Considerations Before Extending Credit to a Customer or Client
Most companies, in the course of doing business, will need to consider extending credit to a client or customer. There are many factors to consider before deciding to approve or decline credit to customers, for both the business and the customers.
The first step, before evaluating the credit worthiness of the customer, is to determine the credit worthiness of your business—how much credit exposure your company can afford? Extending credit to a customer is essentially the same as a loan; they are receiving goods and services to use immediately and paying for them at a later date—goods and services that that cost your company money upfront to produce. It is important to consider, especially in a recession, what your cash flow needs are and how much exposure your company can afford. Credit is an agreement to pay, not a guarantee. If the burden of late or unpaid debts will put too much strain on your company, offering credit may not be a good business practice in general.
When banks are evaluating customers for credit they consider four factors – liquidity, collateral, character, and ability to repay. Your business should consider the same factors when evaluating customers and clients.
Liquidity – Liquidity refers to the amount of capital a person or business has to invest. Basically, this is the evaluation of the assets that a company has available to spend compared to its debt and credit obligations. How does the ratio of capital compare to these existing credit obligations? If customers owe significantly more than they have available in assets, or they have large credit balances with other businesses or lenders, they may not be a good credit risk. When assessing the liquidity of their capital, it's a good idea to verify bank references as well.
Collateral – Collateral refers to tangible assets used to secure the line of credit. Examples of tangible collateral include property or inventory. Collateral is a pledge of assets as a guarantee of payment against the credit if the situation arises that payments aren’t made. It is important to consider if the customer has already pledged their assets to a secured lender as in the event of default, this creditor will be paid first.
Character – Character can be a bit subjective. It refers to who your customer is, how they conduct business and treat other venders and creditors. Considerations when evaluating character include how long they have been in business, how stable their company is and whether they've established a history of paying back other creditors. Are there existing lawsuits against the company? How experienced is the company leadership? Do they have credit available with other lenders? Character doesn’t refer to personal feelings toward a customer or client. Many business professionals will establish personal and friendly relationships with long standing customers or clients; but this personal affinity doesn’t necessarily make them a good credit risk.
Ability to repay – The ability for you to be repaid, and the actual repayment of credit is possibly the most important factor. For your business to be sustainable, successful, and profitable you need to make money. For that to happen, any credit extended to customers needs to be repaid. Consider when evaluating your customer ability to repay not only IF, but WHEN. Will they be able to pay in 30 days, 60, 90? And how long can your business go before receiving payment? What are your options if they don't pay?
The depth of any credit inquiry and evaluation should match the amount of credit that you customer is requesting. Conducting an in-depth evaluation and securing assets could cost you more time and money than the potential profit. Conversely, not evaluating a customer's credit worthiness or situation thoroughly enough could be detrimental and result in missed payments to your own creditors.
Just as each client and customer is unique, so is every credit situation. Every request for credit should be considered thoughtfully and each customer treated with respect. The information disclosed during a credit evaluation can be very sensitive and should always be treated as confidential. Whether it's the first time your company is considering extending credit, or a standard operating procedure, if you still find yourself unsure about the best decision for your business, the wisest course of action is to consult of a business financial professional.
Photo courtesy of Andres Rueda via Flickr