Part 2 – Not Knowing Your Customer
How do you know who you can trust and who you can believe?
To figure that out, a Credit Manager needs to know their customer. Ultimately, what you want to know is whether the customer will pay you as they have agreed. And as I wrote in Part 1, you probably wouldn’t treat a request for a $5,000 credit limit the same way you would a request for a $10,000,000 credit limit. The due diligence required for each file varies with the risk level and the amount of Credit involved (it says so in your Credit Policy). Regardless of the amount your customer is requesting, you need a method of evaluating how Credit worthy the customer is. The most well-known method for starting this process is a Credit application; in which the customer formally asks for Credit with your business. Until the customer has completed and signed this application, they have not actually asked you for Credit.
In other words, knowing your customer starts with the Credit application. This is an important document that introduces your customer to you.
In my opinion, a good Credit application is brief and covers the essentials: who your customer is, where they are located, and how you get in contact with them. It should tell you:
- What is their legal name, and address,
- who owns them,
- who do you contact in the company to talk about payment and
- how you can contact them.
You also may want to know who their banker is, with the bank’s contact information, and, also, who are their 3 or 4 main suppliers, so you can get trade references. Signing the Credit application should give you permission to check the applicant’s Credit history (credit reports, bank report and trade references) and, also, obligate the customer to pay your invoices, as well as any late fees or interest charges that may be incurred. A credit application is a good introduction, a starting point, but it does not have all the information you may need to make an informed decision.
Pro Tip: A long Credit application will almost never be filled out properly, so the shorter you can make the document, without giving away the essentials discussed above, the better.
For most Credit Managers, figuring out who to trust is about evaluating Risk vs. Reward. And, usually, the more Reward there is to be had, the more Risk that Credit, and the business, can accept. How much is the right amount of risk, meaning how much risk can the business tolerate? Good question. If Credit granted is too tight, then the company is turning away business and the Credit Team will hear about it from Sales. If Credit granted is too loose, then bad debt losses will pile up, and… the Credit Team will hear about it from Sales. In my experience, it is frequently the case that one company will have multiple lines of business and each of those business units will have a different perception about risk tolerance or the level of acceptable risk. As a part of the internal communication discussed in Part 1, the Credit team will have to figure out (calibrate) the right amount of risk for each business unit and how much bad debt expense they can live with. Doing the job successfully is about balancing Risk and Reward, and therefore, is also about taking calculated risks. And taking calculated risks is mainly about getting and analyzing information. The more information you have, the better your decision making will be.
What kind of information? Well, to get an understanding of Risk and Reward, a Credit Manager needs access to two sources of information: some it from Sales (the Reward) and some of it from the customer (the Risk). What are the projected sales to this customer (volume) and how much does Sales think they will make on what they sell (margin)? Measuring volume and margin gives a Credit Manager an idea of how much credit is needed by comparing the projected volume to the proposed payment terms and doing some calculations. Measuring the margin gives a Credit Manager the Reward. But what about the Risk? That’s where the application comes in, particularly if you need more information to approve a large, complex request. It tells you who you can contact at the customer to get that information.
Much has changed in Credit/Collections/AR in the last ten years with FinTech, artificial intelligence, and automation. What has not changed are the Five Cs and I don’t think they will change in the future. No matter how automated these processes become, someone will still have to make a decision about the customer. The Five Cs are: character, capacity, capital, collateral and conditions, and the Five Cs represent the most common model for Credit decision making. No matter how large or complex of the file, the information obtained from the customer should help you address the Five Cs. The digital tools offered to Credit Teams today amplify or magnify what the team can do, but those tools do not do away with the need for the Credit team, nor the Five Cs.
So, what does this all mean? When evaluating a potential customer, you should start with your Credit Policy. Your Credit Policy will tell you how much information you need to get and how deeply you need to dive into each customer so that you can make an informed decision for your company. Then, go talk to Sales and to the Customer to gather information and to ask questions. Don’t just crunch the numbers in a financial statement, read it. There is a lot information in it, especially in the notes, that will give you a better idea of who your customer is, and their financial capacity. When the information in a financial statement raises questions or concerns, ask those questions and get the answers. Don’t leave questions hanging. To better understand your customer’s credit history, review trade credit reports and bank reports. Remember that first hand information is the most reliable; the best indication of payment history is the information available from your own account. If a customer is applying to significantly increase their existing Credit Limit, consider how they have paid your account in the past and factor that history into your decision.
How much information is enough? When you are drafting or updating your Credit Policy, start by talking to the Credit team about how much time and effort should go into new applications, as well as customer reviews, depending on the level of risk and the size of exposure. As I indicated earlier, the due diligence required will vary. Settle on reasonable expectations for the detail required based on reasonable criteria.
And if you are really stuck for answers, reach out to the Credit Institute of Canada; we can recommend some experienced Credit Managers to help advise you.
Coming up: Part 3 – Waiting too long to collect