The accumulation of bad debt is a massive hindrance for businesses that rely on consistent cash flow in their accounts receivable. Piling bad debt reduces your company’s expected revenue and limits your ability to reinvest liquidity into business operations. It reduces your working capital, balloons administrative and operating costs and ties up resources and personnel that can be put to better use in more strategic areas. When unchecked financial challenges compound, businesses find themselves trapped in an increasingly destructive cycle—welcome to...

The Bad Debt Spiral.

In a recent survey report by Atradius, respondents asserted that bad debt accounted for 8% of all their B2B invoices, with a further 50% being past due. The inherent risk of default in businesses extending credit makes bad debt accumulation more than a cursory concern, it is a challenge that can strike at the heart of your operations. 

If left unchecked, bad debt eats into your revenue, making a substantial impact on everything from your cash flow to future credit approvals. When steps are not taken to root out its underlying causes, credit managers may begin to approve new credit applications more sparingly. While this measure can improve DSO in the short term, it can also hurt your company’s long-term growth, customer relationships and future cash flow. 

This is part one of a two-part series. This article will cover the intricacies of segmenting customers by risk of default and the subsequent communication strategies to be employed with each segment. It will also include an example of how customers can be divided into risk segments. 

Risk-Based Segmentation 

Your collections efforts and communication strategies will be most effective in reducing bad debt when they are guided by a risk-based segmentation of accounts, allowing you to prioritize outreach and tailor strategies to customers based on the likelihood of them not fulfilling obligations.  

Account Risk Determination  

Creating a risk-scoring system is a ubiquitous practice for AR departments. However, they can differ considerably across companies due to industry, customer relationships, scale of operations, and many other factors. 

An optimal risk scoring system for an individual account consists of the following factors: 

• Account Balance 

• Average Days Past Due 

• Credit Limit 

• Delinquent Balance 

• Number of Delinquent Transactions 

• Percent of Past Due 

• Years as a Customer 

Combined, these metrics provide a comprehensive overview of a customer's present and historical relationship with your business. They are also an additional source of variance across different AR departments. Some departments consider the length of a business relationship to be of extreme importance when determining risk, others may consider it only as a peripheral factor. How a business weighs its risk scoring system depends on its individual circumstances and observed client behavior.  

Despite these differences, when a common warning sign appears, it is important to recognize it for what it is, trusting your scoring system rather than justifying it with your own judgement. For example, when a long-term customer’s balance goes past due for the first time, a credit manager may be reluctant to take any corrective action because of their long-standing relationship and past performance. Using a scoring model grounded in data and policy-driven criteria is important for objective and consistent decision-making. 

Risk Segmentation Model 

With a standardized risk scoring system in place, the next step is to understand the results delivered and the differences between accounts that pose a high risk of default and those that pose a low risk. 

• High-risk accounts typically show inconsistent financial behavior, frequent late payments, and lack of reliability. These accounts pose the greatest risk of turning into bad debt and therefore require close monitoring. Proactive, consistent touchpoints with these customers make it easier to detect potential issues early and gain a deeper understanding of their payment patterns—ultimately reducing the risk of delinquency.  

• Low-risk accounts show behavior that demonstrates consistency in payments and communication. However, these behaviorally low-risk accounts can be further divided, into financially low or high-risk. Financially high-risk accounts can have all the behavioral traits of a low-risk customer, but because they are accountable for disproportionally larger volumes of transactions, if they were to default it would pose an outsized threat to your business. 

Risk-Based Collection Strategies 

Now that you can separate customers into risk-based segments, communication strategies can be employed that balance potential risk with your available resources, allowing your department to better prioritize its efforts to prevent a bad debt spiral.

• Behaviorally High-Risk: Communication with behaviorally high-risk accounts requires an ‘aggressive’ communication strategy that is frequent and proactive, instead of reactive. Proactive, consistent touchpoints with these customers can do a lot towards preventing bad debt, as you are more likely to discover issues before they lead to defaults when communication is initiated from your department frequently and early on, ideally at the moment of credit approval.
   
• Financial & Behaviorally Low-risk: For financially and behaviorally low-risk accounts, communication should remain consistent and proactive, though with a more measured, defensive approach and less frequent touchpoints than high-risk accounts. While these accounts are a great candidate for automation, reducing manual effort and freeing up managers to focus on high-risk segments, keeping regular touchpoints should still be a key focus for managers to ensure continued engagement and prevent overlooked issues. When outreach is necessary, manually or automatically, it should maintain an empathic tone – such as “We noticed your balance is overdue, we understand this may be an oversight...” - reinforcing strong relationships while keeping accounts on track.  
  
  
• Financially High-Risk & Behaviorally Low-Risk: High-value clients who are considered financially high-risk, but which have a reputable payment and communication history, require a more personalized communication process similar to a low-risk account approach. These clients typically benefit from a dedicated point of contact within your organization, fostering stronger communication and building a working relationship to solve issues before they expand. 

Stop the Bad Debt Spiral 

Customer risk segmentation is only the first step to tackling the bad debt cycle, to learn more about the strategies to employ, read Part 2 “Past Due to Bad Debt: The Strategies You Need to End the Cycle of Losses”