It can be a tricky balance extending credit to customers, managing payment and retaining goodwill.
Here we explore how to ensure any credit advanced by your business is repaid and the customer bond enhanced (rather than strained) by a credit relationship.
We are all familiar with the five C’s of credit – Character, Cash Flow, Capital, Collateral and Conditions. In our experience it is wise to have extra disciplines for assessing the Capacity & Conduct of trade credit customers. Our practical suggestions as a definitive guide to trade credit management using the 7 C’s of credit are as follows:
- Character Establish the character of each borrower. Are they trustworthy? What is their character? Would they hold fast to their responsibility to repay the loan? TIP: Research your customers: Google, LinkedIn, request references. Credit checks will inform of any previous defaults.
- Capacity Is the individual seeking credit eligible to request it in the first place? Can they be held responsible in the event of default or do they have an eligible guarantor if they are unable to meet their obligations? TIP: The legal basis of the credit is as important as the ability to repay. Do a company search or, if an incorporated society, ask who are the office holders. What are the ages (18+?) of the customer? Seek guarantors from parents or parent entities.
- Cash flow Will the debtor have sufficient cash to repay their debt? If a business does not have sufficient cash flow for whatever reason, they will be unable to meet their obligations. TIP: If you are not an accountant or financier, your customers’ cash position can be tough to assess as a trade supplier. If the credit amount is significant, obtain a copy of accounts and check liquidity and other ratios, or ask your accountant for help.
- Capital The amount of equity a business or individual has is important to understanding their capacity to take a ‘hit’ if their market undergoes hard times. If a business has sufficient working capital they will be able to continue to meet their obligations in a downturn. TIP: You are endeavouring to assess your customer’s financial resilience. Share capital is relevant for a corporate entity – other guidelines might be if they have survived tough times before.
- Conditions This refers to how well the industry (of the debtor) is performing. When evaluating conditions there is also an emphasis on how competitive the market is. Will revenues fall because of a lot of competitors entering the market at lower prices? TIP: Use common sense – again, Google search for industry news. Watch for obvious industry issues e.g. you probably would not advance large amounts of credit to video store owners or, in a recession, to a business selling expensive discretionary items.
- Collateral What does the debtor have to secure the credit advance? What assets of importance do they have that they will pledge in case of default? Is this collateral liquid? Is it marketable and easily converted to cash? What percentage of the debt will the available collateral cover? TIP: If it all goes wrong what are your options? Can you recover your goods and resell? Has the business owner given a personal guarantee?
- Conduct Monitor any debtor conduct once credit is advanced. All good credit relationships must be managed properly and performance tracked so that red flags signalling a problem can be discovered early and (hopefully) resolved. TIP: Does the debtor’s behaviour change once there is a credit relationship? Is it easy to get information? Do they respond to your requests, return calls and proactive if unable to pay on time?
Whatever your business, if you advance credit to customers you are a “lender” of sorts. However using these checks and tips will help minimise the instances of trade credit default.
There is one final point, which is extremely relevant in the current economy. With record low interest rates, many businesses may have increased their debt levels and dulled their own sense of sensible “cost control”. It is best your business doesn’t have too many customers like this.