Know Your Customers Before You Extend Credit

The funny thing about customers is that they can keep you in business — but they can also put you out of it. The latter circumstance often arises when a company overly relies on a few customers that abuse their credit to the point where the company’s cash flow is dramatically impacted. To guard against this, diligently assess every customer’s creditworthiness before getting too deeply involved.

Information, please
A first step is to ask new customers to complete a credit application. The application should request the company’s name, address, website, phone number and tax identification number; the number of years it’s existed; its legal form and parent company, if one exists; and a bank reference and several trade references.

If the company is private, consider asking for an income statement and balance sheet. You’ll want to analyze financial data such as the profit margin, or net income divided by net sales. Ideally, this will have remained steady or increased during the past few years. The profit margin also should be similar to that of other companies in its industry.

From the balance sheet, you can calculate the current ratio or the company’s current assets divided by its current liabilities. The higher this is, the more likely the company will be able to cover its bills. Generally, a current ratio of 2:1 is considered acceptable.

Check references and more
Next up is contacting the potential customer’s trade references to check the length of time the parties have been working together, the approximate size of the potential customer’s account and its payment record. Of course, a history of late payments is a red flag.

Similarly, you’ll want to follow up on the company’s bank references to determine the balances in its checking and savings accounts, as well as the amount available on its line of credit. Equally important, you’ll want to find out whether the company has violated any of its loan covenants. If so, the bank could withdraw its credit, making it difficult for the company to pay its bills.

After you’ve completed your own analysis, find out what others are saying — especially if the potential customer could be a significant portion of your sales. Search for articles on the company, paying attention to any that raise concerns, such as stories about lawsuits or plans to shut down a division.

In addition, you may want to order a credit report on the business from one of the credit rating agencies, such as Dun & Bradstreet or Experian. Among other information, the reports describe the business’s payment history and tell whether it has filed for bankruptcy or had a lien or judgment against it.

Most credit reports are available for a nominal fee these days. The more expensive reports, not surprisingly, contain more information. The higher price tag also may allow access to updated information on a company over a period of time.

Stay informed, always
Although assessing a potential customer’s ability to pay its bills requires some work up front, making informed credit decisions is one key to running a successful company.

Contact us if you would like to discuss how we can help you with this or other financially critical business practices.