Safeguard Your Cash Flow
By John Troyer, CPA, Partner, Audit and Accounting Services
The funny thing about customers is that they can keep you in business — but they can also put you out of it. The latter circumstance often arises when a company overly relies on a few customers that abuse their credit to the point where the company’s cash flow is dramatically impacted. To guard against this, diligently assess your customer’s credit worthiness before getting too deeply involved.
A first step is to gather as much information as you can from new customers. Ask them to complete a credit application with the usual information, company name, address, website, phone number and tax identification number, number of years the company has existed, its legal form and parent company, if one exists. And depending on the amount of credit this new customer is asking you to extend to him or her, consider also asking for a bank reference and several trade references.
If the company is private, again depending on the amount of credit your customer is seeking, consider asking for an income statement and balance sheet. You’ll want to analyze financial data such as the profit margin, or net income divided by net sales. Ideally, this will have remained steady or increased during the past few years. The profit margin also should be similar to that of other companies in its industry.
From the balance sheet, you can calculate the current ratio, or the company’s current assets divided by its current liabilities. The higher this is, the more likely the company will be able to cover its bills. Generally, a current ratio of 2:1 is considered acceptable.
Check references and more
Next up is contacting the potential customer’s trade references to check the length of time the parties have been working together, the approximate size of the potential customer’s account and its payment record. Of course, a history of late payments is a red flag.
Similarly, you’ll want to follow up on the company’s bank references to determine the balances in its checking and savings accounts, as well as the amount available on its line of credit. Equally important, you’ll want to find out whether the company has violated any of its loan covenants. If so, the bank could withdraw its credit, making it difficult for the company to pay its bills.
After you’ve completed your own analysis, find out what others are saying — especially if the potential customer could be a significant portion of your sales. Search for articles on the company, paying attention to any that raise concerns, such as stories about lawsuits or plans to shut down a division.
In addition, you may want to order a credit report on the business from one of the credit rating agencies, such as Dun & Bradstreet or Experian. Among other information, the reports describe the business’s payment history and tell whether it has filed for bankruptcy or had a lien or judgment against it.
Most credit reports can be had for a nominal amount these days. The more expensive reports, not surprisingly, contain more information. The higher price tag also may allow access to updated information on a company over a period of time.
Stay informed, always
Assessing a potential customer’s ability to pay his or her bills requires some work upfront. Our recommendations are reminders that your business should have an established criterion that dictates the level of investigation necessary before granting credit based on:
• If the customer is new,
• The amount of credit being sought,
• Any history of not making payments on time, or
• A business environment change that may negatively impact your creditors’ business.
Making informed credit decisions is one key to running a successful company.
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