prospective customer. Credit-scoring models need to provide a solid foundation for credit and collections decision-making, but they also need to be dynamic, to change as the market environment changes.

Companies that want to take their A/R analysis a step further can incorporate statistical modeling into their process. Statistical modeling leverages existing payment behavior data and analyzes the effects of the behavior patterns on payment habits. It can then predict payment performance of a current customer based on how customers with similar characteristics have performed over time. Companies can use this information to assign a precise collection-risk score to each of their customers, then use that score to prioritize the collections team's contact list and to determine what types of activities they should engage in with each customer. 

Sophisticated companies push this customer segmentation even further, prioritizing collections activities based not only on the probability of delinquency, as determined by collection-risk scores, but also on the amount of cash at risk with each customer. "Cash at risk" is simply the probability of delinquency multiplied by the dollar value of outstanding invoices.

Suppose a supplier has two customers with unpaid invoices that are a few days past their due date. Customer A owes $30,000, and its collection-risk score indicates an 80 percent probability that the invoice will pass 30 days past-due, so the supplier's cash at risk with this customer is $24,000 ($30,000 × 80%). Now, suppose Customer B owes the same supplier $90,000, but its collection-risk score gives it only a 5 percent probability of becoming 30 days past-due. The supplier's cash at risk with Customer B is only $4,500 ($90,000 × 5%). The company certainly should proceed with collection activities on both customers, but to get the most out of its limited resources, it will want to prioritize and collect differently from Customer A than from Customer B. 

"Statistical modeling, especially on the collection risk piece, gives a company a huge advantage in becoming as effective and efficient as possible," says FIS' Kresse. "It's a best practice and something we're encouraging our customers and prospects to consider. If 80 percent of your A/R risk lies within 20 percent of your portfolio, as it does for many companies, you want to be as effective and efficient as possible in mitigating that risk. It's all about mitigating risk, and we believe that true behavioral models allow you to do that in the most effective way."

Implement predictive analytics.  Many leading companies are building models of customer payment performance that incorporate predictive analytics. They predict changes to the customer's industry, or to other factors influencing the company's customer segments. "A lot of times that will identify some interesting dynamics, that a customer you believe is OK right now could potentially go bad on you in six months," DeGraw says.

"In order to put predictive analytics into your model, you have to define what a bad risk looks like to you," he adds. "Is 'bad' being 60 days past-due? Is 'bad' being X dollars over the limit? A combination of both? That's what you put into the model, and it's going to look at your portfolio and make predictions of which customers will potentially hit your 'bad' criteria in a certain time frame."

Get the credit and collections function involved early in sales.  The Hackett Group's research has shown that 43 percent of organizations don't get their credit and collections team involved in a sale until after the formal order is received. "What's interesting is that within organizations which said the credit function is involved in transactions at the proposal development or pricing stage, the average days delinquent metric was five days better, on average," DeGraw says. "So the percentage of current receivables was better when credit was involved sooner."

At Future Electronics, credit and collections managers do get involved early in sales. "We're involved in the up-front," Prudente says. "Every customer and prospective customer has a credit limit. If the credit limit won't support an order, then our marketing organization won't book the order. Someone will come to us and say, 'Hey, we just got this million-dollar order for a customer with a $5,000 credit limit. The watermelon won't fit through the garden hose. What can we do?' We'll give them some direction on our appetite, which will inform how they proceed with the sale."

At DS Services, by contrast, the credit team may not get involved on certain transactions until a sale looks likely to go through. "We like to make sure there is a real opportunity to secure the business so that we don't have to acquire a credit report for every prospect, which could be costly." Ball says. "At the same time, we don't want to get involved so late that we run the risk of rejecting an opportunity that has already consumed company time and resources." Properly timing credit managers' involvement requires a clear understanding of the company's A/R goals.

Be collaborative. Credit and collections should not operate in a silo, either before or after a prospect has been established as a customer with a specific credit limit. "Your policy on disputes impacts your sales process, how you apply cash, and your collections activity. You can't look at any of these individual cycles in a vacuum," says FIS' Kresse.

At McCoy's, the credit and collections team supports sales efforts by reducing the chance that an existing customer will become delinquent. "Our salespeople and our stores will get notifications on their cell phones five days before they become past-due so that they can go out and make a call," Neal says. "We don't want a customer getting denied because he's over his credit limit. We want to be proactive, so we try to push that information to the salespeople, so they are alerted in advance of anything that could possibly stop a sale."

Credit teams can also work with sales to identify opportunities for current customers to increase the volume of business they do with the organization. "This is something that isn't really utilized enough," Kresse says. "If credit is sitting on information about customers' unused credit lines, they can collaborate with sales and marketing to understand which segments of the portfolio have the most potential because they have untapped credit. This is one example of the benefits a company can achieve by understanding how to extend the credit and collections footprint into other areas of the business."

Lafarge's de Vera suggests integrating A/R with other customer-facing groups as well. "You need to integrate with customer relationship management, to get information on what is happening on the customer side," he says. "Information gathered in meetings with customers can fuel the A/R risk analysis. This accelerates cycle times for correcting disputes. When the process is smooth end-to-end, cash may be collected more rapidly, and the company will do more business."

De Vera also recommends connecting credit and collections staff with continuous process improvement. "When we have disputes, we get the continuous process improvement team involved," he says. "We look at whether the issues coming from the customer are real problems. If there are issues regarding the delivery itself, the team can embark on fixing them."

How can A/R be more strategic?

Companies that fully optimize their accounts receivable processes can achieve a host of benefits beyond reducing the length of the order-to-cash cycle. One benefit is improved cash forecasting.

McCoy's rolls information from its credit and collections system up into its cash forecasting model. "Data from our credit and collections system is integrated with our payables system," Neal says. "It's integrated with our distribution of dividends. Some of our payments to vendors are due in the middle of the month, and the checks going out may be in the millions of dollars. We really want to make sure we're hitting our cash flow forecasts so we know where to borrow, and having that credit side to the predictive cash flow is huge."

At DS Services, cash flows are a little more predictable, but tying together all the different aspects of the order-to-cash process has improved both the effectiveness of the credit and collections function and the visibility of the function within the company overall. "I've worked in the role for several organizations, and I've never seen an A/R team that is so integrated with other customer-facing roles," Ball says. "At DS Services, credit and collections is not a back-office function. From our key customer care group all the way to the application of cash, and everything in between, we're a cohesive function and we have a seat at the table in most of the company's strategic discussions."

The A/R team at Future Electronics has achieved a similar level of strategic responsibility, thanks to a creative financing option the company has begun offering customers. "As an electronics distributor, what we sell is essentially the same as what other electronics distributors are offering," Prudente says. "What you buy from us, you can typically also buy from our competitors. So one way we've tried to differentiate ourselves is by offering extended payment terms to certain customers. If we need to, we will finance that by using our A/R as collateral on our bank loans or securitization agreements."

The fact that the program is successful, and is integral to keeping the company competitive, has raised the profile of the A/R function. "When I started my career in credit over 30 years ago, vice presidents of credit or collections were few and far between," Prudente says. "Now my title is vice president of worldwide credit, and the credit and collections team at Future Electronics is highly integrated into the leadership decision-making of the company. When senior management is making strategic decisions, we're brought to the table and asked, 'Can we do this? Can we not do this?' In years past, that was not the case."

About FIS

FIS is a global leader in financial services technology. Through the depth and breadth of our solutions portfolio, global capabilities and domain expertise, FIS serves more than 20,000 clients in over 130 countries. Headquartered in Jacksonville, Florida, FIS employs more than 55,000 people worldwide and holds leadership positions in payment processing, financial software and banking solutions. Providing software, services and outsourcing of the technology that empowers the financial world, FIS is a Fortune 500 company and is a member of Standard & Poor's 500® Index. For more information about FIS, visit www.fisglobal.com or email [email protected].

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