I was having a discussion with a good friend of mine the other week about carpets. The fact that I managed to turn this into a conversation around credit may indicate that I need to get out more, but the story my friend related to me about an acquaintance of his actually got me thinking about how we use risk assessments in real life.
You see it centred on a scenario that is probably not uncommon, and does lead to an interesting perspective on the use of credit risk assessments. His friend had been dealing with a tradie. For ease we’ll call the friend Peter and the tradie Bill. Bill had completed a job for Peter the previous week and that was the first time Peter had worked with him. Bill had done a good job and when Peter mentioned that he wanted a garage carpet fitted at some time Bill was up for the challenge. A reasonably priced quote duly arrived and as he was able to do the job in the near future all seemed good. Peter said yes.
A few days later Bill told Peter that he had sourced a carpet, but as he didn’t have a trade account with the supplier he would like Peter to pay him for the carpet up front. This was not an insignificant portion of the quote – roughly 50%. Peter agreed and when the invoice from Bill was presented Peter paid it in full. So, was there a sting in the tail I hear you ask? Well actually no – Bill duly appeared the following week with the carpet and the job was completed.
So what’s the big story then?
Well let’s suppose Bill’s business had hit financial difficulties and instead of laying carpet he was in the High Court unsuccessfully trying to stave off liquidation. Where would that leave Peter? Well, you may think that as Peter had paid for the carpet he could at least take possession and get someone else to lay it. However Peter did not pay for the carpet, he paid Bill directly so had just effectively paid a 50% deposit for the job. Even if Bill had paid for the carpet that asset would form an asset in the liquidation of the business so Peter would have to claim as an unsecured creditor – and that comes with all sorts of uncertainty as to how much, if anything, Peter could eventually get back.
So, is there anything Peter could have done to protect himself?
Well, if Peter had been invoiced directly by the supplier and paid that invoice than the carpet would be his and fall outside of the liquidation of Bill’s business leaving Peter free to get another tradie to complete the job.
OK fair enough, but what has this got to do with credit risk assessments I hear you scream? Well quite how Peter should have approached the question of whether he should have paid the deposit as Bill wanted or insist on being directly invoiced should be determined by the level of risk he faced. And this can, in turn, be determined by applying two separate risk assessments – the first the risk of losing his money (insolvency risk), and the second the amount of money at risk compared to how much he could afford to lose (exposure risk).
Let’s say in this case that Peter assesses his insolvency risk as “medium”. He could perhaps assess the risk as being “low” if he was dealing with an well-known large company or “high” if the company concerned had known payment issues, or a poor credit rating.
Next comes Peter’s assessment of exposure risk. If the carpet cost $1000 and Peter had $100,000 in available capital he could assess this risk as “low”. If however the carpet cost $10,000 and Peter only had $15,000 in available capital then this risk level could well be “high”.
To determine whether Peter should go ahead all he has to do is put the two risk assessments together. If the risk of losing money is “medium” and risk of loss impact is “low” he may feel he can go ahead. If his assessment is “medium” and “medium” then maybe alarm bells should start to ring.
And this is a similar approach that businesses can make when determining whether to extend credit to customers and on what terms. “Low-Low” or “Medium-Low / Low-Medium” may indicate that extending normal credit terms is fine, but the more risk that is introduced the more you may need to look at other options, for example shorter non-standard terms and/or additional security. A decision matrix can be created to guide you.
Risk assessment in this manner does have a considerable subjective component (insolvency risk determination can involve deciphering quite a lot of sometimes conflicting information), and it is obviously important to get it right so it would be prudent to get expert advice. This method of determining overall credit risk is a core service of BizEnhanz and we would be happy to help.
Just not with carpet laying though.