Think Like a Banker

Extending credit to customers requires strong policies, thoughtful benchmarking, and active management.
Mike SelfridgeNovember 21, 2011

The CFOs I know don’t typically think of themselves as bankers, but a walk in wingtips would serve them well. Paramount to a bank’s success is the chief credit officer, responsible for the institution’s credit portfolio, lending practices, and overall risk management. Successful policies established by the chief credit officer lead to a strong financial foundation, which in turn spurs future growth.

In many regards, the CFO position is akin to that of the chief credit officer. Both extend credit to clients, implement strong policies and procedures, and ensure that the extension of credit supports the firm’s overall strategy for growth — without compromising its financial condition. CFOs can thus borrow from the chief credit officer’s playbook when establishing an effective credit policy and process, or when fortifying an existing one.

Goals and Metrics
The objective of a good credit policy is to establish approval authorities, define the guidelines, outline responsibilities, and specify the lending practices that will be employed when extending credit to customers. Policy objectives cannot be accomplished, however, without an emphasis on credit quality, which is enhanced by a thorough knowledge of clients and their businesses, as well as a thoughtful evaluation of risk, supported by proper documentation.

By using industry benchmarks, a credit policy can provide stated goals for such credit metrics as days sales outstanding, bad debt expense ratios, and the allowance for doubtful accounts. For banks, net charge-offs are the equivalent of bad debt expense, and a net charge-off ratio of less than 0.75% of average loans is considered acceptable by most commercial lending institutions. Less than 0.50% would be strong. For corporations, depending upon the industry and its typical gross margins, a bad debt expense ratio of less than 0.25% would be acceptable. (The Credit Research Foundation’s 2010 Bad Debt Report shows figures for net bad debt write-offs as a percent of sales by industry.)

The third metric, the allowance for doubtful accounts, is an estimate of receivables that could go uncollected. This metric is comparable to the loan loss reserve ratio for a bank. The average allowance for corporates is generally 1% or less, depending on the industry.

Terms of Trade
Clearly outlining the credit approval process, responsibilities, and terms of trade is another way for a finance department to be more “banklike” in its receivables management. Bad debt is expensive — for banks and for corporations. A business operating on a 5% net profit margin must generate an additional $1 million in new revenue to pay for $50,000 in bad customer debt. Similarly, a bank must generate nearly $33.3 million in new loans to pay for a $1 million write-off, assuming a 3% net interest margin. Good credit decisions today will have a significant impact on future financial results, and the best decisions require good credit judgment coupled with a well-defined credit process.

Credit departments should establish limits for all active customers. Such limits may be based on credit reports, such as D&B or Experian, as well as National Association of Credit Management reports, bank credit references, and financial statements.

In situations where a customer’s credit quality is not strong, or the size of the credit is larger than the CFO deems reasonable, alternative terms of trade should be considered. There are also ways in which credit can be enhanced: receivables credit insurance, documentary collections, credit-card payment programs, and letters of credit. Selling receivables on a nonrecourse basis to banks through factoring or asset purchase programs can be a viable option.

A credit policy should also identify collection practices, establish the time frame in which a customer becomes a collection account, and describe the collection process and the parties responsible for collecting. A thorough policy will also outline the timing of a deemed charge against the allowance for doubtful accounts. Uncollectible accounts usually include bankruptcies, assignments to creditors, and customers that do not respond to normal collection activities. In such cases, the accounts are often referred to collection agencies or attorneys.

Ongoing Management
Every good lender manages and monitors a credit portfolio actively, and a finance department with outstanding receivables is no exception. A credit policy should outline the practices for ongoing credit analysis and credit management. Analyses may vary, but could be as frequent as monthly if credit quality is an issue. Monthly summary reports help management monitor accounts-receivable status and collections activities. A monthly report would include current and prior month accounts-receivable balances, total collections, and total net sales. Some ratios should be included to reflect the financial health of customers, coupled with a brief financial analysis.

Even with a solid credit policy and active management, though, things can slip by. Be sure to watch payment-history trends with customers and relevant industries vigilantly, and do not ignore global economic conditions. Like the chief credit officer, a CFO should be actively involved in the extension of credit, its monitoring, and the review of credit decisions to ensure that sales and credit are working well together. Shareholders are counting on it.

Mike Selfridge is the head of regional banking for Silicon Valley Bank. He leads the company’s commercial-banking teams in the early-stage and middle-market technology and life-science practices.