According to an analysis conducted by the Edinburgh School of Business, there are several factors to be considered by a creditor before issuance of credit. These factors include but not limited to the political will, financial stability, and strength of the currency among others. However, it is impossible to assess credit risk of the debt without proper client information, thus risking a bulging receivable account at the end of a given financial year.
Determining a potential defaulter is an art which has to be well understood by creditors. According to Bonaya in the paper, ‘The Effect of Credit Information Sharing On Loan Performance of Commercial Banks in Kenya’ Before extending any type of credit, companies offering trade credit assess the potential debtors based on their financial performance, credit ratings and debt exposure.
This article shall explore how conducting prudent due diligence can be used to reduce the number of defaulters because when a creditor has proper financial information on a potential debtor, they can be able to make sound decisions on whether the credit should be issued.
Due diligence is considered the traditional method of assessing risk in debt and issuance of credit. Conducting qualitative and quantitative analysis of the market is important but it can only be accurate after involving the intended debtor details such as their financial ability and existence of attachable securities in the event of default.
According to Rouse, C.N (1986), in the book Bankers Lending Techniques, diligence should be conducted as a way of assessing the risk of issuing credit because as a matter of principle, lenders and financial institutions are expected to always incorporate the margin of default in the event that the borrower fails to meet their contractual obligations.
Furthermore, research from the Edinburgh School of Business shows that credit management is always a wide and complex activity, which if not well managed can, oftentimes, lead businesses to bankruptcy or abrupt closure. Management of the credit starts from the issuance stage where creditors are supposed to conduct due diligence and ensure that they issue credit to financially trustworthy persons who have the ability to service their debt. This is usually done by conducting proper background checks before approvals to help a business resolve the ever-swelling receivable accounts.
The quality of the credit approval process from a risk perspective is determined by the best possible identification and evaluation of the credit risk resulting from possible exposure.
How to conduct due diligence
Some of the most recommended ways of conducting prudent due diligence include:
- Having a prudent and Comprehensive Credit approval Policy
While focusing on ensuring that credit is serviced, lenders must note the importance of assessing the viability and practicability of their credit management policies. A credit management policy is supposed to, among other things, have a comprehensive credit approval mechanism with thorough due diligence mechanisms such as collecting as much information on the Debtor, their financial ability, place of business, sureties among others.
- Have a comprehensive Debtor information database.
Have reliable information on the debtors trading information such as their place of business, viability of the business they are engaging in and their past credit records.
- Always confirm existence of security
Some Debtors give securities that cannot be realized. Others even use property that they do not own to secure credit. As a lender, the security should be clear and confirmed in case of a default
- Have clear credit agreements
Because debtors are always at the losing end in case a debt is not repaid, they should always ensure that the agreements they sign are bulletproof and always have their interests and monies covered. They can be useful in dispute resolution processes when claiming breach of contract.
- Having well-trained human resources in charge of credit approval
Training of staff to ensure those in charge of issuing credit are well versed with conducting background checks on their potential debtors is important. The background checks should unearth the Debtor’s character, previous debt repayment ethics and their consistency in business. The staff should also be trained on asset tracing and skip tracing methods. These checks should, however, be conducted in a way that adheres to data protection laws. This is to avoid legal action against lenders who go beyond legal limits in accessing data of debtors which includes personal data. Lenders should watch out for such an overreach even in credit application forms.
- Engage professionals to help recover debt and conduct background checks
In the unfortunate event of default, creditors should engage the services of trustworthy debt recovery professionals.Furthermore, debt recovery firms have the resources and infrastructure which are not available in other businesses which can help conduct due diligence, skip tracing and facilitate debt recovery.
Due diligence is one of the ways to reduce bad debts. However, it does not guarantee full repayment of debt because sometimes, a client may pass the credit approval test but still default. And when it comes to this, the business might have to come up with a good plan on how to get back their money or value for services rendered.
It is imperative that firms consider making use of support from debt recovery firms in the process of issuing and recovering debt. This is because these debt recovery professionals have experience in recovering debt. They also have an advantage of dealing with non- compliance. This gives them a third eye of being able to see the problem before designing solutions to the problem. They deal with the debtor thus are able to advise on how to avoid falling into the hands of bad debtors.
Dealing with non-compliance helps them take note of the important details which should be considered or looked out for during the approval stage. These firms have enhanced skip tracing mechanisms which helps in tracing defaulters by checking whether they changed their business names or rebranded to avoid being detected, moving to a new town or even changing names to facilitate recovery of the debt. This should be done within the confines of the law and by professionals to avoid incidents of harrassment, among others.
Mr. Evance Odhiambo is the Head of Debt Recovery Practice. Ms. Benta Moige is a trainee lawyer in the Debt Recovery Practice and a seasoned writer.