What is Customer Creditworthiness and How Can It Be Determined?

Simply put, creditworthiness is the ability of your customers to pay you, which is why it’s important to understand how to determine creditworthiness 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.


Using the 5 Cs of Credit to Evaluate the Creditworthiness of a Company

You can determine the risk of extending credit and quantify credit limits by using the five factors termed “the five Cs of creditworthiness.” While there are no strict guidelines for how to weigh these 5 characteristics, considering each can help you perform a credit assessment to determine the likelihood of default and potential financial loss should you extend credit.

The five Cs that help you determine the creditworthiness of a company are:

  1. Character: It is important to determine that your trade partner has the background and credentials that indicate they are trustworthy and have a reputation for sound business practice. To assess character, you should call business references, review the business’s credit history, and analyze the reputation the business has in the industry.
  2. Capacity: You want to make sure the prospect or client can pay your invoices. Understanding the business’s cash flow situation will provide this insight. You should examine cash flow statements, analyze its debt-to-income ratio, and compare that to historic revenue.
  3. Collateral: If your invoices remain unpaid, your client could liquidate certain assets to settle the debt. Part of an effective credit analysis is to understand what assets your client or trade partner has, such as equipment or accounts receivable.
  4. Capital: Understanding how well capitalized your treading partner is can help you understand their ability to pay for your goods or services. Ask to review a potential client’s certified financial statement.
  5. Conditions: Take a close look at the conditions that could affect your trade partners’ business. The economy, political situation in the county of operation, and threats or opportunities for the industry the business operates in can help you understand if the business will continue to be viable or if challenges could indicate a potential for late payment.

How to Determine 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 the 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. Trade credit insurance is a prime example of how companies can easily obtain more customer data to improve credit processes.

Using Allianz Trade as an example, the credit insights we provide to customers come from a variety of sources, some of which include:

  • 85 million+ companies monitored in our proprietary risk database
  • 1,700 sector-specific credit analysts in 62 countries + 30 full-time data scientists
  • An extensive array of proprietary and third-party data sources
  • Direct contact with monitored buyers to request and analyze financial statements
  • Real-time past-due and claims reporting from 55,000+ customers around the world
  • Machine learning and artificial intelligence to augment our expert analysts

The more extensive the insurer’s database, the better their access to invaluable customer information, based on data from a worldwide network of analysts and clients. These analysts have local expertise and customers that give information about their payment experience with their clients. This confidential financial information about companies gives much deeper insight into their strengths or weaknesses. It helps spot high-risk companies before it’s too late.

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 to get their credit rating. 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 judgments 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; 
  • 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 find out how a company is doing financially, 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 of 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 the 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. 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.


Reduce Non-Payment Risk with Trade Credit Insurance

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

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