What the 2023 Banking Crisis Can Teach Accounts Receivable Leaders
One month has passed since the bank collapses that sent shockwaves across the world. After weeks of uncertainty and some extraordinary intervention on the part of the U.S. government, the situation has calmed. On March 21, U.S. Treasury Secretary Janet Yellen proclaimed, “The situation is stabilizing. And the U.S. banking system remains sound.”
As the dust settles, experts are looking closely at what caused institutions like Silicon Valley Bank (SVB) to fail, trying to detect red flags that may have been missed. At the core of the problem seems to be a significant failure in terms of risk management.
Understanding and mitigating risk are central to a successful accounts receivable process. While the pitfalls that helped undermine SVB don’t have an exact corollary in accounts receivable, there are still valuable lessons for AR professionals.
Risk Management 101
According to analysts, SVB failed to take several basic precautions that would have protected it from failure. Among these were the complete absence of a Chief Risk Officer, and a lack of hedges to protect their bond portfolio. John Sedunov, a professor of finance at Villanova University, suggests that the latter was a basic, bare-minimum type practice that should have been at the forefront of their risk management. He even went so far as to say, “That’s one of the first things that I teach an undergraduate banking class. It’s textbook stuff.”
In accounts receivable, Risk Management 101 starts with creating a credit policy that details how and when your organization will extend credit to customers. It also outlines the steps that will be taken when a customer fails to abide by the terms of the policy.
“A well-defined credit policy is important for reducing the risk of late payments and bad debt, but it is also one of the first touchpoints in the customer onboarding process for your brand. With customer satisfaction being critical in business retention today, it is important that this process runs smoothly and provides a great customer experience.” - Gregory Wineberg, Senior Product Director, Quadient
The Credit Research Foundation (CRF) has established six key questions that should be answered when developing a credit policy:
-
What is your mission?
-
What are your goals?
-
Who has specific credit responsibilities?
-
How is credit evaluated?
-
How are collections handled?
-
What are your terms of sale?
The answers to these questions will serve as the foundation for the credit policy you create.
Determine Your Risk Level
Both Silicon Valley Bank and Signature Bank dealt in a high volume of uninsured deposits. In fact, according to Wedbush security, over 90% of their deposits fell into this category. By contrast, the average U.S. bank typically deals with around 30% of its deposits being uninsured. Consequently, when customers sensed trouble at the banks, they were quick to withdraw their funds, fueling the banks’ failure. Both organizations either failed to take into account or ignored the level of high-risk deposits they handled, which left them open to rapid collapse.
In accounts receivable, it’s equally important to understand your exposure. This is handled by a close examination of your portfolio and determining how much credit you can afford to extend to customers. This data will also help you plan a safety net for your cash flow when payments are late or defaulted on. When looking at your customers, examine the company size, industry, and average credit extended to get an idea of what you can afford to offer and the level of associated risk.
Understanding your organization’s exposure also comes from analyzing metrics like days sales outstanding (DSO) to determine which of your customers regularly pay on time, and which are regularly paying late.
DSO = Accounts Receivables / Net Credit Sales X Number of Days.
Are large companies slower to pay? Do the majority of your accounts pay within their prescribed terms? Are there specific industries or markets that account for your aging invoices? A clear answer to all these questions will not only help you optimize your credit policy but will give you the information you need to strategically approach the collections process.
For instance, looking at the numbers may lead you to implement programs such as credit requests over a certain dollar amount needing to meet a variety of checks such as a favorable credit report. It can also help you determine the nature and frequency of follow-ups for accounts, which require more supervision, and which can be trusted to pay on time.
Time and resources devoted to data analytics will yield long-term security and improved accounts receivable performance.
Plan for the Worst
As noted, experts have cited SVB’s failure to account for risk as a fundamental contributor to their failure. Both the absence of a Chief Risk Officer and failure to hedge bonds represented an approach that seemed to ignore the possibility of potential problems, such as the lowered values of their bonds when interest rates were raised. By failing to take basic precautionary measures, the organization was essentially defenseless.
93% of businesses experience late payments.
Beyond establishing a clear credit policy, accounts receivable teams must plan for “worst-case scenarios” regarding non-payment from customers. That means establishing a clear-cut dunning process to be followed when payments go past due.
Creating a dunning process involves determining how often notifications will be sent out — typically at 30, 60, 90, and 120 days past due — and what will be included in the communications. Each message should include the relevant invoice number, date, total amount due, and information on any penalties or fees that have been accrued. For transparency, it is also important to include a clear explanation of what will happen if delinquency continues, up to and including any potential legal action.
Ideally, a dunning letter will also include an explanation of methods customers can use to quickly resolve the issue and, when applicable, a link they can use to immediately remit payment. This will increase the odds of prompt payment.
Having these workflows and templates in place allows you to immediately shift into management mode when an account goes past due, rather than scrambling to come up with a plan after the fact. This is vital because the longer a debt goes past due, the less likely a company is to collect the full amount.
According to Dun & Bradstreet, “an account that is 90 days past due has a 69.6% chance of being paid. After six months, the probability rate drops to 52.1%, and after one year of delinquency, the chance of collecting payment falls to 22.8%.”
Each of the steps outlined above will help minimize your organization’s exposure to risk and place you on firmer footing when problems do arise.
To learn more about practical steps that can be taken to protect your organization from bad debt, download our Definitive Dunning Letter Toolkit.
