Determining Customer Creditworthiness

Trade credit, or an agreement that your customer can purchase goods or services from you and pay at a later date, is a normal process in B2B transactions. It’s an effective tool to encourage sales and stimulate business growth.

Yet, any time you invoice clients at a later date after providing goods or services, you expose your business to the risk of late payment or default. This can disrupt your cash flow, the lifeblood of your business.

Determining customer creditworthiness before you extend credit is an effective way to reduce your financial risk. Read on to learn the best practices and important resources to help you understand how to assess customer creditworthiness.

To protect your business from late or nonpayment on invoices, it is important to use the right tools to thoroughly check the creditworthiness of customers before you extend credit. Here are six ways to determine creditworthiness of potential customers.

What is Creditworthiness and How Can It Be Determined?

It’s important to understand how to determine creditworthiness – the ability of your customers to pay you – before you extend trade credit. To determine the creditworthiness of a customer, you need to understand their reputation for paying on time and their capacity to continue to do so.

Those factors include their revenue and outstanding obligations. You also need to understand the company’s future business prospects and trends within their industry that could affect their ability to pay you.

How to Check the Creditworthiness of a New Customer

To protect your business from late or nonpayment on invoices, it is important to use the right tools to thoroughly check the creditworthiness of customers before you extend credit. Here are six ways to determine creditworthiness of potential customers.

1. Assess a Company's Financial Health with Big Data

Big data is helping companies improve the efficiency of their credit departments, now empowered by tools that substantially reduce the time required for critical tasks. Using Euler Hermes as an example, we recently developed the TradeScore tool to help companies quickly assess the financial performance of their clients and prospective clients.

Here's how this particular tool enables companies to quickly access trade data:

1. Users simply search and identify the company they want to do business with
2. TradeScore returns a color-coded score indicating the company's relative creditworthiness, enabling better informed credit decisions

Visit eulerhermes.us/tradescore if you'd like more information.

2. Review a Businesses’ Credit Score by Running a Credit Report

Another useful way to determine the creditworthiness of a customer is with a business credit report. This report illustrates a business’s ability to pay invoices based on its payment history and public records. The credit report provides a profile about the business, financial data like annual sales, invoice activity and credit limits over several years, legal judgements and collections activities, and a business credit score.

The business credit score is a measure of a company’s financial stability and can predict how likely they are to pay you on time. Typically, the score is between 1 and 100, with a score of 75 or higher considered excellent. You can purchase a business credit report from business credit reporting agencies including Dun & Bradstreet, Equifax Business and Experian Business.

It is important to remember that credit reports are based on information made available by the provider according to a snapshot in time, which is not necessarily apparent to the user. Users of credit reports should understand that the information available may be upwards of a year old and may not reflect real-time developments in the company's creditworthiness. It may be necessary to combine credit reports with additional credit assessment tactics, such as risk data analysis that comes with a trade credit insurance policy.

3. Ask for References

In the process of assessing creditworthiness, companies will often request trade references before extending credit to a customer. Trade references can include the customer’s bank, as well as businesses or suppliers that already extend trade credit to that customer.

Good questions to ask these references include:

• how long the business or supplier has extended credit to the customer;
• the credit or purchasing limit the business or supplier has extended the customer;
• when the customer’s last purchase was and the amount; and
• how many times the account has been late.

It is important to be aware of potential selection bias when reviewing bank and trade references.  When asking a prospect for their references from other suppliers, for example, they are most likely to provide information on companies they pay on time and omit companies that they don't. 

Collection of this information can also consume a great deal of time as you are dependent on receiving timely replies.

4. Check the Businesses' Financial Standings

Companies that want to do business with you should not hesitate to provide the financial information that will help you determine their ability to pay for your goods or services. To evaluate the financial health of the company, you should ask for and review its certified financial statement in order to learn about the company’s financial performance.

You should also ask for and review the company’s cash flow statement, which indicates the company’s current operating results.

5. Calculate the Company's Debt-to-Income Ratio

Another way to determine a client’s creditworthiness is to calculate its debt-to-income ratio. This calculation shows you what portion the company’s debts make up its earnings. To determine the ratio, divide the company’s monthly debt payments by gross monthly income. These numbers are available from the company’s financial statement.

The lower the number (below 36) the better. However, good debt ratios vary from industry to industry. It is important to understand what those baseline ratios are.

6. Investigate Regional Trade Risk

When assessing creditworthiness of a client, it is important to review the risks inherent in the geographical region where your client is located. Country-specific credit risks are affected by fluctuations in currency exchange rates, economic or political instability, the potential for trade sanctions or embargo, or other issues.

These are all factors that can negatively impact a potential client’s cash flow and make trade credit a risk. Euler Hermes can help. We offer a library of research about sector and country risks that can help inform your decisions about extending credit. In addition, we can leverage our credit-risk grading model to help you forecast credit risks and potential customer defaults.

Reduce Non-Payment Risk with Trade Credit Insurance

When you insure your accounts receivable with trade credit insurance from Euler Hermes, you can count on being paid, even if one of your accounts faces insolvency or is unable to pay. In addition, trade credit insurance from Euler Hermes comes with the added benefit of the support necessary to make data-informed decisions about extending credit to new clients or increasing credit to existing clients.