Tactical Approaches to Assess Customer Creditworthiness in Today’s Economy

When the economy was more stable, AR credit managers could rely on credit scores, financial statements and even news clippings to determine how much credit to extend to customers. Today’s macro-economic environment does not allow for that approach.

Such superficial and lagging indicators do you little good given how much today’s complex supply chains are marred by inflation, international tariffs, and global conflicts.

Today’s economy requires a deeper and more forward-looking examination of your client’s creditworthiness.

Four Ways To Better Understand Your Customers’ Credit:

1.      Analyze payment history. Review average days late, dispute frequency and any prior broken payment promises. If a customer usually captured early-pay discounts and is now just paying on time, that could be a red flag that a DSO or aging report wouldn’t catch.

 2.      Request references. Ask customers to provide a few vendor references and check their payment history. If they balk at providing at least three vendors for whom they are paying on time, it’s a red flag.

 3.      Search UCC filings. Uniform Commercial Code searches can reveal if a customer is using receivables as collateral for a loan, which could indicate cash flow issues.

 4.      Review your customer’s customers. Ask for a listing of their biggest customers and the share of revenue for each. A high dependency on a limited number of customers could spell trouble; diversification suggests a more stable cash position.

What To Watch for Within Unstable Industries

From a cash flow perspective, not all sectors are created equal. Some industries are just more erratic than others. It doesn’t mean not to do work with companies in those verticals, but you do need to be more careful.

Here are a few examples:

Construction: Red flags include frequent lien filings, project delays, and over-reliance on a few big jobs.

Retail: A reduction in the number of brick-and-mortar stores, low inventory turnover and rising returns could all spell trouble.

Saas/Technology: Just because the customer is in a hot “new technology” doesn’t mean the math shouldn’t math. Examine the cash burn rate (and if it’s exceeding revenue growth), customer churn, and how reliant it appears to be on the perpetual next round of VC funding.

Manufacturing: Changes in raw material prices, high inventory levels and missed delivery deadlines are all signs of concern.

Hospitality: Be weary if you hear of booking downturns, cancelations or an over-reliance on tourism (far fewer international travelers are vising the US).

What to Do If a Customer Raises Red Flags

In this economy, you’re unlikely to be positioned to turn away business. So, what can you do if a customer’s credit is worrisome?

1.      Partner with sales. Find a way to yes by creating creative sales strategies. Consider asking for partial payments upfront or at key milestones, especially for new or high-risk customers.
2.       Implement rolling reviews. Instead of annual credit checks, switch to more frequent reviews and/or examinations triggered by new business. This is especially important for your largest customers that would leave your cash flow in a precarious position.
3.      Use tiered exposure limits. Be conservative with credit at first but allow for ramping up of credit based on manager approval and clan payment history.
4.      Integrate benchmarks into a risk matrix. Tighten credit limits on customers in high-risk industries or with relatively low revenue compared to your average customer. Adjust limits based on economic indicators (i.e., if new housing starts slip in your region, tighten credit on all construction customers).

Don’t Fall For A One-Size Fits All Strategy

Every customer is unique, but successful credit managers still must come up with a way to visualize all customers’ creditworthiness.  Consider a risk matrix, using the following example:

 Example Risk Matrix

*The higher the score, the lower the potential risk

How to interpret the risk matrix table

·         85-100: Low risk. Extend full credit limit.

·         65-84: Moderate risk. Limit exposure; offer more limited credit.

·     Below 65: High risk. Require customers to prepay or provide collateral.

This economy will test your skills as a credit manager. But be sure not to use yesterday’s strategies when analyzing tomorrow’s risks.