Effects of Late or Non-payments

Now that you know what a credit report is and what kind of information might be included in a credit report, the next step is to perform a credit risk assessment.
The principles of risk assessment are particularly critical for several reasons; but, most importantly, any extension of credit requires an analysis of a buyer requesting credit and a determination as to the level of risk associated with a buyer’s financial ability to pay a seller according to terms.
The risk, specifically commercial risk, associated with an international market is very important. In dealing with global or international markets, the assessment of a buyer takes on another dimension, the dimension of being international, namely, the risk of selling and getting paid in a timely manner when a buyer is in a country different from a seller.
Commercial risk in international markets refers to the same situation encountered in the domestic market, which is the risk of late/non-payment by a (foreign) buyer or intermediary for goods shipped/services completed, resulting from
insolvency or bankruptcy of a buyer
a buyer’s failure to pay for goods/services per the due date of the agreed upon payment terms
a buyer’s failure or refusal to accept the goods that were shipped or the services provided as agreed in the contract.
When performing a risk assessment, sellers must consider the implication of selling into the international market. A seller must take into account factors that exist in global transactions, but not in domestic sales. Such factors include changes in country governments, currency values, economic and cultural issues. Assessing political and economic risks and cultural issues of other countries is discussed in detail in Module 1, so here you will find highlighted only a few points in context with granting credit.
The bottom line point is that risk assessment is important because the impact of non-payment to a seller may result in cost of money and bad debt events.

Unit Objective [edit]
The goal of this material is to describe for you the commercial risks and the effect of late and/or nonpayment from overseas buyers. By the end of this unit you will be able to
identify commercial risk.
identify the tenets of risk assessment.
identify the “Eight C's" of credit risk assessment for the global seller.
identify the impact of nonpayment.

Unit Outline [edit]
Introduction
Tenets of Risk Assessment
Risk and Reward
"Eight C's" of Credit Risk Assessment for A Global Seller
The 5 "C's" (Domestic and International
The 3 "C's" (International)
Applying the "C's"
Impact of Nonpayment
Identifying Costs
Bad Debt Value
Interest
Opportunity Cost and Alternate Use of Capital
Administrative
Tenets of Risk Assessment [edit]
The tenet, or established fundamental belief, of risk assessment is that international credit managers must constantly attempt to gather as many facts as possible in order to make the best credit decision for their companies. Their challenge is to evaluate and quantify the risk factors associated with granting credit to a buyer. This task becomes more challenging when a buyer is from another country. In the previous lesson, five factors were presented to consider when assessing a credit report: credibility, cost, value, timeliness, and completeness. Although each influences the level of risk to some extent, credibility of the information is particularly important in a risk assessment. For example, how does an international credit manager differentiate between fact and opinion? Another challenge is the fact that many buyers, especially if they are private, will not or cannot provide the necessary tangible information to assist in the risk evaluation process.
Company credit policies do not normally address the specifics of making the “best” credit decision. The credit procedures established by an exporter should include risk parameters. Risk parameters typically focus on clearly stating who is responsible for credit decisions, including the payment terms as well as the transaction value each person is empowered to make in a decision as to payment terms of sale to a buyer.
The credit procedures might also include how much credit an individual or department can extend, the escalation or approval process to decline or increase customer credit lines, and specifics as to when and who determines if a customer credit decision may require collateral.
Risk and Reward [edit]
To risk non-payment or to risk not meeting sales expectations--that is the decision. The issue of selling into the international environment revolves around balancing the risk of being paid on time against the reward of meeting sales and profit targets. The goal, therefore, is to maximize sales while minimizing losses by being paid according to payment terms. There are many risk/reward factors that must be taken into account to balance the expectations of sales and marketing against the financial concerns of slow, partial or complete non-payment. Each company normally establishes expectations or policies as to sales volume and market share.
An example of risk/reward factors could involve selling at a higher price to a customer in a country with significant political and/or economic risk, where risk of nonpayment would be greater than selling the same product in Western Europe at a lower price where risk of nonpayment is lower. Another example might involve working with the sales department for a “first sale” into a new market, perhaps at a lower price than listed on the price sheet, in order for a seller to try and gain a “foothold” for additional business in a country new market, one not sold to before. The risk of selling at the usual price may increase the risk that a foothold in that market will not be gained.
With financial statements, trade references, and bank relationship information, an international credit manager can begin to evaluate a buyer by determining a buyer’s financial capabilities, the manner in which a buyer pays competitors, and how and when a buyer pays bank loans.
The credit risk evaluation is also influenced by the specific situation and country of the customer. Experienced international credit managers (five or more years of credit and collections experience) use their experience to establish levels of risk factors, high and low, depending on the manner in which a seller approaches risk analysis, and reach a credit decision that best meets the needs ofmarketing and finance
“Eight C's" of Credit Risk Assessment for A Global Seller [edit]
Whether a sale is a domestic or international transaction, there are five “C’s” to consider during a credit risk assessment: character, capacity, capital, condition, and collateral. In addition, there are three more “C’s” to consider when the assessment is considered an international transaction: country, currency, and cultural risk
The 5 “C’s” (Domestic and International) [edit]
Character, capacity, capital, condition, and collateral are as follows:
1. Character refers to a buyer’s willingness to pay obligations.
2. Capacity is a buyer’s ability to pay.
3. Capital refers to a buyer’s equity and signifies the financial strength.
4. Condition reflects a buyer’s economic situations.
5. Collateral refers to a buyer’s access to additional resources to use for payment.

Character [edit]
A buyer’s willingness to pay obligations is assessed by considering a buyer’s morality, integrity, trustworthiness, and quality of management. Character is also assessed by considering a buyer’s success, payment record, and information from current suppliers. Examples of information for such assessments should be intangibles (family background, employment record, personal credit history) that are used to form a tentative opinion. The range of findings could include favorable payment records or, on the negative side, a record of bankruptcies or litigation. For many credit mangers, bankers, and risk managers, the trait of “character” is often considered the most important.

Capacity [edit]
A buyer’s ability to pay or a buyer’s ability to generate cash flow and pay when a debt is due can be determined when assessing capacity. Assessing capacity involves considering prior business experience with related operations, particularly large volume orders, exacting specifications, or tight delivery schedules. The outcome of the assessment should show positive evidence of successful operations and on-time bill payments.

Capital [edit]
A buyer’s equity or net worth signifies the financial strength of a buyer and may demonstrate an ability to pay obligations. A positive capital assessment reveals a business that shows increasing sales, profits, and net worth as well as favorable operational trends.

Condition [edit]
The market’s current and expected general economic situations may affect the applicant's business. When assessing condition, consider past and current political history, recent economic events, and currency issues. During the assessment, also consider analyzing industry cycles and consolidations and whether the industry is subject to favorable or unfavorable trends. Credit managers should analyze the business cycle of credit applicants.

Collateral [edit]
A buyer’s ability to access additional resources (equities or other assets) to use for payment if that buyer’s capacity or character fails is important. Specific assets, such as receivables or inventories, can be pledged via liens against these assets, based on international laws that regulate these types of transactions. Other forms of collateral are letters of credit, standby letters of credit from the applicant's bank, guarantees by the firm or its parent, personal guarantees from the principals, and pledges of investment holdings such as stocks or bonds, or other investments. It is important to determine whether potential collateral is free and clear and has not already been pledged to other creditors.
The 3 “C’s (International) [edit]
In international credit management, country, currency and culture risks are inextricably linked to assessing a buyer’s risk. They must be evaluated together for the assessment of one will depend on that of all others.

Country Risk [edit]
Globalization is not just a cliché. It is happening all around, as businesses increasingly look at the world as if it has no national boundaries. Governments, on the other hand, still tend to make policy in what they perceive to be their country's national interests. With globalization, competition sharpens worldwide, but nationalistic laws frequently make for a highly uneven playing field. There are three important principles in country risk assessment:
1. Countries are interdependent.
2. Country conditions affect customers.
3. The assessment must be systematic, objective and relevant.
a. Systematic means it must be proactive, looking ahead rather than being merely reactive. There must be specially assigned people charged with the task of country evaluation who can be held accountable. The process of assessment must be continuous for markets in which the company has an interest, not just a task undertaken when a new order comes in. The process requires regular, reliable, assured flows of information, both into the company and within the company, for instance, from international credit managers to sales people. The evaluation of country information must also be structured so that important signals are not overlooked and key questions are being asked.
b. Objective means that the evaluation should be free of all personal bias. Countries can and do change, both from good to bad and from bad to good, all too often within very short periods of time. External conditions also can change, as they did for Argentina when Brazil devalued its currency; so countries should be assessed not in isolation, but in the context of what goes on around them.
c. Relevance relates to how practical and pertinent the evaluation of the country risk elements fit with the needs of a seller. For example, if a seller is considering the risk factors of selling to Italy and Italy has a change in government, this change might not be enough of an impact for a seller to find it relevant to if or when he/she will be paid. A global credit manager may question the value and significance of examining the cultures that exist in countries where export business is projected. The pro-active company and international credit manager will recognize that personal and company relationships still are critical, both in the development of new markets and in ensuring that payment obligations are processed in a timely manner.

Currency Risk [edit]
Currency risk in international credit management arises from an export invoice (a receivable, an asset) that remains unpaid either because an importer's country has imposed exchange controls, making it impossible to convert the funds to the agreed upon currency or because a devaluation has taken place that raises the local currency cost of paying the invoice so much that an importer is unable to pay. The result can be nonpayment in convertible currency (even if local currency payment has been deposited with a local bank) or delayed payment in convertible currency.

Culture Risk [edit]
Even though an international credit manager may question the value and significance of examining the cultures that exist in countries where export business is projected, the mores and culture of a business located in an offshore country impact risk. In evaluating "culture" as a risk element, it is appropriate to consider examples of cultures in the world and the way they may impact how business is conducted. For example, in Japan, “WA” or “Inner Harmony” is a concept that many Westerners fail to grasp. When it may appear Japanese will have eyes closed at meetings, they are gathering their thoughts, not sleeping! Management in Japan is known to be very participative and team-oriented. In India, the caste system still exists, with underlying cultural variables that structure the life of a person from India. Managers in India generally make most decisions; employees follow rules. In Latin America, the family is of central importance, and loyalty often determines career paths and promotions. In each of these examples, an international manager would be wise to try and understand the “cultural” elements of the business transaction which could impact the process of risk evaluation.
Applying the "C's" [edit]
The number of variables that can influence how each “C” element is interpreted is countless. However, an international credit manager learns, through experience, the situations where one “C” may be more or perhaps less important in evaluating a credit decision.
For example, the “character” of the management may be of such a concern to an analyst (for example, the owner may have been in bankruptcy) that despite a strong company financial structure, the seller may limit credit to the buyer. Likewise, a “country” assessment may result in a risk manager requesting secured credit with a buyer located in a country that is in economic turmoil, even though this buyer is financially sound.
Usually international credit managers who have developed their skills through years of solid training, mentoring, successes and mistakes (yes, mistakes) are well-equipped to balance and weigh the “C’s” of credit in attempting to reach a decision.


Impact of Nonpayment [edit]
What happens if the credit information that is available indicates the buyer is credit-worthy but the buyer still defaults? The impact of nonpayment or true cost of credit in international business is almost invariably greater than it appears. There are four types of impacts associated with nonpayment, over and beyond the impact to sales:
1. bad-debt (loss)2. lost interest3. opportunity costs (alternative use of capital)4. administrative (chasing the reluctant debtor)
Margins, or profits, on export trade are low to begin with and are constantly under attack because often there are more competitors in a global market than in a local market. In many countries, payment delays are expected, so that a credit manager needs to contend with “credit taken” as well as credit extended.

Credit Taken [edit]
The focus of this module has been the concept of extending credit. The next step is to discuss an expanded version of credit extended called “credit taken.” An example of credit taken is as follows:
Buyer XZY is given a line of credit of $100,000 and expected to pay in 30 days. On the 25th day, the buyer asks the seller to approve another order for $100,000, meaning that on the 25th of the month, the credit extended is $200,000. The seller agrees because the buyer commits to make payment for the first $100,000 on the 30th of the month. However, the buyer reneges on this promise so that the seller is owed more than the original agreed-upon credit line.
The chances of nonpayment are always possible, which means the costs associated with nonpayment always take a toll on the profit.


Identifying Costs [edit]
Before presenting the types of costs associated with nonpayment, you should first consider how sales are tracked from a bookkeeping perspective and then consider how costs impact sales.
Some companies do not separate exports sales from domestic sales in their accounting systems. To them, a sale is a sale. However, international sales, as you are learning, sometimes carry costs and risks that domestic sales do not. So what happens if domestic and international sales are combined?
Imagine for a moment that Company A sells its products for $100 each. Costs for selling domestically are $92 for each unit. Costs for selling internationally are $94 for each unit (due to a shipping cost differential). It may seem easy enough to track the differences, but a problem could occur when you add the method of payment and potential risk of nonpayment because variable costs (costs that vary from sale to sale) change. Assume, for example, that domestic sales are paid via 25% cash and 75% credit. The chances of losing profits are less than if all sales were credit. If the domestic credit tends to be low risk of nonpayment, costs of nonpayment may not be a large factor. However, international sales would probably be all credit. Add to that an increased risk of nonpayment and the profit associated with international sales could be significantly impacted.
Keeping the sales and costs together makes it difficult to identify the true profit of domestic sales versus international sales. Knowing the costs of international sales can impact marketing strategies, pricing strategies, and credit decisions.
Bad Debt Value [edit]
Bad debts are obligations that are not collectible for a variety of reasons such as lack of cash flow from a buyer to remit, misunderstanding of terms and conditions and a resulting inability of a buyer and seller to agree on those differences. Bad debts, under the tax laws of the US, can only be written off as an expense by sellers if they can demonstrate, usually through hiring of a collection agency or lawyer, that every effort has been made to make the collection.
In a survey of over 5,000 businesses in manufacturing, distribution and retail, the National Association of Credit Management found that each dollar of accounts past due is worth the following:
Three Months
Six Months
One Year
Two Years
$.90
$.50
$.25
$.00
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Interest [edit]
Assume for a moment that you are a seller and can earn 12% on your money if it were in the bank. This is money that you earned from sales (Sales-Cost=Profit). Assume now that you have agreed to wait for your payment (that is, you have extended credit). Had you not extended credit, hypothetically you would have money from the sale, which would be in the bank earning interest. Extending credit means you are losing the opportunity to earn interest and, therefore, this is a cost.
Another way to consider interest as a cost is to assume you have a loan from the bank. That loan was used to produce your products. Until that loan is repaid, you are charged interest. If the buyer were to give you cash at purchase, you could apply that money to your loan and thus reduce your interest charges and thus your cost. By extending credit to the buyer, you are agreeing to incur interest costs against the money you borrowed in order to produce the product.
Do some math and see how these scenarios might play out (in simple terms). Assume that for each $100 in sales, $95 is cost and $5 is profit. Assume you extend credit and therefore do not receive your monies until some time in the future. If your interest costs are 12% per year (assuming that this money could generate a return of 12% in interest to the seller), your first month’s cost would be $1.00 (12% x $100 = $12.00 divided by 12 months = $1.00). See the table below for additional clarification.
Sales
Cost
Net Profit
Month
Amount
Profit After Interest Payment
$100
$95
$5
First
$1.00
$4.00
$100
$95
$5
Fourth
$4.00
$1.00
$100
$95
$5
Sixth
$6.00
($1.00)
$100
$95
$5
Eighth
$8.00
($3.00)
$100
$95
$5
Twelfth
$12.00
($7.00)
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Retrieved from "http://en.wikiversity.org/wiki/Effects_of_Late_or_Non-payments/Interest"


Opportunity Cost and, Alternate Use of Capital [edit]
Consider an example using a yearly sales figure of $12,000,000 or $33,000 per day. If you were receiving $33,000 in cash every day, you would have the opportunity to invest that money back into your business by making more product, investing in marketing, creating a new product line, purchasing new equipment, and investing in internal improvements for employees.
However, if you extend credit to a buyer and agree to wait for that $33,000, you are missing the opportunity those investments could yield. Depending on the investment, the opportunity cost would vary.
Therefore, the goal is to gain access to your $33,000 per day as soon as possible. One way to do this is to reduce your DSO (day’s sales outstanding). If you are currently receiving your daily $33,000 45 days after the sale and you reduce that 45 DSO to 30, you have just gained access to approximately $500,000 that you could invest sooner rather than later. Sooner could mean the difference between getting into the Chinese market or not.
Administrative [edit]
There are several examples of administrative costs.

Losing the ability to discount [edit]
For example, if a seller sold to a buyer who was slow to pay, this seller’s cash flow is impacted. Assume this seller has purchased products and services from vendors as part of the business. These vendors may offer a 1% discount to the seller if paid in 10 days. If the buyer had paid on time, the seller could have paid the vendor in 10 days and therefore saved 1%. This is an example of the seller losing the ability to "take" the 1% discount offered by the vendor.
Another discount example may include a transaction with a bank. Assume a seller has the option to prepay his loan with a bank. In return, the bank will discount the fees due the bank. Just as in the other example, if a buyer does not pay on time this seller might not have the money to prepay the loan and receive a discount. This seller has lost the opportunity to save costs associated with the loan. This is a crucial cost, especially in a high-interest period.

Paying penalty/late charges [edit]
In this situation, instead of missing out on a discount for not being able to pay earlier, a seller has to pay a penalty for being late. If this seller does not receive payment promptly from the buyer, this seller’s cash flow may be impacted; thus, there is the potential that suppliers will be paid (obligations) late and therefore incur charges. Another impact associated with late penalties is the possibility of restricted credit in the future.

Increasing risk factors [edit]
Uncollected debt is a cost to a business. The older the debt, the harder to collect.

Maintaining administrative, bookkeeping functions [edit]
Uncollected debt costs not only include the cost of the product sold and the lost profit but they also mean administrative costs ( letters, bill chasers, etc) that a seller might use to try and recoup some of the initial cost associated with the product. In other words, another impact of nonpayment is the need to chase the reluctant debtor.