For business owners, the decision to extend credit to customers will happen sooner or later. A customer may ask if you can extend the terms of their credit. Extending a customer’s credit, even by as little as 30 or 60 days, is essentially offering an unsecured loan. You’re providing goods or services in return for a promise to pay. As many business owners learned during the recession, promises are easily broken. Accepting customer credit is not a decision to be made lightly.
What should you do if you get such a request, especially from a longtime customer? Before you decide, you need to determine how much credit exposure your company can afford. Every business has different overhead and cash flow needs. Some have lines of credit or revolving bank loans to help prevent cash flow problems, but many don’t. If your business is one of the latter, it’s much more dependent on prompt client payments. In that case, extending customer credit terms can be risky business.
Just as banks consider unsecured loans high risk ventures, so should you. After all, you’re lending to clients when you give them your merchandise or services on credit. Banks evaluate a client according to certain criteria before making an unsecured loan, and you should do the same.
When banks make an unsecured loan, they typically begin their evaluation of a borrower with these four points: liquidity, collateral, character/repayment history, and ability to repay.
Liquidity: You can assess the liquidity of a customer’s assets by verifying average account balances with the customer’s lenders. If you’re considering a substantial customer credit extension, be sure to check banking references as well.
Collateral: What collateral can your customer offer? What assets, secured and unsecured, does the customer have? How accessible is that collateral? Remember, if your customer has already pledged assets to a secured lender, your claim will be considered only after that lender is paid.
Character: Who is the customer and what’s their background? Have they conducted business in the past that has ultimately resulted in a loss to creditors?
Ability to repay: What’s the customer’s payment history? Does the customer pay bills within credit terms, stretch terms to the limit, or go beyond them?
The depth of your investigation should depend on the amount of credit your customer has asked for. If it’s significant, you may want to obtain a financial statement that provides details of the customer’s assets, liabilities, and equity. Since this information is confidential, you’ll likely have to sign a nondisclosure agreement before you get it.
You can also ask the client to fill out a credit application. Some business owners fear they’ll offend clients if they’ve never asked for one before. Use your own judgment here.
In light of the recent economic travails and subsequent increase in bankruptcy filings, this is probably a good time to institute a new customer credit extension policy. You might also consider asking customers for things like downpayments, personal guarantees, letters of credit, cash on delivery, and standby letters of credit (payment guarantees by a customer’s bank that are used only if needed).
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