Steve Harms

Monday, January 27, 2014

Credit Risks Require Current Financial Information!

Every extension of credit is a risk. Some customers are worthy of more risk than others. Making a decision of whether or not to extend credit is really an art more than a science and is a tricky business. Much of the process is rooted in your instincts toward a customer and conditions in general. Your instincts are guided by the credit risk factors and the five Cs of credit (character, collateral, capacity, capital, and conditions).

The core concept isn’t complicated: Some customers are better credit risks than others because of their financial condition, age, payment history, industry, quality of management, or willingness to provide liens or guaranties make them more likely to pay for their purchases.

But after you trust a customer enough to extend credit, how much credit should you give? The answer varies by business and industry. A $50,000 line of credit may be a minimal risk for some businesses, but a $5,000 line of credit may be high for others. The key here is your margin of profit; your ability to take risks while extending credit rises and falls with your profit margins. The smaller your margins, the less risk you can afford.

So you track credit information, apply the five Cs, and carefully consider your customer’s situation and industry trends. You set up a system to gradually extend credit to customers who are newly formed or are just new to you. You watch for red flags that indicate trouble ahead.

Your customer may suddenly want to double or triple credit purchases. Your sales department wants the increase in business, but your credit department is going to have to deal with any credit headaches that result. Whether you’re evaluating a new customer or large orders, conducting a routine periodic credit review, or responding to concerns about a customer that’s slowing down in its paying habits, you need your customer’s financial information to evaluate credit.

The most important reason to maintain current credit information (such as tax returns, balance sheets, operating statements, credit reports, and aging sheets on payment history with your firm) in your customer’s file is to spot trends. Downward trends are red flags that indicate increased credit risk and require action.

No comments: