Creditworthiness: The Key to Predict Payments within Terms

businesses should not overlook the advantages of extending credit to customers: Extending credit can build customer loyalty, encourage customers to place larger orders, and provide you with a competitive advantage over less generous partners. There is a fine balance, however, between enjoying these benefits and suffering the risks that come with delivering goods or services to customers for payment at a later date.

Credit risk management is the practice of determining a customer’s creditworthiness based on its financial health, which can indicate its ability to pay on time. If a customer doesn’t pay, the balance must go to collections or be written off as bad debt, neither of which is desirable for the creditor. 

How can we define creditworthiness?

Creditworthiness is in the dictionary as “the extent to which a person or company is considered suitable to receive financial credit, often based on their reliability in paying money back in the past”. If you’re a company seeking a line of business credit, it’s valuable to imagine how your suppliers might view you, and what their concerns might be when considering you. Most of the time, it boils down to this: Is your company capable of paying the invoice in full, on time, and within terms?

Although you can consider subjective criteria when determining a customer’s creditworthiness (such as whether the customer seems easy to work with), objective criteria is what can reveal truths that your prospect might not openly disclose. These objective criteria include things like whether financial statements show sufficient cash flow, or whether trade references show the company has a history of paying on time.

We can summarize the most insightful elements of these objective criteria by speaking about the 4Cs of credit: Capacity, Capital, Collateral, and Conditions.  

Capacity

What is the business’s financial capacity to pay its invoices? Does it have sufficient cash flow? Is it heavily saddled with debt? Business credit applications typically ask the applicant to supply bank references, trade references, and financial statements. These documents will reveal the applicant’s capacity to pay. If an applicant can’t provide financials or references, credit managers will need to find other ways to assess the company’s capacity to pay. Many consult credit reports from third parties like CIAL Dun & Bradstreet, reports which can shed some light on the potential credit risk of working with someone.  

Capital

The financial and non-financial assets that a business holds, as well as the amount of money the business owners have invested in their company. If the assets listed in a company’s financial statement demonstrate growth, that may imply a lower risk of non-payment. Having a financial statement makes it easier for a credit manager to assess the credit seeker’s capital strength. Some industries that require major investments in inventory and equipment may seem riskier than those that operate with lower overhead, but this is where an experienced credit manager’s expertise comes into play.

Collateral

Applicants with a questionable credit history may be asked to put up collateral to secure their debt obligation for a high line of credit, the same as any other type of loan. Here, the inventory, machinery, and other equipment noted under Capital as assets can be used as collateral. While collateral offsets the lender’s risk, it’s important to remember companies would rather work out a payment plan with their customers than try to seize an asset as part of the collections process.

Conditions

A smart credit manager can look at the big picture and consider if an applicant comes with any special conditions which might affect the decision-making process one way or the other. The applicant’s industry, its competition, or its geographic location might end up making the decision to grant credit easier or harder.

Character

Before credit decisions were automated, the credit profession placed a strong emphasis on the applicant’s character and the professional relationship between the customer and the credit manager. If they knew their customer’s business well, they would be more willing to work with that customer account in times of slow payments. A customer that doesn’t return phone calls or emails may wind up having their invoice sent to collections, which can hurt the business’s chances for future credit requests.

Considering these four elements of creditworthiness and incorporating them into a standardized credit application review process is smart policy. The goal is for finance departments to start thinking and operating like growth enablers, instead of assuming a traditional gatekeeper position.