According to the Financial Times, UK companies are failing at the fastest rate since the financial crisis.
22,109 companies were registered insolvent during 2022, a 57% increase when compared to 2021. Small business owners need to be aware of this, as it means there’s a higher risk that one of your clients could go bust.
If this happens, your business could suffer bad debt — that’s when your client can’t afford to pay their invoices and your company is forced to absorb the loss. For some businesses that are already struggling, this financial loss may be unsustainable. You might be forced to file for insolvency too.
The best way to avoid this is to manage your credit risk.
What is Credit Risk?
Credit risk measures the probability of your business experiencing a loss from a borrower's failure to repay its debts or fulfil its contractual obligations. It is sometimes called default risk or default probability.
It is usually expressed as a rating or a score. For example, Red Flag Alert rates healthy companies as gold, silver, or bronze, and companies at risk of insolvency with one, two, or three red flags.
If you assess your clients’ financial situations, you can predict which businesses are most likely to default on their obligations and limit any losses you might experience. It’s also important to regularly monitor your customers for changes to their credit risk rating.
Why should your business manage its credit risk?
Managing your credit risk will help you avoid losing money to customers who can’t pay their invoices due to financial difficulties.
Here are some benefits of managing your credit risk:
Maintain cash flow
If your clients experience financial difficulties, they may delay invoice payment. This will impact your cash flow, making it harder to meet your own financial obligations.
These could include staff wages, licence fees, materials costs, or even your own invoices.
Managing your credit risk helps you avoid these problems or plan to cover any cash flow gaps.
Avoid bad debt
If your clients become insolvent and owe you money, you are unlikely to get it back. HMRC and secured creditors like banks and company directors are all repaid first as part of the insolvency process.
Unsecured creditors — companies with outstanding invoices — will be paid last. And often, there isn’t any money left by this point.
Losing money in this way can be fatal for businesses. Companies that experience bad debt are three times more likely to go out of business within 12 months than they would normally.
Managing your credit risk won’t eliminate the possibility of this happening, but it will reduce it to an acceptable level. You can aim to keep losses to a level your business can tolerate.
Many B2B businesses rely on just one client for a large chunk of revenue. Losing this client can be catastrophic and lead to the company becoming insolvent.
Lost revenue isn’t the only issue. Replacing customers is also expensive. The average cost of acquiring a new customer can be up to £1,000.
Managing your credit risk helps you predict the likelihood of losing a customer and take preventative action. For example, you could assign more resources to prospect new customers and cover the potential loss.
Avoid losing key suppliers
It’s also a good idea to manage your supplier credit exposure levels. If a key supplier goes out of business, you may struggle to deliver goods and services. This can slow down cash flow, damage customer relationships, and even lead to the loss of clients.
Finding replacement suppliers is also time consuming and expensive. Even if you find a suitable replacement, agreeing on favourable credit terms with them can be difficult. You may end up paying more for goods and services or being forced to repay them earlier than you usually would. This will also eat into your cash flow.
Five steps for managing credit risk
Managing credit risk involves deciding what level of financial risk you are willing to tolerate. You then regularly analyse your client’s financial data to ensure they don’t pose a credit risk. You’ll also need to plan what action to take in different situations.
Here’s a brief overview of how to manage your credit risk:
1) Set your levels of credit risk tolerance
Begin by deciding how much of a loss your business can tolerate from each customer. Use this to set credit limits.
You also need to decide on a minimum financial health level, below which you will withdraw credit from a client, or refuse to provide it. Another factor to consider is whether you will accept a company with a poor credit history. These high-risk borrowers are more likely to default on their loan obligations.
Remember, the more stringent these limits are, the fewer businesses will pass your credit checks. This could stop you from working with potentially profitable clients.
2) Run credit checks
The right approach to credit risk management is to know your client’s financial position before you work with them.
The best way to do this is by using credit reference agencies like Red Flag Alert. We provide you with data and tools to perform company credit checks on more than 15 million businesses in the UK and worldwide.
You can apply your credit risk tolerance and choose to work with companies that meet those requirements.
3) Monitor customers
Once you’ve started working with customers, monitoring their financial health regularly is a good idea. This means you will know if it starts to deteriorate, giving you time to take decisive action.
Red Flag Alert allows you to set up credit risk monitoring alerts that automatically warn you as soon as a customer’s financial position drops below an acceptable threshold. This enables you to take preventative measures and protect yourself.
4) Plan preventative measures
Plan what action you will take if one of your clients presents a higher risk of insolvency.
You’re likely to take different measures depending on the situation. For example, if an established client shows a slightly heightened risk, you may monitor them more closely.
But if a relatively new business shows a very high risk, you might call in invoices or even refuse to extend credit to them.
5) Get insurance
Credit insurance allows you to receive a payout if a debtor can no longer pay. This helps your business operate normally when its cash flow is interrupted.
Understandably, credit insurers will analyse the financial condition of your customers before offering you a policy.
What happens when credit risk management goes wrong?
Unfortunately, there are many examples of companies that have fallen foul to bad debt due to the UK’s struggling economy.
Here are three recent examples:
This 60-year-old firm employed 20 people. It faced various operational problems, including increasing costs, supply issues and cash flow difficulties. The company had been a principal contractor on several large construction projects. However, its customers were unable to meet their debt obligations to the company, and it was hit with over £1 million in bad debt. The company filed for insolvency in May 2022.
This affordable housing provider employed 40 staff. However, the company faced a fall in trade, planning delays and increased supply costs, mainly due to Covid-19. Bad debt contributed to this and weakened the company’s cash flow. It filed for insolvency in early 2022.
Community Commodities Limited, Cookson & Clegg Clothing Ltd and Norton & Sons Limited
These three clothing companies were part of a group of businesses owned by fashion designer Patrick Grant. The companies suffered several trading difficulties due to the pandemic. Then they experienced significant bad debt when Debenhams went into administration in 2020. All three companies were sold out of liquidation, saving their employees’ jobs.
What How effective credit risk management can help your business
Good credit risk management does more than protect you from losses. It can help you optimise your business and improve revenues.
Below are two examples of Red Flag Alert customers who have used credit risk management to improve their business:
HIICOM is a business communications infrastructure provider. The company would start working with clients, only for those companies to be rejected by its third-party lease partners due to their poor finances.
The company lost 60% of potential clients this way, and staff were demoralised. The company wanted a way to ensure that it would only approach businesses that met the required lease criteria.
They used Red Flag Alert’s credit search facility and live data to filter out businesses that didn’t meet their criteria.
HIICOM experienced a record month as soon as it started working with Red Flag Alert. 92% of proposals were approved by their lease partners — a 52% increase on the previous month.
NSL Telecoms was founded in 1996 and provides telecoms solutions. It has many SME clients and wanted a quick and easy way to access real-time data and identify credit risk within its customer base.
We audited its data and determined what information was critical to identify credit risks. We then integrated our business intelligence into its existing CRM system.
With our help, NSL Telecoms improved revenue per client by 21%.
What to look for: Manage your credit risk with Red Flag Alert
Red Flag Alert provides real-time financial data on every business in the UK and millions of companies worldwide.
We are the UK’s only independently owned credit ratings agency. Our risk scores provide a vital early warning system, allowing you to spot credit risks amongst clients.
Red Flag Alert offers:
- Financial health data for businesses in almost every country in the world.
- A detailed rating system that predicts each business’s financial situation.
- Sophisticated scorecards that provide clear ratings.
- Data automatically sent to your CRM and updated in real-time.
- Credit risk monitoring updates provided in real-time.
- Tools to help you fulfil regulatory requirements like AML and GDPR.
Red Flag Alert is the UK's most comprehensive credit management tool. To discover how your business could benefit from Red Flag Alert's rich data set to protect and improve your decision making, request a free trial today.