To simplify ordering and sales, companies will offer special financing known as trade credit. Trade credit allows a customer to take ownership of a product at the time of the sale based on a promise to pay at a later date. While trade credit can help turn orders into sales much faster, it is also an unsecured form of credit, which means that trade credit lenders are not likely to recover money owed if the customer files for bankruptcy. Establishing a process of evaluating a customer’s credit worthiness will reduce this risk.
Gather information about your customer's company and finances. You should obtain information like the customer’s name and related business names, address, phone number, tax identification number, at least three trade references and a bank contact. For customers that need a large amount of trade credit, you should obtain their audited financial statements.
Verify that the company exists. Scam artists may try and order on trade credit, resell your product and vanish without making payment. There are many ways to verify that a company exists. If they produce products that are sold at retail, try and find retailers that carry their product. Commercial credit bureaus collect credit information on most companies and will verify if they have records for a company for free (see Dun & Bradstreet in Resources).
Request references from the credit applicant’s vendors and lending institution. This is a common practice and should not surprise or offend a potential customer. For trade references, ask about payment habits and high credit balances. Credit candidates will supply the vendors that they do the most business with and pay the best. Any negative feedback from a reference is a clue that the customer is a poor credit choice. For banks, inquire about balance levels and non-sufficient funding. If a customer does not have a large enough balance to pay the credit they are requesting, they will struggle to pay their invoices.
Obtain a credit score from a commercial credit bureau. Companies have credit scores similar to individual credit scores. For a fee you can obtain payment, balance and public record information on a credit applicant. Be careful basing your credit decisions solely on credit reports. These reports will provide a wealth of information, but scoring can be based on outdated, incorrect or incomplete information. Review them with a critical eye.
Perform a financial ratio analysis. Financial ratios mathematically test accounts on a company’s financial statements to help determine financial strength. There are four types of ratios. Liquidity ratios test a company’s ability to pay back regular creditors like trade credit. Leverage ratios help to establish if a company has taken on too much debt. Profitability ratios test a company’s ability to make sales and earn profit. Efficiency ratios analyze a company’s operations, like how many days it takes for the company to pay invoices.
Calculate the Altman Z-Score. This step is sometimes considered part of the financial ratio analysis. Altman Z-Score is a statistical algorithm performed on certain financial statement accounts and is used to identify companies that are likely to file for bankruptcy. The formula calculates a score that can be compared to three ranges. One range identifies companies likely to file for bankruptcy. Another range is indeterminable. The last range is safe from bankruptcy. According to the CPA Journal, the Altman Z-Score has successfully predicted 72 percent of bankruptcies up to two years prior to filing.
Evaluate the information you have gathered. There is no official method for determining credit worthiness. Some credit managers create internal scores by rating a company's performance in each of the previous steps, then comparing to a potential maximum score. Others look for red flags, like an Altman Z-Score in the bankruptcy range or a poor liquidity ratio. Regardless, the analysis is looking to answer two basic questions: "Can the customer pay for their orders?" and "Will they pay timely?"
All companies have varying financial strengths and weaknesses. It is important to look at these steps as pieces to a bigger puzzle. A few negative aspects should not deter you from lending to a customer who has a strong financial position overall.
It can also be helpful to review the notes of the financial statements. Occasionally, companies will hide critical obligations or liabilities in these notes, off of the financial statements.
While it is common to ask for financial statements, private companies often resist furnishing them.
- All companies have varying financial strengths and weaknesses. It is important to look at these steps as pieces to a bigger puzzle. A few negative aspects should not deter you from lending to a customer who has a strong financial position overall.
- It can also be helpful to review the notes of the financial statements. Occasionally, companies will hide critical obligations or liabilities in these notes, off of the financial statements.
- While it is common to ask for financial statements, private companies often resist furnishing them.
Shaun Fowler is the author of a personal finance blog. He works full-time as a financial analyst while completing a Master of Business Administration in accounting.