Funny thing about customers: 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, you need to diligently assess every
customer’s creditworthiness before getting too deeply involved. And this
includes running the numbers on entities you do business with, just as lenders
and investors do with you.
Information, please
A first step is to ask new customers to complete a credit
application. The application should request the company’s:
- Name, address, phone number and website address,
- Tax identification number,
- General history (number of years in existence),
- Legal entity type and parent company (if one exists),
and
- A bank reference and several trade references.
Depending on which industry or industries you serve, there may
be other important data points to gather, as well. If you haven’t updated your
credit application form in a while, consider doing so — especially if you’ve
gotten burned on the same type of credit failure multiple times.
Financial data
When dealing with private companies, consider asking for an
income statement and balance sheet. You’ll want to analyze financial data such
as 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 like those of other companies in the customer’s industry.
From the balance sheet, you can calculate the current ratio, or
the customer’s current assets divided by its current liabilities. The higher
this is, the more likely the customer will be able to cover its bills.
Generally, a current ratio of 2:1 is considered acceptable. Again, there may be
other metrics that are particularly important for the types of businesses you
work with.
An evolving challenge
Reviewing financials is only one key step in determining whether
a customer is creditworthy. It’s also important to contact the references the
customer provided, and you may want to purchase a credit report. Finally, be
sure to look at coverage of the customer both by traditional media and on
social media. Doing so could reveal information that will impact your decision
on whether to extend credit.
When competing to win and keep customers, it’s easy to get
carried away with credit. Approach this task carefully and bear in mind that,
for most businesses, extending customer credit is a learning process and an
evolving challenge. For further help and info on assessing customers’
creditworthiness, please contact our firm.
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