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Relationships at Risk – How much tolerance is too much?

When it comes to credit risk, trusted business relationships can turn sour if trading partners don’t pay attention to warning signs and react in time.

Risks and Rewards

From the very beginning, there are many things business owners must learn to be successful. One some may find surprising, and risky, is the need and importance of building personal relationships with customers and vendors.

Once a business gets going, it’s easy to fall back on the solidity of early customers; but what happens when one or more of these trusted relationships get into trouble and a customer can’t meet its obligations?

How long should business owners keep the trust and let an account slide for the sake of the relationship? How do they determine if the risks are outweighing the rewards and it’s time to cut a longtime customer loose?

Defining customers and risk

To begin with, it’s useful to define the term customer. It may sound simple, but it’s actually a complex question depending on the nature of the business.

Primarily, of course, in any public-facing or client-based business, customers are just that: the people who buy directly from a company—members or consumers or whoever purchases the goods or services.

Just as important, however, is customers can be partners and investors, employees, and—crucially, when it comes to calculating credit risk—vendors, consultants, and suppliers.

Simply paying for these services isn’t enough to build a personal relationship, just as a strong relationship is no substitute for a reliable vendor who delivers on time every time.

Next is defining credit risk. Briefly, it can be defined as loss, or the possibility of loss, resulting from a debtor’s failure to meet a payment, repay a loan, or fulfill the terms of a contract.

Credit risk can cause problems with cash flow, and tend to spiral out of control. A major default or failure to pay by a customer or vendor can then put its trading partners at risk, making them a liability to their own creditors, partners, or lenders.

Good Credit Risks

Credit and debt are the bedrock of the economy, and it’s simply not feasible for any business to operate without them. Making smart decisions about credit risk doesn’t mean avoiding it altogether; properly assessing risk can actually provide a number of benefits.

Banks and other lenders look at credit utilization—the way debt is used, not just the overall amount—to calculate risk and determine future lending. While too much credit utilization is bad, none at all is a warning sign as well.

Generally speaking, using more than 30 percent of available credit signals problems with debt-to-income ratios, but zero percent utilization can suggest defunct or inactive accounts.

Determining creditworthiness

When determining the creditworthiness of a partner, customer, or vendor, consider using the “Five Cs” used by most lenders: capital (the degree of investment, earnings, and assets controlled by the customer), capacity (the customer’s debt-to-income ratio), conditions (the specific terms of financial obligations), collateral (what is pledged as security against accounts), and character (includes history, reputation, and relationships).

It’s the last of these that can so often cause problems for a business owner. If a vendor is regarded as having good character, with a reliable history of on-time payments and a reputation for fair trading practices, it can be difficult to see past previous experiences to make a reasonable determination about future risk. When a longtime personal relationship is part of the mix, it becomes even more complicated when something has gone awry.

Still, making the right call can be invaluable. Reliable, well performing customer relationships are a boon to cash flow and are reflected in the bottom line—which makes a business more attractive to other partners and lenders, providing access to more financial opportunities and the ability to be flexible when needed.

Good, solid relationships with customers will not only provide both tangible and intangible benefits on a regular basis, but also make dealing with any difficult situations that may arise much easier.

Bad Credit Risks

Poor-performing customers can be as much of a hindrance to business as well-performing ones are a benefit.

Credit risk can vary widely depending on the type of product or service and the nature of the business, as well as many other factors, and can be as much an art as a science. It should be thought of as dynamic rather than static, is always a primary threat to financial stability, and can be measured in almost every form of income-producing activity in which a business participates.

There are obviously definitive and set costs to defaults on credit. They cause major disruptions in cash flow, the primary cause of a stunning 82 percent of small business failures.

One company’s failure to pay may affect numerous trading partners within the supply chain, with a domino effect on credit risk and ratings. This can be particularly devastating during uncertain financial times when lenders feel the need to tighten their belts and restrict lending.

During the Covid-19 pandemic, many banks lowered interest rates, but also raised the bar on who qualified for lending, loan extensions, lines of credit, and other avenues for growth. Businesses with negative credit items were the first to feel the pinch.

But it’s not just these factors that make bad credit risks a threat. “Soft costs”—such as the time spent on resolving disputes and disagreements with customers and the paperwork, labor, and hours involved in chasing down debts—can pile up, meaning a company is throwing good money after bad.

The time spent on collections and the navigation of bad debt is time away from focusing on other tasks and projects like building a business or expanding its customer base.

Warning Signs

Aside from the obvious signs of a bill coming due and no payment being made, there are many ways to tell if a customer is in trouble or represents a serious credit risk.

Slow pay rate

The clearest sign of treacherous waters ahead is also the simplest: taking too long to pay bills. It could be for any number of reasons, but in the end, when a customer’s credit rating suffers, so do its partners.

Being inattentive to pay patterns could result in a customer going under and taking others with it. Less dire, though still problematic, is a failing customer’s losses hindering others’ ability to stabilize and generate new business.

Fluctuating orders

It may seem obvious, but any customer that can’t pay for what it has already purchased is less likely to purchase anything else. If the reverse is true, then there’s real trouble ahead.

Ordinarily, if a customer begins to falter and is unable to pay its accounts, there’s usually a slow but steady decrease in orders reflecting its inability to finance future purchases. When fewer shipments are going out, less revenue is coming in and so begins a downward spiral.

If, on the other hand, the struggling customers continues to place orders in an attempt to shore up its own accounts receivable, with making payments to its suppliers, then it is knowingly creating risk and could take trading partners down with it.

Poor communication

No one likes to admit when a business is going through a difficult period, but silence may be more telling than words. If a customer doesn’t check in as often as in the past, or if communications are evasive or curt, it may be an avoidance to discuss difficulties, financial or otherwise.

When the lack of communication extends to the sale of product or services, both parties and their trading partners will begin to feel the pinch and is a sure sign something is wrong.

Broken promises

Many business relationships, especially in the early stages, are built on trust—and a lack of trust can be fatal to those same relationships.

Giving trusted clients the benefit of the doubt when it comes to pay can yield dividends in the long run, if the business is just running into temporary issues. But repeated pledges to pay that are broken or renegotiated, along with scant communication, are a sure sign it’s time to reconsider the risk factors.

Cutting the Cord

It can be enormously difficult, especially for smaller businesses in industries based on relationships and trust, to make the decision to cut loose a customer whose credit risk has soared.

It’s not a decision that should be made lightly or casually, but once made, it should be firm and straightforward to protect the business interests of everyone involved. After all, the income and creditworthiness of the company owed money are at stake too.

Before making a final decision, however, it’s best to be forthright and open with the poor-performing customer: communicate clearly and directly on the nature of the problem, making expectations clear. Of course, all communications should be polite, firm, and avoid judgment or unprofessional language, with a focus on setting definitive next steps.

If there are significant receivables, exhaust all options for collection. To preserve the relationship, try to work things out as directly as possible. If this is no longer possible, then pursuing more formal options or legal action are the next step.

While these alternatives should be a last resort, they are a useful tool, especially to prevent the same actions being taken on the company owned money.

Before sending an email or letter, or making a last resort phone call, it can be useful to prepare a script to stay the course and not get lost in irrelevancies or distractions. And if the relationship is severed, there is much more work ahead.

Reevaluating processes

For a company on the losing end of receivables, it may be time to reevaluate the methods used for determining customer creditworthiness. Examine how this determination was made in the past, and unearth any flaws in the process that left the company vulnerable.

When it comes to replacing the lost customer, a return to the basics—such as using the many readily available and often inexpensive tools for determining a customer’s credit risk—is a good place to start. Asking for and thoroughly vetting references is another frequently overlooked practice.

Another step is to measure internal costs by evaluating the customer acquisition process and a prospective customer’s lifetime value. Performing a cost-to-serve analysis can help determine the total expenditures involved in gaining a new customer, as well as the planning, sourcing, delivery, returns, and any other aspects involved. Of course, this may vary from customer to customer depending on the nature of the business.

But don’t neglect the opportunity to build volume with existing, well paying customers. According to the 2015 book Marketing Metrics: The Manager’s Guide to Measuring Marketing Performance, businesses have a success rate of 5 to 20 percent when selling their products or services to new customers, but a 60 to 70 percent rate when selling to existing customers.

Conclusion

While dealing with troubled or nonpaying customer can be difficult and costly, it should be remembered that no relationship is unsalvageable. Determining the worth of a customer should be judged by a number of factors, including any personal relationships.

Ultimately, if a poor-performing customer has the potential to damage your own business, it’s crucial to know when the risk has gone from marginal to toxic, regardless of the personal relationships involved.

Remember, too, that while credit risk is a paramount factor in deciding whether or not to end a customer relationship, there is more to it than cash flow. Problematic trading partners can cost time as well as money, and accommodating difficult customers that aren’t paying is a recipe for disaster.  Many business owners tend to think success is measured by the total number of customers, but a customer that demands more than it is willing to give is a net loss, not a net gain.

Finally, remember that the best time to deal with potentially risky customers is before entering into a relationship. Calculate the tolerance of risk, reevaluate frequently, and make expectations clear.

And when it comes to the risks associated with longtime customers that appear to be struggling, open, honest, and frequent communication will be best for the relationship, on both sides.