Volumes have been written about the criteria you should use to make a credit decision. The rigor with which this information is often presented belies the fact most business credit decisions are not that difficult. Using objective criteria, it is relatively easy to determine which companies are worthy of open credit terms and which are not. There is a challenge, however, with the 20 to 30 percent of credit decisions that fall in between.
Backing this up, a study found credit scores to be useful in arriving at credit decisions for the top 60 percent (approvals) and the bottom 20 percent (denials). For the marginal 20 percent in between, the best decisions were made using a combination of objective factors and the credit analyst’s insights.
Common sense also dictates that credit evaluations need to be more rigorous when the amount of credit required exceeds the working capital and cash flow capabilities of the company being evaluated or when derogatory information clouds an otherwise financially stable enterprise, but that’s a discussion for another day. This review of the ABCs of credit evaluations focuses on the 70 to 80 percent of decisions that will be relatively easy to make.
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Credit Evaluations Start with You
Before you even begin evaluating business customer credit worthiness, you need to understand your own tolerance for risk. In large part, this will be determined by your profit margins. As a rule of thumb, firms with higher gross margins can afford to be more risk tolerant than enterprises with tight margins. This is because the higher your profit margins the fewer sales it will take to compensate for any bad debt losses.
A secondary consideration is your production capacity. As your production pipeline approaches full capacity, the fussier you can be about who you grant open credit terms. Conversely, if you have ample spare capacity, for which you are incurring overhead costs, it makes sense to be more generous in extending credit.
There are the factors, on top of your own tolerance for risk that form the basis of your credit policy. The question you need to answer is: should credit policy be liberal or conservative?
Credit Applications and Credit Reports
The primary sources of information for you credit evaluation will be found in the customer’s credit application and a credit bureau report. A credit application provides ownership information, the type of entity (proprietor, partnership, corporation, etc.), age of the business, credit and bank references, and possibly financial statements (click here for more information on credit applications). A credit bureau report will confirm some or all of these details, most importantly payment history, plus provide other public record information such as judgments and liens.
Many times, the payment history section of the credit report will show you enough to make a solid decision. If the payment history shown in the report is limited, then checking the credit references from the application may be necessary. With payment history, you should look for instances of credit being extended above or equal to the amount of credit required for your sale. If payments are also reasonably prompt, and it looks like there is sufficient credit availability on the credit lines reported, then, in the absence of any other derogatory information, a credit approval is appropriate.
When you are dealing with a new business (e.g., under two years in existence), you will need to be more thorough in your credit examination. This is because many startups fail, but the failure rate drops significantly after a couple years of continuous operations. The rule of thumb is the longer in business the lesser the credit risk.
With relatively small dollar credit requirements, you can save money buying a credit score (or credit score report) rather than a full credit report. All you are looking for is a satisfactory score. If it isn’t, you will need to dig deeper.
Readers of Your Virtual Credit Manager can now access sharply discounted business credit reports from D&B, Experian, or Equifax through our partner accredit.
An Introduction to Financial Statement Analysis
When extending a higher credit is required, financial statements are invaluable. Go here to for tips on getting customers to share their financial statements. Assuming you are able to get complete financials - the Income Statement, Balance Sheet, and Source & Application of Funds - here’s five fundamental items to inform your review and analysis:
Profitability: Obviously, it’s a plus if a company is making a profit as shown by their Income Statement. If not, you should look at year-to-year trends and take a close look at their Free Cash Flow (FCF) to see if they are a satisfactory risk for the short to medium term.
Liquidity - Quick Ratio: This is the sum of cash, marketable securities, and receivables divided by current liabilities. If the ratio is less than 1.0, the firm will have trouble paying its debts on time. Even if the ratio is just slightly over 1.0, there could be a problem if their receivables are turning over slowly. On the other hand, a high Quick Ratio can compensate for a low Current Ratio (current assets divided by current liabilities), which is another liquidity measure.
Inventory to Net Working Capital: Net Working Capital is defined as the excess of Current Assets over Current Liabilities. A high ratio can be indicative of overbuying, falling sales, or carrying old inventory. If the ratio is low, make sure liquidity is sufficient.
Leverage –Current Debt to Tangible Net Worth: When the ratio exceeds 1.0, it’s an indicator that the suppliers are at risk, especially if there should be a deterioration of business conditions or an interruption in cash flow. Another leverage indicator is Total Debt to Worth: the higher the ratio, the greater the leverage and corresponding risk. With both these ratios, you need to understand how much of the debt is secured (typically the bank loans). The higher the percentage of the debt that is secured, the greater the risk to any unsecured creditors (most suppliers).
Free Cash Flow: FCF is simply the cash a company generates for paying creditors, or to pay interest and dividends to investors. It is a reconciliation of Net Income in that it adjusts for non-cash expenses, changes in working capital (e.g., rising or falling inventory, receivables, and accounts payable), and capital expenditures. FCF is used to realize problems in a business’s fundamentals before they show up on the Income Statement. In a loss generating scenario, the Burn Rate, the rate at which a company is depleting its liquidity, provides an indication of when the company will become a payment risk.
There are other factors you may need to examine if these don’t indicate a positive determination of credit worthiness. However, most of the time, a cursory review will tell you all you need to know.
Need help setting credit policies and procedures? The experts at Your Virtual Credit Manager will analyze your situation to provide you with actionable insights to reduce risk, increase performance, and accelerate cash flow.
Setting Credit Limits
Besides determining whether or not to approve open credit terms, your credit analysis will also need to determine a credit limit. There are no hard and fast rules for doing this, but there are some general guidelines. Keep in mind that your company’s profit margins and operating capacity will be a factor in your decision process, whichever of these four guidelines you choose to apply to the situation:
Credit Ratings: Agency ratings are not as widely available for smaller private companies as they were 50 years ago when D&B was a virtual monopoly. However, ratings are available, often from multiple sources, from the Wall Street rating agencies (e.g., Moody’s, S&P, Fitch) as well as credit bureaus on public companies and many large private firms. It’s a simple matter to create a table that associates a credit limit with a public credit rating.
Order Volume: This is probably the most widely used factor for setting credit limits. If a new customer is looking to order $5,000 per month, and terms are Net 30, assuming your credit evaluation has been favorable, a $10,000 limit is reasonable. This allows a second order to be billed if the first is not yet due, or only slightly past due. It’s simply a matter of using common sense with consideration given to your firm’s environment and the order scenario with a particular customer.
Percent of Net Working Capital: This is a bit more objective than the first two guidelines. To determine the percentage, you should factor in the number of major suppliers to the company in question (the payment history section of their credit report should provide some indication). If you determine there are 20 major suppliers, it is reasonable to set 5% of Net Working Capital as your limit, or a little less if you want to be more conservative. With a large corporation, even just 1% of Net Working Capital can be a large amount, and thereby provide you with a substantial level of comfort if the credit limit needed is higher than what you typically grant.
Percent of Tangible Net Worth: This works the same way as the Net Working Capital guideline. If your customer is highly leveraged, you may want to base the credit limit on Net Worth instead of Working Capital.
Over time, you will want to factor in your own payment experience with your customer’s to adjust their credit limits. The rule of thumb is to set limits high enough so that most orders can be automatically approved, but also conservatively enough so that you don’t find yourself suddenly overexposed to customers that may be facing headwinds.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
The Four Cs of Credit Provide Perspective
This article has focused on objective criteria for making solid credit decisions in 70 to 80 percent of the situations you will face. As for the other 20 to 30 percent of the situations which involve marginal accounts and/or marginal circumstances, your decisions will become more subjective.
A good outline of the issues involved in credit evaluation is found in the old standard: The Four Cs of Credit which are summarized below:
Character – willingness to meet obligations: This is probably the most important factor and the hardest to determine. An owner who values his integrity will do everything possible to pay you.
Capacity – ability to sustain operations: Profitable businesses that are generating Free Cash Flow in good times and bad provide minimal credit risk.
Capital – financial condition/ability to pay: Under-capitalized businesses are riskier because they are more likely to run out of the funds to pay you.
Conditions – economic, geographic, industry, political: This is probably the most overlooked factor. For example, seasonal and cyclical businesses bear closer scrutiny because they are more subject to external factors than the typical business. Always keep in mind that as much as 80 percent of the success of a small business is determined by their local economic conditions and competitive factors.
The more credit evaluations you do, the more valuable will be your intuition. Automated systems using Artificial Intelligence (AI) and Machine Learning (ML) will undoubtedly shrink both the number of manual and marginal decisions to be made, but in the final analysis, there will always be a need for a person to add value to the credit evaluation process.