Checking a Customer's Credit

In an ideal world, you'd be able to demand full cash payment upon delivery of your product or service. 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.

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. Regardless of the method you choose, you'll want to build a credit relationship slowly and carefully. It's best to approach the issue on a case-by-case basis, as not every customer deserves the same credit terms. One key item 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 still be around.

Here are some steps that will help you manage your credit risk:

• Consider calling the customer's banker. Ask how long the bank has had a relationship with the company. What is the average balance in the checking account? Has the bank extended them any credit? How much? If a loan was given, did the company meet its obligations?
  
  
• Ask to see the company's 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 why 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.
  
  
• Obtain a 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 he or she 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 issue. You may also want to discuss credit issues with any investors in the firm.
  
  
• Ask for a letter 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.
  
  
• Be on the lookout for red flags. In addition to the standard inquiries into a company's credit situation, keep your eyes open for clues 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.
  • Has the company pledged any assets as collateral?
  • Does the company operate in a cyclical industry or in a business sector that is prone to seasonal turns?

Keep in mind that your decision may also depend on 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 cautious about 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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