Credit Best Practices (#86)
/In this podcast episode, we cover a number of best practices that can be applied to the credit function. Key points made are noted below.
This is all about whether to grant credit to a customer, and if so, for how much and under what terms. Credit granting is treated very differently among companies. At a smaller level, companies tend to not treat it as a key accounting function, until they have a large bad debt. And even then, if there’s only one serious bad debt, it’s quite possible that management will avoid setting it up as a stand-alone function.
However, if there’s a string of bad debts, then they get pulled into credit management, whether they like it or not.
The Credit Policy
So… let’s assume that management is grudgingly requiring a credit function. What do you do? Well, the first step is to be consistent in how you treat customers, and that means a credit policy. The credit policy outlines who is responsible for the function, and the general process flow for evaluating and assigning credit, and even general guidelines for the terms of sale.
Once you have that, the next thing to consider is when not to spend time doing a credit evaluation. In other words, credit analysis takes a lot of time. And if you have a lot of customers, the cost-benefit of reviewing everyone will not be good. Instead, you want to focus on the largest and riskiest transactions.
This means that you establish a lower cutoff, below which you accept all orders. For example, if someone places an order for any amount under $1,000, that’s fine. However, this figure can vary all over the place. In some industries, product margins are so tight that you just can’t afford to lose much in write-offs, so the minimum credit review level is really low. Conversely, if the gross margins are really high, then a fairly high level of bad debt may not be that big a deal.
You can also loosen the credit policy in special situations. For example, if you have a few remainder products that you’re trying to clear out of stock, it may make sense to really loosen up credit for anyone who orders those items. If you’re going to throw away the goods otherwise, then there’s really not much downside risk.
And another issue is how frequently you update the credit policy. Once a year should be a minimum, and you really want to jump on it if the economy goes into a nose dive, so that you can tighten the credit standards.
Information Collection
Beyond the credit policy, the next issue is collecting information about the customer. This tends to start off as a really short credit application, which gets longer as the credit department becomes more sophisticated – and gets a bigger budget for doing more analysis.
At the most minimal level, the application is just asking for identification information, so the credit staff can run a credit check on the customer through a credit service, like Dun & Bradstreet. If the credit score comes back high enough, then the credit staff grants a moderate level of credit, and subsequently changes that level based on how well the customer pays – or not.
Now, that’s a pretty minimal level of credit analysis, since you’re essentially outsourcing the analysis to a third party. The next level of review is asking for credit references in the application. This takes more work by the credit staff, and the information you get is not always that good. After all, the customer is cherry-picking its best credit references, so it’s probably treating those three or four references listed on the form especially well. To squeeze out any good information, you need to contact the references and see if they know of any other customers of the target, and then you contact them, to see what’s really going on.
This all takes a fair amount of time, and it may not be cost-effective to dig around for days on end, especially when the sales staff is badgering you for a credit decision right now.
So, what else can you do? Lots of things. Getting back to the credit application, you can keep expanding it. One option is to add a personal guarantee clause. This works well for smaller customers, though larger customers get irritated and cross it out. You can also include a clause about the company getting a security interest in any goods that it ships to the customer. It’s also possible to make the customer reimburse you for collection fees, and for bounced check fees. Part of the reason for these extra features is to cover the company, but it also gives the customer the impression that the company is serious about collecting its receivables.
And, the big item is a request for financial statements. Reviewing financials doesn’t really take much time, and it provides a really good picture of a customer’s financial position. The trouble is, it’s kind of tough to require audited financial statements, especially from smaller private companies that have never had audits done. So, keep in mind that those financials may not be entirely correct.
There are also some procedural things you can do with a credit application. One is to require a new application if a customer hasn’t placed an order for some period of time, since the old application may not reflect the customer’s current financial situation. Also, any time a customer does not fill out a field on the application, or crosses out a clause, that’s a big warning flag, and that application should automatically receive a lot more attention.
You can also require a new application whenever a customer consistently butts up against the upper end of its credit limit, or if it ever sends in a check that bounces. Though, if their check bounces, the first thing you should do is yank their credit entirely until the situation is resolved.
Credit for Large Customers
Now, let’s cover credit for large customers. This is where you spend most of the credit department’s time, because a bad debt on a large order is a really serious issue. For a large customer, you do want audited financial statements, and you want them every year. If they’re publicly held, then you’re in luck, because their financials are on file with the SEC, and you can access them on-line. In addition, the credit manager should get to know the customer. This means lots of phone calls, and a periodic site visit is a really good idea. This also means running credit reports on a regular basis, so you can track any changes in their credit score.
These techniques help, but they don’t necessarily give enough clues about how a large customer is doing. For that, you might consider joining an industry credit group, where they exchange information about customers. If people there start mentioning problems with a customer, then it would be very prudent to start dialing back the credit level.
When Customers are in Trouble
So, what if the credit picture just doesn’t look good. There are still some ways to do a limited amount of business with a customer. One method is to impose a really short payment period, and if they don’t pay on time, you cut them off.
Another possibility is to refer a customer to a distributor, because the distributor might have a looser credit standard, and be willing to take on the risk. Or, you could ask for a partial cash-in-advance payment. Or, you could require a letter of credit, or you could obtain credit insurance on the customer.
There are a lot of variations here, so instead of just dumping a customer or requiring an all-cash payment, sit back and think about all of the possible variations where you can still make some kind of a sale without violating your credit policy.