Some business owners are just happy to have customers. Whether or not they can actually pay their bills can become somewhat of an afterthought until their lack of payment becomes a cash-flow problem for their company. Assessing the financial risk of each customer before the transaction is completed can help avoid this problem and potential drain.
Remember, customers that do not pay are collection problems. Consider starting your financial risk assessment with the following tips.
Do your homework on your potential customer.
One way to help reduce financial risk is by searching for your potential client's website and any other information that can be found on the internet. Look at the Google Street View of the company's address to see if their location makes sense based on their industry and size.
You may also want to consider looking for feedback from other companies that have done business with them, and blog or social media reviews from their own customers. Happy clients may mean a more profitable company, which may mean they'll be in a better position to pay you.
Fill out the credit application.
This should include their company name, address and Tax ID number. Some businesses are so eager for new customers that they skip this step.
Examine the customer's credit reports.
To help further reduce financial risk, you can use services like D&B and Experian to check out the identity of the customer. Some companies deliberately have similar names to secure credit from a small business.
Once their identity is verified, you may want to examine the reliability of the customer paying on time based on the reported history. A client is not helpful in growing a business unless they pay their bills within specified terms.
Ask for trade and bank credit references.
You can look beyond the data and possibly reduce your financial risk by asking the company for other trade vendors they have done business with over the past five years that can be called as references. These should be similar size companies with comparable transaction values.
Also consider asking their bank for a reference. A good place to start is by asking, "Is the company good for trade credit of $1,000?" and listening closely to their reply.
Ask for your potential customer's financial statements.
While this may be difficult to get, the balance sheet can show their ability to pay their accounts payable by carefully reviewing their quick ratio—the company's current assets divided by its current liabilities. While healthy quick ratios vary by industry, a 2 to 1 ratio can help reduce financial risk.
Set a credit limit for your customers to help reduce financial risk.
You could strictly enforce the amount of credit that is given at any point in time, especially for new customers.
For example, if their limit is $1,000, you may not want to ship them additional products on credit until the payment they owe to the company is below that amount. Consider creating a process to keep monitoring their business credit on an ongoing basis.
One of the biggest issues small businesses have is they concentrate too much of their revenue on a handful of customers. If those large customers do not pay on time, it can increase overall financial risk and could have a huge cash-flow impact on the company. To combat this, I recommend knowing your customer revenue concentrations and which of them account for 80 percent of the business.
Credit is a privilege, not a right. If the customer seems like too high a financial risk, you may want to ask them to prepay their first few transactions to build up a credit history within your company.
In the final analysis, creditworthiness is very specific to a company and their situation. You can assess the financial risk and the financial return before you decide to work with anyone. Consider analyzing the risk of not getting paid for this particular transaction. If the gross margin is high and the costs of providing the product or service is low, it may be acceptable to take a higher financial risk of the customer not paying. But I think it's important for companies to be aware of the risk they are taking each time they give credit to a new customer.
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The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.