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 about best practices and important resources to help you understand how to assess customer creditworthiness.

What is Creditworthiness and How Can It Be Determined?

Creditworthiness is the measure of an individual’s or business’s ability and likelihood to repay a debt. In other words, it represents a client’s risk level as a borrower. It’s important to determine a customer's creditworthiness before you extend trade credit to them.

To determine the creditworthiness of a customer, you'll need to look at their reputation for paying on time and their capacity to continue to do so. You'll also need to understand the company’s future business prospects and trends within their industry that could affect their ability to pay you.

What are the Factors of Customer Creditworthiness?

There are five core factors that most businesses look at to assess a company’s creditworthiness: character, capacity, capital, collateral, and conditions. Known as the five Cs of credit, these factors can lend insight into a business’s financial history and responsibility, helping you determine if it’s safe or risky to extend trade credit to them. Here’s a deeper dive into these factors and what they could indicate about a borrower.

Assess Character

One of the most influential factors in assessing creditworthiness is character, or how reliable and trustworthy a client is with money. This can be assessed by examining the business’s credit history and credit score.

Higher credit scores and clean credit reports often indicate decent character, which means a customer can generally be trusted to prioritize the agreed-upon repayment of their debt. Qualitative measures — like a business’s reputation and their interactions and relationship with the lender (you) — may also be considered.

Check Capital

A client’s capital includes their personal investment in their business, plus company profit and other assets. It influences creditworthiness because those who have invested their own money into their business are committed and likely more motivated to avoid default. Plus, a healthy amount of assets and earnings can serve as an additional means to settle debts, if needed.

When reviewing a client’s capital before making a decision about extending trade credit to them, examine the company’s financial statements and the owners’ investments in their business. If they have experienced stable capital growth and are committed to the business, the client usually presents lower risk.

Inspect Capacity

A customer’s capacity is their ability to repay their existing debts — and take on a new one. To analyze their capacity, consider the business’s current debt obligations and income, payment history, and cash flow history and stability, as well as the owner’s ability to pay if the business runs into trouble. Two metrics can also give you insight into a customer’s capacity to repay credit: the Debt Service Coverage Ratio (DSCR) and Debt-to-Income ratio (DTI).

The DSCR is a business’s net operating income divided by its debt obligations, including principal and interest, and it measures a business’s overall financial standing and ability to repay its debts. DTI is the business owner’s total monthly debts divided by their total monthly income, showing what they can afford to pay.

Ideally, a DSCR of 1.25 or more and a DTI of 36% or less are preferred. These metrics can help you be confident that the customer earns enough to comfortably cover their existing debt obligations and repayment of any trade credit you extend them.

Review Collateral

Collateral is the asset(s) a customer offers to back a line of credit. If they fail to repay the money they borrow, the collateral can be used to settle the debt. Businesses may use assets like equipment, inventory, real estate, or accounts receivable to secure credit. The owner may also offer personal assets, like their home, as collateral on a business line of credit.

If you have a customer who you want to extend credit to but who may be a risky borrower, collateral can help add security and reassurance to the agreement — just make sure they have sufficient collateral to cover their trade credit.

Examine Conditions

Conditions are harder to assess. They refer to the specific terms set by you regarding the trade credit, such as the interest rate, as well as external factors that may influence a business's ability to repay it. These conditions typically include the overall state of the economy, industry trends, and trends and regulations in the customer’s area. Businesses in stable, thriving industries and areas generally face lower economic volatility that could hinder their ability to repay credit.

How to Check the Creditworthiness of a Company

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

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

Analyzing big data, the large amount of data in any business, is helping companies improve the efficiency of their credit departments. Using tools like machine learning, programming, and statistical analysis to examine this data that substantially reduces the time required to identify patterns that can predict a company’s future financial health. For example, Allianz Trade Online allows our customers to quickly assess the financial performance of their current and prospective clients to protect themselves against risk.

2. Review a Business’s Credit Score by Running a Credit Check

Another useful way to determine the creditworthiness of a customer is to request that business’s credit report. A business credit report illustrates a business’s ability to pay debts based on its previous and current financial standing and behaviors. The report will include basic information about the business, financial data like annual sales, account and payment history and activities, public records like legal judgements and collections, and a business credit score.

The business credit score is a measure of a company’s financial stability and can help you predict how likely they are to pay 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 reported to and made available by the provider at one moment in time, which is not necessarily apparent to the user. Users of credit reports should understand that the information 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
• How much credit they have extended to the customer
• 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 wait to receive replies.

4. Check the Business’s 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 statements in order to learn about the company’s its financial performance.

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

5. Investigate Regional Trade Risk

When assessing creditworthiness of a client, it is important to review the risks in of their geographical region. 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. Allianz Trade 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.

How to Evaluate Creditworthiness of a Company with Limited Data

Imagine you have a prospective client who wants trade credit, but the credit reporting bureaus have little to no accurate information on them. This doesn’t necessarily mean the business isn’t creditworthy — it just means the bureaus haven’t received much information about them. So, how do you evaluate the creditworthiness of a company with a nonexistent or limited credit profile? You use trade references.

Trade references come from professionals like financial institutions, vendors, or suppliers that the prospective client has an established relationship with. These entities can provide you with feedback about their financial experiences with that business and insight into their payment patterns and financial behaviors.

A few questions you should ask trade references when checking the creditworthiness of a company include:

●        When was the last time a late payment was made? Is this a frequent occurrence?

●        What’s the most amount of credit the client has used?

●        How much does the client currently owe? Is any of it past due?

●        What are the terms of your credit offer to the client (such as collateral and interest)?

What is your overall impression of them? Would you extend credit to them again or consider increasing their credit limit?

Reduce Non-Payment Risk with Trade Credit Insurance

When you insure your accounts receivable with trade credit insurance from Allianz Trade Canada, 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 Allianz Trade comes with the support necessary to make data-informed decisions about extending credit to new clients or increasing credit to existing clients.

Creditworthiness FAQs

Below are a collection of common questions surrounding evaluating a customer or company’s creditworthiness. 

What is the Best Measure of Customer Creditworthiness?

To best assess a business’s creditworthiness, you should analyze their character, capacity, capital, collateral, and conditions — also known as the five Cs of credit — to get a deeper understanding of their risk level as a borrower.

What are the Factors that Determine a Company’s Creditworthiness?

In a broad sense, the two main factors that influence a business’s credit risk (or creditworthiness) are its current financial standing and its financial history. Its current financial picture helps you understand the business’s current debt obligations and its capacity to reliably repay an additional debt if you extend trade credit to it. Understanding the company’s financial history — including bankruptcies, collections, late payments, and credit usage — will give you insight into its financial responsibility and habits.