By Dean Kaplan+
To what extent the credit department evaluates a potential new customer’s credit risk depends on the level of credit the customer wishes to establish. Thorough credit and financial statement analyses can give a company confidence in a new customer, and can prevent future debt collections at the same time. This is the fourth article in a nine part series of articles about financial statement analysis. This article will discuss how the level of credit investigation should change depending on the credit level requested by the new customer.
Every company should develop a credit policy which gives the credit department the necessary steps to take to authorize a specific level of credit to a new customer. The policy should be tiered, with increasing levels of scrutiny required for each increasing tier of credit. The analytical requirements of a credit policy are usually determined by looking at industry norms, the size of the company (how much credit can the company afford to extend) and the willingness of the company to take on risk in an effort to increase its market share.
For smaller potential new customers (for example, a customer who requests a credit limit of less than $25,000), the amount of effort put into the credit analysis will be less than for larger customers. A credit policy in this case could require the credit department to examine the completed credit application, check bank references and ascertain account balances and any available credit, and check trade references to understand credit lines extended, credit line usage and payment history. Once these data are evaluated, the credit department could decide whether or not to set up an open account for the new customer, and what credit line will be extended to the customer.
For larger potential new customers (for example, a customer who requests a credit limit in the $25,000 to $100,000 range), all of the above data could be analyzed as well as checking credit reporting agency data for payment history and examining the past three years of financial statements. This data would provide the credit department with varying sources of similar information, providing an opportunity to crosscheck the customer’s payment history, bank account balances and available credit and the overall financial health of the customer’s business.
When the credit department analyzes the customer’s financial statements, the place to start is with the Accountant’s Opinion. The opinion would bring up any irregularities found in the company’s financial reporting or management actions. The next step is to read all accompanying notes to the financial statements. These notes will help the credit department identify any unusual accounting procedures, ongoing or potential litigation, upcoming large loan maturities that could negatively affect cash flow or other events that occurred during the reporting period which do not appear in the financial data reported.
The final step in the analysis for this level of credit is for the credit department to look at the financial statements themselves. The financial statement analysis includes ascertaining the company’s net worth to see if it strong and stable, comparing the company’s financial data to known industry standards, determining if the company’s working capital position is adequate for the level of credit requested, and confirming the profitability of the company. These data should give the credit department plenty of information to make an informed credit decision.
For even larger potential new customers (for example, a customer who requests credit in excess of $100,000), additional management approvals could be required. The credit manager, credit director and chief financial officer could have different levels of authority to make credit decisions. For increasing levels of credit, different levels of management sign-off could be required.
In this situation, the credit department would conduct all the credit analysis previously discussed, plus an even more in-depth look at the financial statements including calculation of a number of analytical ratios. Typically for this level of potential new customer, the credit department would put together a written analysis of the credit worthiness of the customer in a narrative format including a recommendation of the credit to be extended. This report, along with the data used to arrive at the conclusions could be sent to key management for the final credit decision. Once management has made the credit decision, the customer would be assigned the appropriate credit line and the business relationship would begin.
Collection agencies do not typically perform credit analysis; however, a few professional debt collectors are usually skilled at understanding and gleaning important debt collection information from a debtor’s financial statements. Debt collections can become necessary even with customers who have never had accounts receivable problems before. Tough economies and unforeseen industry challenges can sometimes appear seemingly out of nowhere. When accounts receivable collections get out of control, credit departments may decide to hire a collection agency to help get things back on track. All of the credit analysis done when a customer was under consideration should be turned over to the collection agency along with all past due invoices and other contractual information. The professional debt collector will spend a lot of time looking at the customer’s credit history to determine the best debt collection action to take. The debt collector must be fully up to speed on the client before the first contact is made. This preparation is what makes debt collectors so successful where in-house collectors fail. When looking at the credit worthiness of a new customer, the time spent on the credit analysis is usually time well spent, even if later on debt collection becomes necessary.
Click here if you are ready to go on to the next article in this nine part series Financial Statement Analysis And Debt Collections 5 of 9.
And be sure to check out the rest of the articles in this series:
- Credit Analysis
- Financial Statement Analysis
- Financial Statement Reliability
- Credit Investigation Levels
- Net Income Analysis
- Financial Strength of a Potential Customer
- Liquidity Position of a Potential Customer
- Cash Flow of a Potential Customer
- Operating Cycle of a Potential Customer
The Kaplan Group is a boutique collection agency specializing in large (over $10,000) debt collections due from businesses. Founded in 1991, the company has a stellar reputation (A+ rating with the Better Business Bureau) and is recognized as one of the leading collection agencies for results on large and complex matters.