Basics of Evaluating Credit Limits for Customers
Making credit limit decisions for a small business can be a challenge because it involves tough issues for both obtaining and evaluating the key information. Banks and credit companies spend a lot of time making credit decisions, and even they still have issues. In many smaller companies, the establishment of credit is often just an educated, or overly hopeful, guess.
Although this is a common problem for a supplier, it is a very challenging one, especially since the manufacturing and sales department and internal revenue targets often become the Company’s own worst enemy when evaluating credit for their customers.
Here are some of the key steps involved in deciding whether or not to extend credit limits:
1. Get the relevant information – from the customer
- Historical financial statements
- Projected financial statements
- Schedule of aged receivables and payables (perhaps with the names deleted)
- Trade References
- Bank references
- Letters addressed to the customer’s trade and bank references asking them to share and disclose information to you
- Income tax returns and related IRS transcript request form.
2. Evaluate the accuracy and completeness of the gathered data
3. Decide whether to seek data from outside sources that relate to the prospective customer
- Credit bureau information, such as Dunn & Bradstreet
- Third-party credit analysis company such as credit.net (not endorsed) or other credit analyzing services.
4. Use all of the data to judge the creditworthiness of the prospective customer
5. Decide what (if any) the credit limit will be
6. Decide what terms will be offered
7. Decide whether any personal guarantee, or other collateral will be required.
8. Ask the customer if they have been turned down for any credit recently or if they have had any of their credit limits or credit lines curtailed in the last twelve months.
Problems and Issues you May Encounter
One problem with this list is that many customers may not want to provide much of this data. Applicants for trade credit may not be willing to fully disclose their financial information, company history and near-term goals to their suppliers for competitive reasons, or merely because other suppliers in the past have not demanded such information in the past.
Also, you may have trouble getting third parties to disclose information about their customers, even if you have signed release forms. This is because: (1) they don’t want to waste time helping you to make your credit decision, (2) you may be a competitor of some of the trade references, (3) they may fear the legal repercussions of sending out a bad report and therefore may have a policy of “it’s easier to just never disclose”.
So, without full information – one is basically guessing and hoping; and even with all the information, it takes a great deal of insight and business judgment to make wise credit decisions. The decision becomes even harder when the sales team, and possibly upper management, is pushing for the extension or increase of the credit limit to the customer.
Finally, in many smaller companies the person analyzing the credit limits is not doing it full-time. He or she is squeezing it in to an already busy schedule. And, many potential customer relationships are just too small to merit all of this attention. In that case reliance on the Dunn & Bradstreet report and calling a few trade references may suffice.
If a customer is requesting a significant credit limit, then you need to pay attention to many more details. We suggest, at a minimum you look at fully documented GAAP basis financial statements and a summarized list of the aged receivables and payables. If many of the payables are more than 45 to 60 days old then you may be facing a difficult and risky credit decision.
There is much more to this process, but I hope this introduction is helpful. If you need more information on this topic, we would be happy to schedule a meeting to discuss this topic further.