Magazine article Business Credit

Credit Decision-Making, Long-Term Profitability and Strategic Goals

Magazine article Business Credit

Credit Decision-Making, Long-Term Profitability and Strategic Goals

Article excerpt

Risk is a measure of the degree of uncertainty inherent in a decision. In credit risk management, it is the uncertainty inherent in each credit decision. In this context, uncertainty can be broadly described as the risk of either slow payment or no payment. Credit managers must weigh potential rewards against potential risks.

In a sense, the amount of risk in any individual credit decision can be measured at least in part by the courage required to make that decision. In many credit situations, measuring the relationship between risk and reward is difficult, and decision-makers recognize the uncertainty inherent in such decisions. Credit professionals need to correctly gauge their employer's sensitivity to the possibility the decision made will result in a financial loss.

In credit risk management, when credit or risk managers come to a fork in the road in which they must make a credit decision, they have to go one way or the other. The question is how to make the right decision at that point. Of course, a number of factors influence the credit decisions being made. In each company, the relative importance of each of these factors is different. The factors that influence what is and what is not an appropriate decision for the creditor company include (but are not limited to):

* The competitive business environment

* (Payment) terms offered by competitors

* Competitor company's credit policy and tolerance for uncertainty and risk

* Demand for the creditor company's goods and services

* General business conditions

* The level of bad debt reserves

* The amount of bad debt losses experienced

* Inventory levels at the creditor company

* The creditor company's profit margin

* The creditor company's market share goals and strategies

However, these factors alone or in combination do not address the overarching question--how does the credit decision-maker go about making the tough calls?

To answer this question, we need to take a closer look at the bigger picture. For example, we need to understand the long-term and short-term strategic goals of the company in relation to:

* Market share

* Profitability

* Geographic expansion

* Appetite for credit risk and uncertainty

Keep in mind that the credit risk management function cannot operate in a vacuum. The credit department needs to work together and share responsibility with finance, marketing and sales to support the decision-making process. For example, a company that operates in a highly competitive market with low net profit margins generally must pay much more attention to strict credit risk mitigation compared with creditor companies with high net profit margins that operate in expanding markets. For this reason, no one way or right way exists to manage credit risk because every company is slightly different and has a different appetite for credit risk.

The Customer Value Balance"', as described in the book: The Customer Profit Maxim, offers a structured methodology to make sound and sustainable decisions on marketing, sales and service investments at an individual customer and/or customer segment level. Although this model does not directly address the strategic value of individual customers, it can be helpful to determine which customers to invest in based on current and potential customer profitability.

In this model, credit risk and late payment risk are explicitly valued as an integral part of the customer profitability calculation, where current and potential direct and indirect revenues, and current and potential direct and indirect cost are taken into account. This methodology obviously requires close collaboration with sales, marketing, finance and credit management. It results in better, more individualized, more customized, more profound and more accurate credit decision-making based on financial, commercial, risk and strategic elements. …

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