4 C's of Credit - Portfolio Analytics
The consumer credit arena has been and most likely will continue to lead and push advances in automation for the commercial credit space. Consumer lending institutions have long ago realized the wealth of information contained within their own customer portfolios. These lenders have taken advantage of and used this information to segment accounts, profile customers and ultimately drive business practices and results by applying portfolio analytics to their customer base. Today, an increasing number of savvy commercial credit professionals are essentially doing the same by endorsing portfolio analytics. This is because they have recognized the insight and hidden, unique value the portfolio offers. As a substantial business enabler, portfolio analytics allow credit professionals to create value and ultimately position themselves, their organization and their companies for success.
Using the power of portfolio analytics may take some perseverance – especially in business situations where the internal understanding of roles and responsibilities are not clearly defined. However, one could argue that these also represent the best environments since they offer no restrictions on creating value and in some sense the “sky may be the limit”. Let’s face facts, at the end of the day, all quality initiatives, all process improvements and ancillary activities are ultimately judged by the value they create for the business.
Value is subjective and can be defined many ways by different people. However, it should always result in a strategic or competitive advantage for the enterprise. The issue is simple, the Risk Management function and those professionals managing it have the unique capability of providing an introspective, insightful view of the behavior, characteristics and profile of their customer base. This detail, when acted upon, is the foundation for confident decision making and knowledge-based change in a company’s strategic activity or the direction it takes.
Speaking of change. At one time the original 4C’s of credit represented character, capacity, condition and capital.
Today, progressive enterprises are considering and adhering to four new tenets.
There are numerous operational advantages to using analytical tools, such as the ability to review outputs and performance by location, salesperson, business unit, product, line of business, risk management analyst, etc. for relevant facts about outputs, behaviors, and tendencies relating to best (and worst) practices. What this means is that the aggregation and segmentation of portfolio data provides the foundation for more strategic decision-making at all levels of an organization. This ability for an organization to share and cascade information helps in defining policies and the appropriate subsequent operational practices. This is an on-going process as an organization looks to mine it’s own data while also considering external economic influences.
A full, consistent analysis of the portfolio enables the Risk Management practitioner to employ a sound practice for establishing standards and timing for account reviews. Consistency also enables an objective approach for raising and lowering credit limits. Similarly, it eliminates the potential for subjectivity by analyst or a differential in output based on tenure or knowledge base. Thus, allowing for the most professional evaluations for both your internal and external customers. A preferred timetable would be determined as a result of the information culled through the analysis. However, the overarching factor driving the frequency of account reviews is the company’s appetite for risk.
The strategic use of portfolio analytics also enables you to comply with internal and external audit requirements driven by your company’s established risk management policy. If the company’s risk tolerance dictates an annual or semi-annual review for non-risk customers; a semi-annual or quarterly review for slight risk customers; a quarterly or monthly review for slightly higher risk customers, or a weekly or daily review for the highest risk customers, a monitoring tool will allow you to answer the mantra of today’s corporate environment – do more with less. In other words, you’re following the first commandment of credit – thou shalt evaluate every account within the portfolio at least once a year. With the increased focus by auditors on established policies, portfolio analytics provide an optimum solution to maintain compliance.
Proactively sharing the output from your portfolio review with audit teams to witness the movement of risk – or lack thereof – can prove very powerful, virtually enlisting your audit team as a well informed business partner and eliminating a year end interrogation. The outputs are also a fundamental opportunity to discuss portfolio dynamics with senior management in both the sales and finance organizations, to gauge how best to modify and/or adapt to changing economic or strategic conditions.
This type of compliance approach can also be employed if an organization has chosen to protect their accounts receivable investment with credit insurance. The fine print on the insurance policy will usually reveal a requirement to review all accounts according to a specified frequency. Armed with data gathered through portfolio analytics, the stage is set not just for compliance with the policy’s primary requirements, but for a more meaningful, fact-based dialogue with your provider. Since you are now able to offer an accurate, absolute and detailed profile of your account base – current or historic – and based on the frequency your insurance provider dictates, you are now able to discuss a reduced policy premium. Additionally, by having the insurer agree to the components of the decisioning platform that drives the portfolio being reviewed you have a basis for removing or discussing any restrictions the provider has suggested on credit lines that might limit revenue growth on specific accounts.
Operationally, you can also use the outputs from portfolio analytics to forge a better relationship with your banker in cases where the accounts receivable has been pledged for working capital purposes. Essentially we’re talking about providing insight into the strength of the full portfolio and again, the history of the portfolio. Besides adding to the confidence the banker has in your company, such knowledge is a support point for the issuance of a more attractive advance rate from the financial institution. Even an additional few cents on the dollar might be worth a significant, ongoing boost in working capital.
Portfolio analytics have also proven to be extremely valuable in industries that are subject to significant variations in pricing based on changing economic conditions. When economic activity drives a substantial increase in the price of a commodity, there is an immediate impact on the credit line. For example, should prices double, now only half the amount of goods will be approved for shipment if the credit line is not moved proportionately. This compression places a substantial burden on the risk management professional. It sets up a balancing act between the need to drive revenue and the fact that your customers may not be in the right financial condition to handle an increase in price. In the extreme, a price increase may become a heavy burden on your customer. After reviewing the full account base and segmenting it by risk class, you are now in the position to actively approach management with a recommendation that will maintain the compliance standard previously established. This can be done by collaborating you’re your sales and marketing and finance management to apply consistent standards for any modifications in credit lines by increasing similar accounts with an equivalent percentage increase, decrease or no change. This process can be performed easily, factually, without emotion or variation from one analyst to another allowing the organization to maintain an appropriate level of consistency. This methodology also applies in times of declining prices.
In the end, this presents a positive image of the risk management function to the entire organization.
From an operational perspective there are also countless ways that portfolio analytics enable the credit management function to serve, in addition to the traditional function, a consultancy role within the organization. Some examples:
- Activity-based costing as a way to internally expense or charge for services
- Establishment of bad debt reserves and standards by objectively extrapolating risk classifications and revenue values
- Linkage of related accounts for consolidation of exposure across disparate billing systems
- Monitoring the financial state of accounts that continuously discount or pay within terms thus not prompting a forced review when presumed healthy by virtue of their remittance practices
Risk Management functions and portfolio analytics are most critical in merger and acquisition activities. The commonality of customers or related businesses often aggregates risk to levels that are unacceptable once identified and linked. Specifically, if both organizations are selling Company A, the appropriate credit line may not be the combined sum when a merger occurs. Additionally, the acquired customer base may resemble the poorer performing, non-growth or high-risk portion of your existing portfolio. This could prompt a need for an increase to the bad debt reserve, an increase in staff or both (a hidden cost in the analysis of the acquisition). Conversely, the acquired portfolio might improve the general base and offer that more risk should be assumed thus growing more revenue.
Beyond the operational benefits, portfolio analytics also create significant strategic advantages. Once again, this hinges on performing a full analysis of the existing customer base. For the sake of argument, let’s assume your company has made sound selling decisions and let’s say these are intelligent decisions, because you’ve identified a customer profile that best suits your corporate or strategic needs. If you know who your customers are, where they are, and you've performed the aforementioned diagnostics to establish an acceptable risk tolerance level; the next logical question is – who did you miss? The answer to this is in two parts.
Part one - who we missed - Those customers who are related to the base of customers you are already selling, i.e. subsidiaries, operating divisions, etc. With an existing relationship already in place with a division of the firm, the door is open for additional business opportunities with other subsidiaries or divisions.
Part two - borrows from the real estate sector – Location, Location, Location! You want to find companies that closely resemble your existing base and who are in the area you can physically reach. This is a rich source of potential sales leads.
If we take these factors and begin to append data to our base, the limits to creativity are boundless! By adding a field for ‘risk,’ we can actually establish another way to pursue this prospect universe. We can refine this list again by appending profitability. There’s no need to debate the definition of profitability, as long as the application for profitability is consistently applied within the region, division or portfolio you are reviewing. The result is a risk ranked and/or a profit ranked list of potential prospects that can be given to your sales force. This can be refined by using a portfolio analytical tool to establish a recommended credit limit using the criteria you had previously established. The profile should resemble the existing characteristics of your current customer base. You can now offer your sales force pre-approved leads with identified credit limits and more strategically defined outcomes for your accounts receivable portfolio. This also drives increased profitability. Finally, this supports the overall improvement in the portfolio by identifying the highest potential accounts to pursue and maintain.
Portfolio analytics also enable the use of family tree linkages that allow you to identify customers with related business objectives or locations that mirror your physical manufacturing capabilities. You can also append economic data that shows the historic growth or decline of certain industries and what is forecasted to happen with these sectors. This compass will significantly enhance your existing profiles. It is another variable in your review and when coupled with risk and profitability factors you’ve built a sound, insightful, comprehensive and detailed portfolio diagnostic.
Another example of the many possibilities that proactive portfolio management creates is the ability to append product dependency and demand estimation marketing models to your risk management portfolio. The outputs from these models can provide more insight about the strength of the relationship between your product/service and your customer’s final product for sale. This along with the total consumption estimates provides you with a more strategic view of your portfolio. Whether performed on existing customers or for the prospect universe you've identified, you’ll now understand much more about your portfolio and what might drive it. You’ll know exactly who you are selling to and their relationships in your account base. You’ll also have a better idea of related concerns or locations you’ve missed; the associated risk and the credit limits that can be expected; the propensity to buy and how much; whether or not it is a growth industry; and, the impact on your bottom line should you capture all these opportunities.
Here’s the ROI. Using the strength of portfolio analysis – whether for operational reasons, strategic purposes, or both – a company that seizes the power of portfolio analytical tools and adjusts their behavior by one percent, one half of one percent or even a quarter of one percent will significantly alter their company’s bottom line performance. Clearly, such diligence can easily pay for itself in a very short time.
Information is power. Progressive corporations that leverage internal information, combine it with appropriate external data and understand the power that this insight provides – can, at a minimum engage in more informed and intelligent dialogue with customers and internal resources to drive the most profitable activities.
Finally, risk management practitioners need to own, lead and drive internal change. Essentially, they need to personally invest in creating an enhanced value proposition for both the company and themselves. . The Risk Management discipline has moved from basic order management activities to more strategic customer level credit management and will significantly prosper when it applies the substantial operational and strategic advantages presented by portfolio analytics.