As we all know, the SME industry is the backbone of our nation’s economy. With around 6.3 crore MSMEs, India has become the largest SME market in the world generating $1.8 trillion.
But it’s not all sunshine and roses.
About half of the Indian SME giants face major financial challenges such as liquidity crunches, credit availability, and credit risk management. One of the similar challenges faced by our small and medium enterprises is the dreaded credit risk analysis.
Well, let’s first understand credit risk!
Credit risk is the possibility that a borrower will not repay a loan or fail to meet contractual obligations. For example, you sold machinery worth INR 10 lakhs and offered the customer to pay after 30 days. But a few days later, that customer defaults on payment and files for insolvency. Here, these 10 lakhs can be a game changer for some business owners.
But you don’t have to worry, my fellow business owners! We’ve got some nifty tricks up our sleeves to tackle this pesky problem.
Assess your credit capabilities
Before moving further, perform a credit analysis of your company:
- Do you offer credit to your customers? If yes, then how do you manage the payment process?
- What is your process for determining which customers are eligible for credit sales?
- How do you ensure that customers who receive credit sales pay their bills on time?
Identify the creditworthiness of your customers
Step 1: Get the customer’s financials
- Obtain the financials from your customer for the past two to three years.
- If the customer is an MCA-registered entity, you can download its financials from the below link
Download the company financials
Step 2: Calculate Creditor Velocity
Creditor velocity, also known as accounts payable velocity or payables turnover, is a financial measure of how quickly a business pays its suppliers and creditors. It will help you perform credit analysis for new customers/vendors you wish to onboard.
Formula: (Average Creditor/Total Purchase) x 365
You can pick the balance of average creditors from the balance sheet and the total purchases from the trading or P&L account. To get average creditors you can use the formula: (Opening Accounts Payables + Closing Accounts Payables)/2
How do we asses this Creditor Velocity?
Let’s take the example of AV Solutions.
In 2022, AV Solutions, reported annual purchases of ₹50,000 and had an opening balance of ₹25,000 and a closing balance of ₹35,000.
Step 1: Calculate Creditor Velocity
Average Creditors = (Opening Balance + Closing Balance)/2
Here, Average Creditors = (25,000+35,000)/2
Average Creditors = (60,000)/2
Average Creditors of AV Solutions = ₹30,000
Calculating the Creditor Velocity for AV Solutions:
Creditor Velocity= (30,000/50,000) x365
Creditor Velocity= (0.6) x365
Creditor Velocity= 219 days
AV Solutions is a Code Red company for any industry, since 219 days is an extremely high payment.
“Customer is the king,” as Sir Peter Drucker so aptly stated.
Almost every business has financial problems in some form or another. So, you cannot immediately refuse deals with Code Red businesses. You have to find a way!
Credit Risk Management
So, how do you address this risk? Don’t worry, we’ve got you covered!
Let’s take the case of AV Solutions again.
You signed a deal of ₹1,00,000 with AV Solutions, where your gross margin is around 25% and the decided payment period is 45 days.
As calculated above, AV Solutions has a creditor velocity of 219 days. Now, even if you ask for payment within 45 days, the track record of AV Solutions doesn’t allow them to do so. You cannot refuse all companies that have a higher payment period. But, you can make a provision to make sure you don’t face any losses due to their high payment period.
How will we do this? Provide a finance cost with your credit terms.
To stay ahead in the game, you can calculate a finance cost for the credit facility you provide to AV Solutions and add it to the total amount you will take from them.
To calculate the finance cost, use the following formula;
Finance Cost = Credit Sale Value x Interest Rate Per Annum x (CTO/365)
Let’s assume the interest rate as per the industry standard, 12.5%
Here,
Credit Sale = ₹25,000
Here, CTO will be the number of days AV Solutions delays the payment by. Let’s assume they have delayed it for 91 days.CTO= 91 days
Finance Cost = 25,000 x (12.5/100) x (91/365)
Finance Cost = 25,000 x 0.125 x 0.25
Finance Cost = ₹781.25
You can charge this finance cost to AV Solutions as interest for the credit facility provided by you.
Why charge a finance cost, you ask? Well, a delay in customer payment will lead to a working capital block, forcing your business to rely on a bank loan. To compensate for the interest you pay on the loan and the delay in payment, you can pass on this cost to the customer.
We all know – every business has its own risks and rewards. However, the vast majority of business owners still rely on their instincts when making decisions. Although every business owner is skilled at closing deals, there should be a strategic
approach and set processes with the above methods to avoid dealing with your Code Red clients.
Looking to implement more such cost recovery mechanisms in your business? Want to release your blocked cash and create 10x value of your investment?
We, at Contetra, have worked with 125+ business owners to – address the risk of credit defaults, identify bottlenecks, release blocked cash and also make sure their budgets for the upcoming year are in place.
So, what are you waiting for? Set up a FREE exclusive business review with our team of strategic consultants today and take your company to the next level by understanding your code red clients.
Feel free to book a slot here for a personal one-to-one review: https://calendly.com/reachout-_g/30min?month=2023-09
