How to Assess Customer Credit Risk

Extending credit to your customers stimulates business growth. At the same time, this creates risk. The risk is not only related to the activities of your customers but also to numerous economic, technological, and climate-related credit risks that can emerge unexpectedly across the globe, as reported by Moody's.

When you sell or trade on credit, you essentially “lend money” to your customers. Some will pay on time. Some will pay late. Some may not pay at all. In the end, late and missed payments hurt your cash flow and make it harder to pay your bills.

To assess customer credit risk, start by collecting facts about a customer's payment history. Also check their financial health. From there, give them a risk rating and set credit terms that match that rating. 

This process helps you judge customer creditworthiness before you agree to wait for payment. It also gives you a clear record of why you said yes or no.

This article provides a rundown of how to assess customer credit risk while also emphasizing that the work does not end once you approve a customer. As customer finances change, keep watching for warning signs and act when the risk goes up. It’s important to follow each step to protect your business and grow your sales.

Strong credit decisions start with facts about how a customer pays, what the credit bureaus report, and what other suppliers say. Gather all this evidence early in your credit risk assessment process so you can set fair limits and terms.

If the customer has bought from you before, your records are the best place to start. Your accounts receivable data shows real payment behavior with your business, not someone else's.

As you pull an aging report, look for these patterns:

• Average days to pay compared to stated terms.
• Number of late invoices in the past 12 months.
• Disputed invoices.
• Short-paid invoices.
• Changes over time, such as a customer who used to pay in 30 days but now takes 60

A slow trend often matters more than one late payment. Note as well any broken payment promises or bounced checks. 

So what should you do when taking on new customers? Ask for a credit application that lists bank and supplier details. You will use those details in later checks. A business credit report shows how a company pays many suppliers.

The major providers include Dun & Bradstreet, Experian, and Equifax. Here’s what to check when you pull these reports:

Warning: Do not rely on one credit score alone. Instead, compare reports from more than one bureau when the order size is large. Each bureau uses different data, so you will notice that scores can vary.

Ultimately, your analysis of credit risk needs to determine a customer’s ability to pay. The risk depends on steady cash flow, manageable debt, and enough working capital to cover short-term bills. You also need to weigh the risks of the customer’s industry and how much money you stand to lose if they don’t pay.

Start your risk analysis by asking for the customer’s recent financial statements. These include the balance sheet, income statement, and cash flow statement. Request at least two years of records so you can spot trends.

A word to the wise: profit alone does not prove a customer will pay. A company can show a profit on paper but still run short of cash. This makes it important to focus on operating cash flow, which shows the money the business brings in from its main operations.

Another aspect to consider is working capital (current assets minus current liabilities). This metric shows whether a customer can pay its bills within the next year. Positive working capital gives them room to pay on time.

Next, compare debt to income. For a small business owner or sole trader, the debt-to-income ratio shows how much income goes toward debt. For larger companies, compare total debt to cash flow or equity.

You can use this table as a quick guide:

A high credit utilization can mean the customer relies on borrowed money to cover daily costs. That raises the financial risk for you.

Creditworthiness also depends on the customer’s industry. Some sectors, like construction and retail, face more ups and downs. Check whether demand is falling, costs are rising, or other firms in the sector pay late.

Also compare the customer to industry averages. A thin profit margin may be normal in one field but a red flag in another.

Then think carefully about your exposure size. This is the total amount you could lose if the customer stops paying. From there, match your level of credit risk evaluation to that amount.

For small orders, a credit report and a basic check may be enough. For large and ongoing accounts, review the full financial records and set up regular check-ins. And with high-risk customers, ask for a deposit, use shorter terms, or set lower credit limits.

A risk rating turns your research into a grade that sets limits, terms, and who can approve the account. Documenting the evidence and the reason for each decision lets you defend it later and spot patterns across your customer base.

Your credit assessment should pull every input into one place. This includes payment history, bureau data, financial statements, public filings, and trade references.

Weigh each input by how much it tells you. For an existing customer, your payment records usually matter most. For a new customer, bureau reports and references carry more weight. Also use the same template for every account so that two staff members will reach similar conclusions.

Here’s an example of a simple record:

·   Customer details (legal name, registration number, owner).

·   Key findings (days beyond terms, liens, judgments, reference results).

·   Rating and limit (the grade you assign and the approved amount).

·   Reason (explaining the decision).

·   Approver and date (note who signed off and when to review again).

This record helps when customers ask for more credit or stop paying, or any time you need to review.

Credit scoring gives each customer a number based on set factors. Many models estimate the probability of default, which is the chance a customer will not pay within a set time.

How is this done? Some tools use data analytics, machine learning, or artificial intelligence to find patterns in large sets of payment data. The resulting score is useful but has limits. Bureau scores often lag behind real events. A struggling customer may pay key suppliers on time while paying you later each month.

So what should you do? Treat the score as one input in your credit risk assessment. Check it against your records and recent changes, such as new liens or a new owner. If the score and your data disagree, note which one you trust and why.

Risk categories link each rating to a specific action. Include these rules in your credit policy so staff apply them the same way to each customer.

Set rules for exceptions too. This includes deciding who can approve an order above the limit. Require a reason and an end date for each override, and review ratings when something changes, not only once a year. A broken promise to pay or a drop in a bureau score should prompt a new look at the account.

Your credit limits, payment terms, and added protections should reflect how likely each customer is to pay. Low-risk customers can get more flexible trade credit while high-risk customers need tighter terms or extra security.

A credit limit caps how much a customer can owe you at one time. How should you set the limit? Base it on the customer's credit score, payment history, and how much they plan to buy. Many businesses start new customers with a lower limit and raise it after several months of on-time payments.

Payment terms set how long the customer has to pay. Shorter terms reduce your exposure and protect your cash flow.

Put all terms in writing so customers know what to expect.

Some customers carry more risk than you want to accept. In those cases, you can ask for extra protection before you extend trade credit.

·   Personal guarantee: The business owner agrees to pay the debt personally if the company does not. This is common with small or new businesses.

·   Collateral: The customer pledges assets, such as equipment or inventory, that you can claim if they default.

·   Credit insurance: You pay a premium to an insurer that covers part of your loss if a customer fails to pay.

Other options include letters of credit and upfront deposits. Pick the tool that fits the size of the account and the level of risk.

Strict terms lower your financial risk. But they can also cause customers to turn to your competitors. Loose terms can win sales, but they raise the chance of bad debt.

To find the right balance, compare the profit from a customer against the loss you would take if they did not pay. A customer with high profit margins may justify more risk than one with thin margins.

The best way to conduct this analysis is to ask these questions:

1.   How much profit will this account bring in over a year?

2.   How much could you lose if the customer defaults?

3.   Can your cash flow handle a late or missed payment?

Review each customer's terms at least once a year. Adjust limits up or down as their payment habits change.

A customer's ability to pay can change months after you approve them. Watch how they pay, update your review when their business changes, and learn to tell a one-time delay from a real risk of default.

Good credit risk management does not stop once you approve an account. Check each customer's payment behavior every month. Look at how many days they take to pay and compare it to past months.

This kind of trend analysis shows you problems before a missed payment. Watch for these early warning signs:

·      Payments that arrive a few days later each month.

·      Partial payments on full invoices.

·      New disputes over invoices they used to pay without question.

·      Orders that suddenly grow much larger than normal.

·      Slow replies to your calls or emails.

One sign alone may mean little. However…two or three together call for a closer look.

Creditworthiness can shift when businesses change. To pick up on such developments, set up alerts through your credit bureau or accounting software so you know as soon as possible.

Then pull fresh credit reports and review the account for these types of changes:

Review your largest accounts at least once a year, even if nothing seems wrong. For smaller accounts, you can wait until a red flag pops up.

Not every late payment means a customer is in trouble. A late invoice can come from a lost bill, a staff change, or a holiday. These delays are usually short and happen once.

Default risk looks different. Over time, the customer pays later and later, and the delays spread across many invoices. Their credit reports may show they also pay other suppliers late.

To tell the two situations apart, ask yourself…

1.   Is this the first late payment in a year? If so, it is likely a simple delay.

2.   Did the customer explain and pay soon after? This points to a minor issue.

3.   Are other suppliers reporting late payments too? That suggests cash flow problems.

When the signs point to real risk, act early. Shorten payment terms, lower the limit, or ask for payment before you ship any products or deliver any services.