THE CREDIT APPLICATION
The first step to avoiding bad debt is to have a formal credit application document. It is equally important that all information on the form be entirely completed. In reviewing many firms’ bad debt accounts, frequently there was no formal application and if there was, the credit application was often incomplete, unsigned, filled in “after the fact,” or never checked prior to actually extending credit.
The application can be customized to your company’s particular needs or style but at a minimum should include the following:
*Company name, address, telephone number, and contact person.
* Trade and banking references complete with account numbers, addresses, contacts,and phone numbers
* Tax information (federal ID #, sales tax #, use tax #, UST)
* Type of entity (C or S Corp., Partnership, Proprietorship)
* Owner/major stockholders’ names, addresses, and social security numbers
* Credit amount requested
* Agreement to your company’s credit terms and conditions.
* Signature and title of person making the application.
* A paragraph under the signature stating that person is authorized to sign for the company.
CHECKING CREDIT REFERENCES
After obtaining the completed application, a telephone call should be made to each trade and banking reference with the following information obtained from each reference:
Credit Limit
Current Outstanding Amount
Payment Performance.
First, review the credit limit. Is this customer asking for more credit from you than they typically receive from other suppliers? Are they asking for more credit from you than they have with their own bank? Unless you have a very good reason, you don’t want to be their largest creditor!
Next, review the outstanding amount of their debts in relationship to their total credit limits. Is the company at 80% – 100% of their capacity, particularly on their bank lines? If so, they are probably strapped and in a cash flow problem! Do you want to risk doing business with them?
When checking performance, we suggest that you belong to a credit reporting agency such as NACM (National Association of Credit Managers), or TRW Business reports to get a total picture of payment performance. Most companies will only list satisfactory accounts on their application so an outside report is the only chance you have of finding out derogatory information. If you use D&B reports, the trade information is often out of date but you can acquire other useful information such as frequent changes in accounting firms, asset liens (UCC filings), and company history and ownership.
SETTING CREDIT LIMITS
Credit limits should be set based on the company’s financial merits rather than simply their buying needs at the time. Too frequently, limits are set by a salesman just saying “I think they’ll buy $__ per month”! In addition to the company’s financial merits, the credit limit should also be based on your own company’s financial picture.
The first benchmark for establishing a credit limit for any customer should be your company’s typical annual profit after taxes. Do you want to risk more than one year’s profit on any one customer?
Next, is the credit limit requested within the normal range of creditors? Does the company have a bank line with enough credit availability to pay the limit you are about to establish? Based on the gross margin you expect to make on this customer, how long would you need to sell product to them to compensate for one month’s bad debt? Is this customer worth the risk?
SPECIAL HANDLING OF LARGE CUSTOMERS
A large customer is usually defined as one where the monthly credit extended is 5% or more of your normal total accounts receivable at month end. For these customers, it is prudent to ask for their financial statements annually and study their financial trends. Some of the things you may want to look for are:
* Are sales up?
* How’s profit?
* What’s the cash balance – increasing or decreasing?
* Are receivables greater than payables or vice versa?
* Has leverage increased?
And you should update your trade reference information annually on these same accounts. What once was a “good as gold” account can change quickly in
a financially stressful environment.
DECREASING CHANCES OF BAD DEBT ON HIGH RISK ACCOUNTS
To decrease risk on a large customer, or any customer you feel warrants some extra measures for safety, use the following strategies:
1) Request personal guarantees from owners and/or major shareholders. It is not as easy to walk away from debt if personal assets and reputation are on the line!
2) Take collateral – ask for equipment, vehicles, or other assets that have value approximately equal to your credit exposure. Before filing your lien, do a title search through Motor Vehicle, County Recorder, or Secretary of State to be sure the asset belongs to your creditor and there is not a prior lien.
3) Require a letter of credit – On a very high risk project (a brand new business for example), ask for a bank standby letter of credit. These are issued by your customer’s bank and are convertible to cash when presented at the bank. Be sure to read the fine print. It states what terms and conditions must be met for you to collect.
These strategies can also be used on delinquent accounts to reinforce payment. A personal guarantee and collateral should always be attempted if a potential loss is foreseen.
MONITORING ONGOING CREDIT
Once credit has been established, stick to the limit and be ready to cut off supply if necessary. Don’t be fooled by “promise to pay” tactics. You must know when to “pull the plug” and limit your losses. If a customer starts to slow pay, find out why. Pull another credit report, call the bank again, and check with trade references again. Look at your credit limit again. Is it still appropriate?
With careful attention to extending credit and monitoring credit, you can effectively reduce your bad debt expense.
