Credit Risk Management

Credit risk is the risk that a customer or counterparty will fail to pay what they owe you. For businesses that sell on credit – issuing an invoice and waiting for payment rather than collecting cash at the point of sale – managing this risk is essential to protecting cash flow and profitability.

A single large bad debt can wipe out months of profit. Systematic credit risk management prevents this by identifying risky customers before extending credit, setting appropriate terms and having clear processes when payments are late.

Why credit risk matters

When a customer does not pay, the impact goes beyond the face value of the invoice:

For a business with a 10% profit margin, a £10,000 bad debt requires £100,000 of additional sales just to replace the lost profit.

Assessing credit risk

Before extending credit to a new customer, carry out due diligence proportionate to the amount of credit involved.

Company credit checks

For business customers, the most common checks include:

• Companies House filings – check the company’s latest accounts, confirmation statement and filing history (all free on the Companies House register)
• Credit reference agencies – Dun & Bradstreet, Experian Business, Creditsafe and others provide credit scores, payment history and financial analysis
• Trade references – ask the customer for references from two or three existing suppliers
• Bank reference – request a bank opinion via the customer’s bank (less common now but still available)
• County Court Judgments (CCJs) – check the Register of Judgments for any outstanding CCJs

What to look for

None of these indicators alone means a customer will not pay, but multiple warning signs should prompt caution.

Setting credit terms

Once you decide to extend credit, set clear terms:

Credit limit

Set a maximum amount of credit you will extend to each customer. This limits your exposure if they stop paying. Review credit limits periodically – a customer’s financial position can change.

Payment terms

Standard payment terms in the UK vary by industry:

Your terms should be stated clearly on your invoices and in your terms and conditions. Under the Late Payment of Commercial Debts (Interest) Act 1998, you are entitled to charge interest on late payments at 8% above the Bank of England base rate, plus fixed compensation of £40-£100 depending on the debt size.

Payment methods

Encourage payment methods that give you more control:

• Direct Debit – you initiate the collection on the due date
• Standing Order – customer sets up a regular payment
• Card payment – immediate collection
• BACS/bank transfer – customer-initiated, most common for B2B

Monitoring and ongoing management

Credit risk management is not a one-off assessment. Monitor your receivables continuously:

Aged debtor reports

Run an aged debtor report regularly (weekly or at least monthly) showing:

Payment behaviour tracking

Track how each customer pays over time. A customer who gradually stretches their payment days from 30 to 45 to 60 may be heading for financial trouble. Your accounting software should provide this data automatically.

Protecting against bad debts

Retention of title clauses

Include a retention of title (Romalpa) clause in your terms and conditions. This means you retain ownership of goods until they are paid for. If the customer becomes insolvent, you can reclaim unsold goods rather than queuing as an unsecured creditor.

Credit insurance

Trade credit insurance covers you if a customer fails to pay due to insolvency or protracted default. Premiums are typically 0.1-0.5% of insured turnover, depending on your sector and the creditworthiness of your customers.

Major UK credit insurance providers include Atradius, Euler Hermes (Allianz Trade) and Coface.

Deposits and staged payments

For larger contracts or new customers, consider requiring:

• An upfront deposit (25-50% of the total)
• Staged payments linked to milestones
• Payment before delivery for the first few orders until a track record is established

Personal guarantees

For small private limited companies , you can ask directors to provide a personal guarantee for the company’s debts to you. This means the directors are personally liable if the company fails to pay.

Debt recovery

When preventive measures fail and a customer does not pay, act quickly:

Internal recovery steps

1. Immediate follow-up on the due date – a polite reminder email or phone call
2. 7 days overdue – second reminder, slightly firmer in tone
3. 14 days overdue – formal letter requesting payment within 7 days
4. 21 days overdue – final notice, stating that the debt will be escalated
5. 30 days overdue – escalate to senior management or debt recovery process

External recovery options

Writing off bad debts

If a debt is genuinely irrecoverable, write it off in your accounts. The write-off is an allowable deduction for Corporation Tax or Income Tax purposes. If you are VAT-registered and the debt is at least 6 months old and has been written off, you can reclaim the output VAT through a bad debt relief claim.

Accounting for credit risk

Your accounts should reflect the reality of credit risk:

• Bad debt expense – debts written off as irrecoverable
• Doubtful debt provision – an estimate of debts that may not be collected, based on historical patterns and current ageing
• Disclosure – your financial statements should disclose your credit risk management policies and the level of trade receivables past due

Maintaining a realistic provision for doubtful debts gives a more accurate picture of your financial position and avoids nasty surprises at year end.