Source: QuickBooksOne of the primary reasons for poor cash flow management is extending credit to customers without assessing their creditworthiness. Small and mid-sized businesses need to have a strong credit check policy before onboarding new customers to avoid cash woes.
Creditworthiness is an essential principle of business, signifying how deserving a customer is of getting credit. A customer is creditworthy if the company believes it can pay the debt on time. It is determined by multiple factors such as revenue, payment history, credit score, outstanding liabilities, etc.
Businesses use multiple criteria to determine a customer’s creditworthiness. The five Cs of credit is one of the most well-known techniques for evaluating creditworthiness. Understanding the five Cs—character, capacity, capital, collateral, and conditions—can assist in determining a customer’s capability to repay the borrowed credit. Let’s look at what each one signifies.
Character assesses how dependable and trustworthy a customer is. To establish a customer’s character, one must analyze their credibility and background. Credit history is one of the main factors to consider while evaluating a customer’s character. It contains a detailed description of the customer’s credit report and credit score. This data includes how long the customer has been in business, bankruptcies, whether they make timely payments, and more. Credit scores vary from 300 to 850, with higher scores indicating strong creditworthiness.
Capacity refers to the ability of the customer to repay their debt. To evaluate the capacity of a customer, consider cash flow statements, business debt, and payment history. The Debt Service Coverage Ratio (DSCR) and Debt-to-Income ratio (DTI) help determine a company’s cash flow and overall health. A DSCR of 1.25 or higher and a DTI ratio of 36% or lower is considered ideal.
Capital signifies the total funds and assets (both financial and non-financial) owned by a company. Before extending credit to a new customer, evaluate the worth of the customer’s business in terms of their investment in fixed assets and other instruments. Review the customer’s bank records and financial statements to get a clear picture of their capital. If these statements show a trend of strong capital growth, the customer is less risky and can be assigned a higher credit limit.
Collaterals are assets that a customer commits to back a line of credit. These are fixed assets like inventories, corporate bonds, or real estate. Companies generally demand collateral as an assurance for extending credit. While working with a high-risk customer, always ask for collateral to limit the likelihood of bad debts.
Conditions are terms established by a company in light of its policies or due to economic conditions or regulations prevalent in the customer’s region of operations. Geographic location, industry type, currency fluctuations, and political environment are some of the factors that influence a company’s payment terms and conditions. A customer with a stable geopolitical environment is more creditworthy since it faces lower economic risks.
Before granting credit, a company should assess the customer’s competence to manage and repay outstanding debts. Collecting and analyzing information about the customer from credible sources to check creditworthiness can help you avoid the pitfalls of late payments or bad debt. Here is a step-by-step guide to determine the creditworthiness of a new customer:
Collecting relevant information about the client is the first step to assessing creditworthiness. The customers should fill out a business credit application form consisting of general business information, bank references, credit references, and more. These details would help to aggregate client data in one place for faster customer onboarding.
Analyzing credit reports is an ideal method to evaluate a customer’s creditworthiness. A credit report contains information on the company and its financials, enabling you to generate credit scores. It depicts a company’s capacity to pay by tracking its payment history and public records. Credit reports of a company are available for purchase from credit reporting agencies such as Experian, D&B, and Equifax.
The financial report of a company provides insights into its cash position. Financial reports include the cash flow statement, income statement, and the balance sheet of the company. The financial health of a new customer should be examined thoroughly by reviewing their public financial statements.
Analyze the DTI ratio of a customer to better understand their cash flow statement. DTI ratio indicates how much of a company’s monthly income is spent on repaying debts. It helps determine the risk associated with the customer account. To calculate the DTI ratio, divide the company’s monthly debt payments by gross monthly income.
A low DTI ratio indicates a healthy balance between debt and income, whereas a high DTI ratio shows that a client has more obligations than the monthly income.
You must use multiple sources to conduct further investigations to evaluate the creditworthiness of a customer. These investigations should contain:
All these factors contribute to better decision-making and customer authentication.
After gathering all necessary information about the new customer, conduct a comprehensive account analysis. Evaluate trade references, scrutinize financial statements, and apply credit analysis to predict the probability of default. While performing credit analysis, the profitability ratio, leverage ratio, and liquidity ratio are some of the key financial metrics to consider.
While onboarding new customers, a company runs credit checks through credit reporting agencies. However, sometimes credit agencies may not have all the required information or may have incorrect data. Such a situation does not indicate that the client is not creditworthy. It simply implies that the company did not supply sufficient information to the agencies to generate a credit report.
Asking the client to provide active trade references can solve the issue. A trade reference is a detailed report of the customer’s payment history with its vendors and suppliers. It provides much information on the client’s credibility. Checking further with these vendors and suppliers can help you get more details on the customer. Here are a few questions you can consider asking:
Mid-size businesses often rely on their customers for their working capital requirements and hence need to keep a close eye on the clients’ financial health. Use the tips provided in this step-by-step guide to optimize your working capital and minimize risk.
To streamline your credit portfolio and customer onboarding, replace paper-intensive credit management processes with digital practices. Utilizing solutions like RadiusOne Credit Risk Application will help you become more efficient. Our automated credit scoring feature, based on industry-specific best practices, helps you predict customer payments. Schedule a demo or visit the product page to know more.
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