Extending labor and/or materials on credit open up the possibility of your business being burdened with bad debt. Since the actual cost of bad debt is many times greater than the amount of the bad debt itself, it clearly makes good business sense to insulate your business’s exposure to this type of situation. While, practically, it may be very difficult, if not impossible, to completely eradicate bad debt, there are ways to drastically limit your potential exposure and to maximize profit – all without resorting to overly restrictive credit policy.

Secured Debt Limits Bad Debt

The above statement may look obvious, but it is often overlooked. Securing the debt owed to your business goes a long way in making sure you get paid. By securing the debt your customer incurred by your company’s extension of credit you place yourself in a much better position to get paid, even if the customer experiences financial difficulties. To see why this is, we’ll start with the basics.

What Is Secured Debt?

Secured debt is a debt backed by a security interest in collateral to reduce risk associated with lending or extensions of material on credit. What this means is that if a debt is “secured” it is backed by a right in an asset that may be claimed by the lender in the event of a default by an indebted party. An easy example of this is a home mortgage; the lender is granted a security interest in the property purchased. If a borrower fails to make the necessary payments on the home loan, the bank may foreclose on the property to satisfy the debt. The home is collateral for the debt and may be sold to satisfy the amount due in the event of a default. A security interest may be either voluntary or involuntary. A security interest provides a stronger incentive for the debtor to pay because his property is serving as collateral.

Why Is Secured Debt Beneficial?

From the above definition, it is fairly clear why secured debt is preferable to unsecured debt. A security interest provides a stronger incentive for the debtor to pay because his property is serving as collateral. In the event that payment is not forthcoming, the property may be taken. Further, in some cases, the exact type of secured debt may give the creditor rights to collect the debt from parties against whom he would otherwise not have rights. Further, the rights of a secured creditor are substantially more robust in bankruptcy proceedings and make a debt easier to collect in general.

Because debt is much more likely to be paid when it is secured, a credit department can use that information in its determination of to whom credit should be extended. The more secure position afforded by secured debt can translate to a less restrictive credit policy – without the corresponding worries that a less restrictive policy will result in a much higher amount of bad debt. This, in turn, may result in a larger pool of customers, and more profits.

Types of Secured Debt

As mentioned previously, a security interest may be voluntary or involuntary. The specific type will have an effect on the structure of a credit policy crafted to take advantage of the benefits of securing the debt.

A voluntary lien is something that must be agreed to by the parties. This agreement typically occurs as a condition to the extension of credit and therefore should take place prior to the decision on whether to extend credit or not. A home loan is an example of this type of voluntary lien. In exchange for the loan, the buyer agrees to grant a security interest in the property to the lender. There is no special law that requires this granting of a security interest, it is just a construct that allows the lender to be more secure in the decision to lend the money. This can work in a similar manner in the regular course of business. A UCC lien is a voluntary lien that grants a party a security interest in some piece of personal property in order to secure some debt or extension of credit. For example, an extension of materials on credit may be made to a company subject to a security agreement that the creditor has a security interest in the inventory and fixtures of the debtor. The creditor may then file a financing statement to perfect the security interest.

An involuntary lien arises through operation of law, whether or not the indebted party consents (provided the proper steps are taken). An example readers of this blog are familiar with is a mechanic’s lien. A mechanics lien is a statutory creation that arises with or without the consent of the property owner if the various rules and requirements necessary for the perfection of the lien are complied with.

Integrate Secured Debt Into Credit Policy

It is important to integrate a system for securing the debts owed into [a] business’s credit policy. So, since securing debt is so beneficial to a business’s bottom line, it is important to integrate a system for securing the debts owed into that business’s credit policy. For companies in the construction industry, this means formulating and sticking too, a substantial and proper lien policy. This includes putting a policy in place to comply with the various notice requirements in the various states in which the business performs. For companies in other industries, it may be beneficial to integrate security interests into the contracts that call for an extension of credit.

 

Securing debt prior to the extension of credit is, in my opinion, one of the strongest weapons in the fight to get paid, and therefore, is an essential part of a thorough credit policy.