"Too many people spend money they haven't earned, to buy things they don't want, to impress people that they don't like."
~ Will Rogers
A large firm that has been in the petroleum distribution business for a long time was having some critical issues. They were delivering tanks of fuel, but their customers were not paying within the 10 days the company required. As you would guess, a tank of petroleum is not an inexpensive purchase.
The firm was continuously trying to get new customers, but they were only negotiating price and not taking any steps to minimize their credit exposure. Only profit margin was being considered in their decision to extend credit to their customers.
Here is why that is a problem. If you have two customers and one is unlikely to pay on time, these two customers should not be given the same credit. The customer whose repayment ability is questionable should receive less credit than the one who is willing and able to pay on time.
The question of extending credit to a customer should not be answered with a yes or a no. Rather, the amount extended should vary based on what is requested or needed. You must establish credit limits that take into account the customer's ability to repay.
Take, for example, credit card companies. Credit card providers use their credit scoring models to determine the risk they are undertaking based on each customer's projected ability to repay. I might want a $50,000 credit limit, but if I have no way of paying it off, the credit card company would limit
me to $15,000 to minimize its risk.
A retail store with prices under $50 would not typically have to deal with setting credit limits. However, a computer technology firm that regularly spends $10,000 or $20,000 on an individual customer needs to set credit limits to protect itself against exposure.
The key to determining an appropriate credit limit is getting as much information as you can about the customer and asking the customer what they would like in credit. When your customers are businesses, there are many methods of approximating credit limits. Some people in the field argue that 10 percent of net worth is a good place to start, but I feel this is a questionable practice. Ten percent just seems too arbitrary to me.
One of my favorite methods is comparing new customers to established customers of a similar size. I can assume the new customer's maximum orders will be in the same ballpark, so their credit needs will be similar too. At this point, of course, adjustments will need to be made based on the firm's financial viability, which you can determine by looking at their financials.
When evaluating financial viability, cash balances and equity are pretty good barometers of financial condition in most small businesses. If you see that cash balances continue to be very low, you can reasonably predict the firm is going to have problems paying off credit. With a customer in this category, you will want to keep credit limits low at first and let them prove they can meet their financial obligations.
You also have to be careful about the amount of credit you extend a firm with a negative or very low equity position. A low or negative equity level indicates the firm could be very near becoming insolvent, which means their debts are higher than their assets.
Finally, the thing to look at very carefully is other firms that have provided credit to this customer in the past.
Jerry Osteryoung, a consultant to businesses, is Jim Moran professor of entrepreneurship (emeritus) and professor of finance (emeritus) at Florida State University. Reach him at email@example.com.