Module 2 - Is My Customer Credit Worthy
Module 2 - Is My Customer Credit Worthy
Module 2 - Is My Customer Credit Worthy
New Customer
Key Takeaways
Introduction
It is no secret that a steady cash flow is crucial for operating a successful business.
However, it may surprise you to learn that cash flow issues often play a significant role
in the downfall of many businesses, particularly SMBs.
According to a QuickBooks survey, 60% of small business owners have encountered
cash flow problems in the post-pandemic economy.
One of the major reasons for cash flow problems is late or non-payment. This occurs
when businesses extend credit to customers without conducting proper creditworthiness
evaluations.
What Is Creditworthiness?
Creditworthiness is an evaluation of a company’s financial reliability to
ensure that it can meet its debt obligations on time. This assessment
is crucial for businesses, as it helps them make informed decisions
about whether to offer credit terms to another company or not.
1. Character
2. Capacity
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
evaluate 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.
3. Capital
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.
4. Collateral
Collateral refers to assets that a customer commits to back a line of credit. These may
include fixed assets such as inventories, corporate bonds, or real estate. Companies
often require collateral as assurance for extending credit. When dealing with a high-risk
customer, it’s advisable to ask for collateral to minimize the likelihood of bad debts.
5. Conditions
You must use multiple sources to conduct further investigations to evaluate the
business credit risk of a customer. These investigations should contain:
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.
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:
Going above and Beyond
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.
In this article, we will explore the meaning of trade credit, how credit
insurance works, the benefits of trade credit insurance, and real-life examples of its
application.
Increased sales: by offering credit terms, it becomes easier and more convenient for
customers to purchase goods or services
Customer loyalty: when customers are given the option to pay for good or services
with credit terms, they may be more likely to return in the future
Enhanced understanding of customer creditworthiness: by extending trade credit to
customer, a business can gain a deeper understanding of the creditworthiness of
potential customers, if supported by the right tools and procedures
A strong credit control procedure is essential for every company, whether large or small,
and outsourcing this activity can be the most effective alternative: for example, a
good trade credit insurance policy, enables companies to control their financial
situation and the long-term management of their client portfolio.
The Credit Insurer proactively monitors customers’ buyers throughout the duration of
the policy, by gathering information and matching them with economic intelligence,
market trends and industry risk analysis. Throughout the life of the policy, the
policyholder may request additional coverage on a specific buyer should that need
arise.
The ultimate goal of a trade credit insurance policy is not to simply pay claims as they
arise,
but more importantly to help policyholders avoid foreseeable losses. Credit
insurance goes beyond indemnification and does not replace a company’s credit
practices, but rather supplements and enhances the job of a credit professional.
If an unforeseeable loss should occur, the indemnification aspect of the trade credit
insurance policy comes into play. In these cases, policyholders would file a claim with
supporting documentation, and the insurer would pay the policyholder the claim benefit.
All the benefits of providing trade credit to customers, such as increased sales,
improved customer loyalty, and enhanced understanding of customer creditworthiness,
can be further amplified by implementing a credit insurance policy. By ensuring against
the risk of non-payment, a company can expand their business, attract new
customers, and retain existing ones, while also trading with a greater sense of security
and peace of mind.
Here are a few examples of how trade credit insurance might be used by different types
of companies:
A credit application is a form a borrower fills out to request credit. The form can usually be submitted
either online or in person.
Key Takeaways
The information included in a credit report helps the lender determine whether the borrower is
a good candidate for a loan.
You can usually fill out a credit application either online or in person.
Lenders are required to notify you in writing and provide a reason if they deny your credit
application.
Revolving credit and installment credit are two primary forms of credit that borrowers can apply
for.
A credit application is filled out by a borrower and submitted to a lender to request a loan or other
financing. A contractual relationship begins between the borrower and that lender when the lender
receives a credit application.
The application provides the lender with important information about the borrower. Applicants will
typically be asked to include the following information on a credit application:1
Address
Phone number
Credit references
The information provided on the credit application will make it easy for the lender to send the customer
to collections or pursue legal action if the loan is granted and the borrower defaults on payment.
How a Credit Application Works
You’ll start the process of applying for credit or a loan by filling out the credit application and providing
all the necessary information. Your lender will then most likely pull your credit report, and it will look at
factors like your income and debt-to-income ratio, as well.
The exact underwriting requirements will depend on your lender. Underwriting is the process by which
the lender determines whether it wants to extend credit. Your lender will use the information provided
in the credit application to determine whether you’re a good candidate for a loan.
Filling out a credit application is easier than ever thanks to an abundance of online lenders. Technology
often makes it possible for borrowers to fill out the application entirely online, and they can find out
whether they’re approved within minutes.
If you're denied a loan, the lender must send you a letter explaining the reason why. All lenders are
required to either provide a specific reason for the rejection or let you know that you have the right to
request this information within 60 days.2
The lender must inform you, as well, if it rejects your application due to the information contained in
your credit report. It must give you the name, address, and phone number of the credit reporting
agency that supplied the report.
Types of Credit
Most borrowers apply for two primary types of credit. Each can be a good option depending on your
needs and your financial situation.
Revolving Credit
Revolving credit is an ongoing type of account, like a credit card or a line of credit. You'll receive a lump
sum of money when you take out a loan, and you'll make payments until the balance is reduced to zero.
You can repeatedly use and pay down the credit line over time with a revolving line of credit.
Your lender will set a credit limit when you're approved for a credit card. This is the maximum amount
of money you can charge to the card. Your credit card will remain in good standing as long as you stay
below the limit and continue making payments.
Installment Credit
Installment credit is a close-ended credit account that you repay in monthly installments. You’ll either
receive the money upfront or the funds will be applied toward an item you’re purchasing. The account is
closed when you’ve finished repaying the installment loan.
Mortgages, car loans, student loans, and personal loans are all popular types of installment loans. They
appeal to many borrowers because of the predictable payment terms and the option to refinance.
Try to improve your credit score as much as possible if you’re considering applying for an installment
loan. A good credit score will help you earn the best rates and repayment terms on the loan.