In an ideal world, you’d be able to demand full cash payment on delivery of your services. In the real world, however, you’re going to have to extend credit to some of your customers.
When you extend credit, you are in effect loaning customers your own money. You want to be reasonably sure that you’ll get your money back. The best assurance of being able to collect is to check each customer’s credit history before extending credit. That can be as simple as a phone call; it can also be considerably more complex.
However you choose to check your customers, you’ll want to build a credit relationship slowly and carefully. Remember, not every customer deserves the same credit terms; thus, it’s best to approach credit on a case-by-case basis. One thing to note is how long the company has been in business. Companies that have been around for at least five years are more likely to pay their bills on time — or they wouldn’t be around anymore.
The key ways to check a customer’s credit include credit reports, credit references, financial statements, personal credit reports on the owner or CEO, and letters of credit.
Credit reports. It’s always a good idea to obtain your potential customer’s credit report before you extend them credit. Credit reports range in price from $15 for a one-page report to $1,000 for a detailed filing. The reports show you historical payment data, bankruptcy records, any lawsuits, liens and court judgments against a company, and a risk rating that predicts how likely a customer is to pay their bills. Even if your prospective customer has little or no credit history, running a credit report is still worthwhile because it will reveal relevant data, including bankruptcy filings, corporate records, fictitious business name filings, court judgments and tax liens.
Credit reporting agencies can send you a credit report via mail or fax. Some agencies also provide reports online. If you request a lot of reports, you might be able to sign a contract that will reduce your per-report price.
Credit references. In addition to credit reports, or for companies not covered by commercial credit reporting agencies, you may want to check a customer’s credit references yourself. These references can be informative, but they aren’t foolproof. After all, your customer picks their own references. To gain a more realistic picture, ask your customer for a comprehensive list of suppliers. Call several and ask if your potential customer owes them money. If so, find out if payments are being made in a timely manner. Ask for a list of other suppliers and other customers and contact them as references.
You might want to call the customer’s banker as well. Ask how long the bank has had a relationship with the company. What is the average balance in their checking account? Has the bank given them any credit? How much? If a loan was given, did the company meet its obligations?
Financial statements. When dealing with public companies, a customer’s balance sheet can tell you a lot about the company’s ability to repay the money you lend. (But not necessarily about its willingness to pay — that’s where you need a credit report.) The ratio of the company’s current assets to its current liabilities is an especially good indicator. If this number, called the current ratio, is less than 1-to-1, the company is probably not a good credit risk. If the number is greater than 2-to-1, you are probably safe. If the ratio falls somewhere between those figures, keep digging.
Personal credit report of the owner or CEO. If you are contemplating doing business with a new, closely held private company, you may not be able to obtain a credit report, references or financial statements. You can, however, run a personal credit check on the owner or CEO of the business. If that person has a strong credit history, it’s likely they will see to it that the company pays its bills on time. If the owner or CEO has a history of debt dodging or late bill payment, the company could follow suit. If your review raises concerns, schedule a meeting with management to address the issues. You may also want to discuss credit issues with any investors in the firm.
Letters of credit. Some new companies may have orders for future business, but not yet have the financial means to produce the finished goods. A letter of credit from a bank that says that a customer has a bona fide order from the company is a good indicator of future ability to pay.
Red flags. In addition to the standard inquiries into a company’s credit situation, keep your eyes open for other things that could indicate a credit problem:
- Does the business engage in unusual price-cutting or discounting strategies? Such practices may hinder the company’s ability to pay you what it owes in a timely fashion.
- Does the company already have trade credit relationships with other companies? You don’t want to work with a customer that is already overextended.
- Are any company assets already pledged as collateral?
- Does the company operate in a cyclical industry or in a business sector that is prone to seasonal turns?
- What is the general economic climate? When business is good you may be more willing to extend credit. When things are slow, however, you may want to be more tight-fisted in extending credit to higher-risk customers.
Finally, pay attention to the results of your research. Sometimes “no” is the right answer when it comes to extending credit, no matter how much you want the business.
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