While it’s impossible to predict which customers may or may not pay you, there are ways you can manage the risks through strong credit risk management practices.
These practices also allow you to:
- offer credit and favourable payment terms, which can help tip sales decisions in your favour, encourage repeat purchases and build loyal relationships; and
- avoid late or defaulted customer payments that can hurt your bottom line and your credit capacity, curtailing company growth.
1. Complete Credit Application
Ask each customer to complete a credit application, and use the information to do a deeper credit analysis. Effective credit applications typically include the following:
- Company information – getting the correct legal name is critical, because if you don’t get paid, you need to know exactly who owes you money. For example, sometimes payments can be funneled through your agent or distributor
- Bank information – find out how much they can borrow and how much they owe
- Commercial trade information
- Provisions in the event of non-payment
- Maximum number of days to report a quality/quantity issue
- Terms of payment
- Description of how disputes will be resolved
- Your rights to terminate credit terms
- Contact signature
2. Assess Creditworthiness
Once you have the information from the credit application, use one or several credit assessment tools to determine whether the limit requested is acceptable. Tools can include the following:
- Commercial trade references (minimum of three, preferably written)
- Your past experience with the customer
- Bank report/recommendation (preferably written and sufficiently up to date)
- Financial statements (preferably audited), taking note that the turnover of their accounts payable provides insight into how quickly you can expect to get paid
- Credit agency report (preferably less than one year old)
3. Set Realistic Credit Limits and Terms
Establish payment terms common for your industry and that your customers can manage. If you are unsure about your customer’s creditworthiness, offset the risk with up-front payment (partial or full), by using letters of credit, setting a shorter payment due date or providing a rebate for early payment.
4. Use Clearly Worded Contracts
A clearly worded sales contract is the best preventative tool for managing credit, identifying the obligations of each party and minimizing the risk of dispute. Write contracts that:
- establish precise payment terms and each party’s obligations;
- include provisions for terminating the customer’s credit; and
- include clauses specifying how disputes will be resolved.
5. Update and Reevaluate Regularly
Situations that call for a reevaluation include:
- Your customer needs to increase their credit limit or is asking for new payment terms
- You have not sold on credit to the customer within the past year
- Your past experience has been less than favourable
- Your customer has undergone a change in structure or ownership
- There are red flags that suggest your customer’s creditworthiness may have changed
6. Establish and Follow Debt Collection Policies
To establish appropriate internal controls, you should:
- define the division of responsibility between your credit manager and sales staff to avoid conflict of interest, and define who has the authority to approve credit limits;
- maintain accurate records, including purchase orders, invoices and correspondence; and
- create a credit manual that defines your credit management process.