Measuring Bad Debt with Predictive Credit Scoring Improves Debt Recovery

When you trade on credit with international customers the risk of non-payment increases. Several factors affect your customers ability to pay you on time. So, you must ensure you adopt all possible tools and means to prevent delinquency and bad debts. One of these is credit scoring.

 

With the support of statistical modelling, credit scoring helps predict future customers payment. By focusing on higher risk non-payers, you can minimise the amount of outstanding receivables. Once you addressed those late payers, you can move on to chase the bad debtors.

 

Credit Risk Assessment

 

To make a credit decision you need to know your buyer as much as you can. You want to be sure to sell as much as possible while minimising non-payment risk.

 

You are in business to your support sales, not financing your customers!

 

That’s the reason why extending credit is a tactful exercise. You must find the right balance of desired benefits against your risk tolerance. Remember that you also have to pay your own suppliers. That is managing receivables and payables.

 

But, other factors are important, for example Country and Currency risk.

 

So, what are the steps your company takes to gather all the relevant information?

 

In general, you should collect information from your customer. For example, requesting trade references, bank information and financial statements. It’s also good to be in contact to know them. You can gather information to understand who they are, how they run their business. Better if you meet them in person.

 

But that’s not enough.

 

You also want to gather other information from reliable sources. For example country risk and currency risk. For these, you use credit reporting agencies and international institutions such as OECD.

 

Yet, if you have customers in several countries this becomes very challenging and time consuming. Automating your credit limit approval would be critical. This would speed up the approval of a repeat order.

 

And it’s here where predictive credit scoring solutions come to help!

 

Industry Developments

 

If until now your customer risk assessment used past experience and your own judgement, today technology accelerates these processes.

 

There are several benefits in using software solutions, such as order processing and receivables management automation. The CICM website provides an interesting study on these benefits to credit departments operations. Among others, cash flow improvements and reduction in unpaid invoices are some of the most important.

 

Yet, one of the most attractive is predictive credit scoring.  This solution helps you extract more information about your customers in less time. It classifies them and reduce your exposure to risk and it’s fully automated.

 

At the same time, you have the freedom to use your own judgement for higher level decisions and checks.

 

What is Predictive Credit Scoring?

 

Your goal is to predict non-payment risk with the highest possible accuracy.

 

Predictive scoring uses a scoring model method to find out this risk about customers. For example, a credit scoring model will identify risk checking on:

 

  •  your customers payment behaviour (to you, your competitors and suppliers)
  •  business age
  •  financial ratios
  •  business sector and industry conditions
  •  inventory, proceedings, judgements

 

Which levels of your customers’ receivables collection period do you consider acceptable? Their inventory levels?

 

Business Credit Scoring Risk Factors

These are factors influencing your model design.

 

But what is your method to assess a bad payer?

 

You may have set that the maximum number of days you are ready to tolerate late payments for is 30, 60 or 90. Or even 120.

 

Then the question becomes:

 

What is your definition of bad debt?

 

Predictive credit scoring helps you focus on those customers having higher risk of becoming delinquent. That is, the probability of not paying you in the future.


You are in business to your support sales, not financing your customers! Click To Tweet

Thus, you are no longer chasing accounts based on age, past due date or amount. The statistical modelling creates classes of risk and help you adjust your credit extension and collections strategy. You will be focusing on those accounts that matter most for your cash flow and prevent delinquency.

 

Credit Scoring Makes Your Internal Data Work For You

 

You can now access large quantities of data at very low cost. As we saw, you have external and internal data.

 

From external sources you get credit rating reports, for instance. From internal ones you retrieve your customers’ past payment behaviour. You usually need around 18-24 months worth of data, at least. The combination of these two help you produce a predictive score.  In turn, this score helps you in the decision to extending credit to customers.

 

What about new customers?

 

If you have to grant new credit, you can only rely on reports and ratings supplied from an international trade agency. This helps you assess the risk whether you should approve a first order or not.

 

But, all the above is an intensive work and uses lots of resources that slows things down. And for new customers, these sources may not be reliable all the times.

 

Why You Should Use Credit Scoring?

 

Technology is now available to small businesses too and its cost has also come down. If in the past forward thinking small firms had wanted to innovate, now there are no more excuses. You can also afford a credit risk scoring solution.

 

Instead of collecting data, you can now focus on credit decisions only. You can automate low level, repetitive tasks and push forward to collecting.

 

Is it only a matter of preventing risk?

 

Not at all. You can improve your sales by reducing attrition due to slow credit approvals. Imagine your customer waiting for you to approve a credit extension. You could also give them better pricing because you assessed risk in no time. This is because your risk scoring solution did the job for you and you are only left with making a decision.

 

Identifying Bad Debt With Credit Scoring

 

How do you account for losses during the year?

 

One way is to create a bad debt reserve. This accounts for losses predicted according to past customer payment behaviour. So, if last year you lost 5% of receivables payments, you may want to create a reserve of the same level this year.

 

However, this should not just be a task of setting a percentage. Your credit policy procedures should tell you to run a periodic review of customers’ credit application. This is because market conditions, customer finances and operations change all the time.

 

So, the information you have in hand right now may not reflect the current state of things. It’s a way to assess risk and credit lines. All the above needs intensive manual work within your credit department. If you are a small exporter this may take a huge amount of time.

 

If you translate this in automated scoring of each account, you can free up your credit analysts time. They can focus on exceptional events that need an immediate re-evaluation.

 

Yet, you can identify bad debts with more accuracy and on time. Changes in customers conditions may help identify troubles ahead. It’s not a surprise that the same factors used in credit risk scoring apply for identifying bad debts.

 

For example, requesting financial statements may bring to light bad news. You may discover increasing risk of delinquency from your customer’s clients. Your customer may also have one or the combination of:

 

– increased levels of inventory

– showing deterioration of cash

– longer receivables collection periods

 

With predictive scoring, all the above can be immediately identified for immediate counter-actions.

 

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Measuring Bad Debt

 

So, what do we mean by measuring bad debt?

 

Having a bad debt reserve helps you with accounting for losses. But, deploying your credit scoring solution in the company reduces your past-due receivables. When your collectors cannot push further, your remaining delinquent accounts are bad debts.

 

Let’s look at TWO hypothetical customers.

 

The first customer’s account shows a 30-day past due invoice for $40,000 with a score of 5%. This means that the risk score value is $2,000.

 

The second customer’s account shows a 20-day past due invoice for $15,000 with a score of 40%. Its risk score value is then $6,000.

 

The age-based collection approach would prioritise the first customer. But, it’s evident that this customer is at lower risk than the second . Conversely, with your predictive scoring solution the collector will call the second customer first.

 

This way you can focus on those accounts that are going to give you headaches if you don’t deal with them right now.

 

But, what about those aging accounts with lower risk?

 

Let’s assume you collected 95% of your accounts so far. Your bad debt reserve is set to 5%. Using credit scoring you identify that the 3% are higher risk accounts. You then collect 80% of the outstanding receivables. That leaves you a 2% lower risk accounts still to deal with. Say you collect 50% of them.

 

Doing some math you are now left with (0.6 + 1.0) = 1.6% of past-due accounts to collect. This 1,6% may still be a relevant amount. If your overall receivables for the period are $ 1,000,000, here you are about to lose collecting $ 16,000 worth of sales.

 

You may say you managed to stay well within your bad debt allowance. But, wait a moment. By definition bad debt represents a company expense and it reduces your profit.

 

You most likely need financing to manufacture your goods/rendering your services. Plus, you have taxes and expenses to account for.

 

What would you be able to pay with those $16,000?

 

Increasing Bad Debt Recovery

 

If your sales net profit is say 7% and financing costs you 6%, carrying outstanding receivables will prove costly. Your profit margin shrinks and cash flow is reduced.

 

Let’s take an example from the NACM/FCIB credit risk management intelligence:

 

How interest may affect net profit

 

You can see that interest will eat up your profits over a few months period. If you’re still not convinced, check this.

 

You’re about to give up collecting your $ 16,000 because you’re happy you managed to collect 68% of your expected bad debt. Fine.

 

Check this:

 

$ 16,000 loss

$ 1,120 loss of net profit

$ 16,000 / 12 = $1,333 total loss to recover

$ 10,000 your average order

$ 700 net profit on average order

 

So:

 

1,120 / 700 = 1.6 sales you need to make to recover just your lost net profit

 

That’s not all.

 

Example on how interest may affect net profit

 

You can see that you not only missed cashing $ 1,120. You also lost $ 700 of your profits because of interest payments. Total $ 1,870.

 

In summary credit scoring helps you filter out the bad customers. What you are left with those who don’t and won’t pay.

 

You have improved your collections efficiency and rates. Now, it’s time to chase and collect those remaining accounts. If you want to further reduce your losses the only option is to outsource your bad files to a debt collection agency.

 

You will make sure you show your bad payers you are serious about your money. It doesn’t matter if you intend to continue to do business with them or not. If you don’t, you’ll recover your money. If you do, you’ll recover your money and your debtors will come back and do business with you. The latter will only happen if you hire a professional and licensed collection agency.

 

Conclusions

 

We all see how credit scoring has been instrumental to the growth of the consumer credit industry. Hundreds of billions dollars of credit are approved every year in major economies around the world.  The same can and will happen in the future for the commercial sector. Companies adopting automated credit scoring solutions will improve efficiency, credit approval times and decision making.

 

We also know that small business and exporters need to optimise their operations to ensure growth domestically and internationally. And the adoption of credit scoring solutions is an opportunity not to miss.

 

Improvements in customer experience will increase sales and convertion rates and make the difference in highly competitive industries.

 

As we discussed, credit scoring reduces delinquency but bad debts still represent a major obstacle to growth, and they do occur. Persisting in the recovery of bad debts you can further reduce losses and virtually achieve 100% payments. Thus, have a plan for even the smallest of bad debts. It’s still your money out there.

 

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This article contains general legal information and material for informational purposes only which are not intended and should not be taken as legal advice. Recoupera is not a collection agency and it is not a law firm or a substitute for an attorney or law firm. All informational material provided may not reflect changes in the law. For legal advice, contact a lawyer.

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