Does your company have a specific method for setting up customer credit? How do you set up dollar limits and why?
We’re going to focus specifically on the credit approval process. We’ll discuss what you need to get from the customer to make an informed credit decision, and then how to analyze that information to make better credit limit decisions and avoid bad debts.
THE CREDIT APPLICATION
Check your standardized credit application to make sure it has the following information:
- Amount of credit requested. Although this seems so simple, many credit applications do not ask the customer how much credit they would like. Therefore, we grant credit in excess of the customer’s own comfort level. If you set the limit low and the customer needs additional credit at a later date, this gives you the opportunity to ask for updated information for a better decision.
- Financial statements. Two years’ fiscal year end statements and a current interim should be required for credit requests above a certain amount. That actual amount depends upon your company’s bad debt threshold, but you should never have that threshold above 5% of your normal total receivables. For example, if your receivables typically run $500,000, financial statements should be required for anyone needing credit of $25,000 or more. For your comfort level, you may wish to reduce this to a smaller amount such as $10,000. (See later in this article on how to analyze the statements.)
- Owner/officer social security numbers. Particularly with sole proprietorships and small family owned corporations, you will want to look at the personal credit history of the principals. How the owner handles his personal debts is reflective of his business integrity. And, if you must rely on his personal guaranty to back up the corporate line, you want to be sure your customer does not have derogatory credit history.
- Corporate Ownership Information. Sometimes our biggest customers are subsidiaries of larger corporations. There is a tendency to think that because the parent company is big, they must be financially strong. This is a myth! Insist on financial information on the parent company, particularly on your large accounts.
- Authority to Bind the Company. The credit application should include language that the person completing the application and signing has the authority to bind the company. This can save you a few pennies if you end up in court later.
- Bank account and trade references. The application should have blanks for account numbers, names and phone numbers of contact persons.
PROCESSING THE APPLICATION
Now that you’ve received the application, here are eight tips for what to do with it:
- Do not sell on credit until the application has been reviewed and approved!
- See #1! It’s so important it bears repeating! When you’re staring a huge new account in the face and thinking about all that margin, it’s tough to delay the first load or ask for cash until the application is processed. But, you must do this! Even an emailed application is fine to get your credit approval started.
- Make sure the application is fully completed. If not, call the company and get the missing information you need to analyze the request.
- Call the bank and ask:
Any overdrafts?
Amount of total credit?
Amount outstanding?
Expiration date of bank commitment?
Length of time with bank?If the company has no overdrafts, available credit many times their requested trade line, and a long history with the bank, approve their request unless it’s a very large customer and you need more analysis. On the flip side, if they don’t have a bank line, you better be sure they have a lot of cash in their account. Be sure you know how you’ll get paid. If you can’t figure that out, maybe your customer can’t either! Find out or decline. - Call suppliers. Pay attention to slow pay information as delayed payments cost you money. How’s your margin on this account? Will you make enough margin to carry the receivable? A very thinly priced big account may become a loser if they consistently pay slow. Also, ask what the credit limits are with the existing suppliers. If everyone else is at $5,000 and your customer wants $50,000 from you, this could be a red flag.
- Get credit bureau information on the owners and the company. Look for derogatory information, particularly on the personal history. How a person handles personal credit is at the heart of their integrity. Decline accounts or owners with derogatory credit.
- Analyze Financial Statements – You should look for:a) Adequate cash balances to pay your bills and any large negative changes in cash from one statement to another, particularly going from a cash balance to an overdraft.
Current ratio (current assets divided by current liabilities). A ratio of 1.5 to 1.0 or more is good. Anything less than 1.0 to 1.0 the company is in trouble should be declined.
b) Accounts payable time – Take the company’s FYE cost of goods sold and divide by 365. (This equals one day’s payables). Now divide the payables on the most current statement by this amount. This equals the average number of days they take to pay their bills. Is it reasonable? Over 30 days? Over 45 days? When do you want to get paid? Decline the request if the company appears to be paying way beyond terms.
c) Compute leverage – Divide the company’s total liabilities by their total net worth. Debt of 3 times net worth or less is OK. Debt more than 3 times worth is dangerous. How will you get paid if the company has unexpected losses? Call the company to discuss the leverage problem before declining the credit in case there is a good explanation and credit strength in another affiliated entity.Just these four simple tests should give you a yes or no answer to extending credit.
- Be prepared to say NO. If there is any doubt in your mind about the company’s financial condition, decline the request. You may make a bad call and lose some potential profit. But if you grant the credit and get a bad debt, you’ve lost not only real profit but the cost of your product as well.
These are just a few guidelines to help you make credit decisions. Meridian is here to help you as well. We have financial information on all types of industries in our resources. Feel free to call us at 800-728-9005 if you need information on what is “normal” for various industries.
