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How to Determine an Appropriate Credit Level To Customers



Credit ReportIt can be quite difficult to determine an appropriate credit level for a customer, since the amount of investigation required to develop an accurate picture of a potential customer’s financial situation may exceed the time available to the credit department.

Accordingly, there are a number of shortcuts I discuss in this post that yield good results while requiring less investigative effort. If the amount of credit contemplated is quite high, however, a full and detailed credit review is necessary. The contents of that review are also noted here. Enjoy!



When Credit Request is Lower

If the amount of credit needed by a customer is quite low, then the credit department can authorize it by default, with no further investigation. However, in order to counter balance this credit with the risk of loss, the amount given is usually very small. In order to authorize a larger amount of credit, the customer should be asked to fill out a credit form, on which is itemized the contact name of the customer’s banker, as well as at least three of its trade references. If these references are acceptable, then the level of credit granted can be increased to a modest level. However, it is a simple matter for a customer in difficult financial straits to influence the credit “picture” that it is presenting to the company, by making sure that all of its trade references are paid on time, even at the expense of its other suppliers, who are paid quite late.


Dealing with Credit Reports

To avoid financial straits [from customers], a credit department can invest in a credit report from one of the credit reporting agencies. The price can vary from $20 to $70 per report, depending upon the type of information requested and the number of reports ordered [the credit services strongly encourage prepayment in exchange for volume discounts]. These services collect payment information from many companies, as well as loan information from public records, financial information from a variety of sources, and on-site visits. The resulting reports give a more balanced view of a customer than its more sanitized trade references list.

Part of the credit report itemizes the average credit granted to the customer by its other trading partners. By averaging this figure, one can arrive at a reasonable credit level for the company to grant it, too. The report will also itemize the average days that it takes the customer to pay its bills. If this period is excessively long, then the credit department can reduce the average credit level granted by some factor, in accordance with the average number of days over which the customer pays its bills.

For example: If the average outstanding credit is $1,000, and the customer has a record of paying its bills 10 days late, then the credit department can use the average credit of $1,000 as its basis, and then reduce it by 5% for every day over which its payments are delayed. This would result in the company granting credit of $500 to the customer.


Credit Reporting Data Can be Manipulated

Credit reports can be manipulated by customers, resulting in misleading or missing information. For example, a privately-held firm can withhold information about its financial situation from the credit reporting agency.

If it knows that there are some poor payment records listed in its credit report, it can pay the credit agency to contact a specific set of additional suppliers (presumably with a better payment history from the customer), whose results will then be included in the credit report. Also, the information in the average credit report may not be updated very frequently, so the company purchasing the information may be looking at information that is so dated that it no longer relates to the customer’s current financial situation.


When the Credit Request Is Higher

If the amount of credit requested is much higher than a company is comfortable with granting based on a credit report, then it should ask for audited financial statements from the customer on an annual basis, and subject them to a review that includes the following key items:

Age Of Receivables – If a customer has trouble receiving its invoices, then it will have less cash available to pay its suppliers. To determine receivables turnover, divide annualized net sales by the average balance of accounts receivable. In order to convert this into the number of days of receivables outstanding, multiply the average accounts receivable figure by 360 and divide the result by annualized net sales.

Size And Proportion Of The Allowance For Doubtful Accounts – If the customer is reserving an appropriate amount for its expected bad debts, then by comparing the amount of the allowance for doubtful accounts to the total receivable balance, one can see if the customer has over-committed itself on credit arrangements with its own customers. However, many organizations will not admit (even to themselves) the extent of their bad debt problems, so this figure may be underestimated.

Inventory Turnover – A major drain on a company’s cash is its inventory. By calculating a customer’s inventory turnover (annualized cost of goods sold divided by the average inventory), one can see if it has invested in an excessive quantity of inventory, which may impair its ability to pay its bills.

Current and Quick Ratios – By comparing the total of all current assets to the total of current liabilities, one can see if a customer has the ability to pay for its debts with currently available resources. If this ratio is below 1:1, then it can be considered a credit risk, though this may be a faulty conclusion if the customer has a large, untapped credit line that it can use to pay off its obligations.

A more accurate measure is the “quick ratio” [cash plus accounts receivable, divided by current liabilities]. This ratio does not include inventory, which is not always so easily liquidated, and so provides a better picture of corporate liquidity. Of particular concern when reviewing these ratios is over-trading. This is a situation in which the current ratio is poor and debt levels are high, which indicates that the customer is operating with a minimum level of cash reserves, and so is likely to fail in short order. This type of customer tends to have a good payment history up until the point where it completely runs out of available debt to fund its operations, and abruptly goes bankrupt.


Ratio Of Depreciation To Fixed Assets – If a customer has little available cash, it tends not to replace aging fixed assets. The evidence of this condition lies on the balance sheet, where the proportion of accumulated depreciation to total fixed assets will be very high.

Age Of Payables – If a customer has little cash, its accounts payable balance will be quite high. To test this, compare the total accounts payable on the balance sheet to total non-payroll expenses and the cost of goods sold to see if more than one month of expenses is stored in the payables balance.

Short-term Debt Payments –  If a customer cannot pay for its short-term debt requirements, then it certainly cannot pay its suppliers. To check on the level of debt repayment, go to the audited financial statements and review the itemization of minimum debt payments located in the footnotes. This should be compared to the cash flow report to see if there is enough cash to pay for upcoming debt requirements.

Amount Of Equity – If the amount of equity is negative, then warning bells should be ringing. The customer is essentially operating from debt and supplier credit at this point, and should not be considered a candidate for any credit without the presence of a guarantee or security.

Debt/Equity Ratio – If investors are unwilling to put in more money as equity, then a customer must fund itself through debt, which requires fixed payments that may interfere with its cash flow. If the proportion of debt to equity is greater than 1:1, then calculate the times interest earned, which is a proportion of the interest expense to cash flow, to see if the company is at risk of defaulting on payments.

Gross Margin and Net Profit Percentage – Compare both the gross margin and net profit percentages to industry averages to see if the company is operating within normal profit ranges. The net profit figure can be modified by the customer through the innovative use of standard accounting rules, and so can be somewhat misleading.

Cash Flow – If the customer has a negative cash flow from operations, then it is in serious trouble. If, on the other hand, it is on a growth spurt and has negative cash flow because of its investments in working capital and facilities, and has sufficient available cash to fund this growth, then the presence of a strong cash outflow is not necessarily a problem. The key factor to consider when using any of the preceding credit review items is that the information presented is only a snapshot of the customer’s condition at a single point in time. For a better understanding of the situation, the credit department should maintain a trend line of the key financial information for all customers to whom large lines of credit have been extended, so that any deleterious changes will be obvious.


Other Worth Considering Points Before Taking Credit Level Decision

If the financial statements are based on one time of year when the seasonality of sales may be affecting the reported accuracy of a company’s financial condition, it may be better to request copies of statements from different periods of the year. For example, the calendar year-to-date June financial statements for a company with large Christmas sales will reveal very large inventory and minimal revenue, which does not accurately reflect its full-year condition.

The presence of potential credit problems will typically appear in just one or two areas, since the customer may be trying to hide the evidence from its suppliers. Fortunately, other sources of information can be used to confirm any suspicions aroused by a review of a customer’s financial statements. For example: the sales staff can be asked for an opinion about the visible condition of the customer; if it appears run down, this is strong evidence that there is not enough money available to keep up its appearance.

Also, if the customer is a publicly held entity, a great deal of information is available about it through EDGAR On-line, which carries the last few years’ worth of mandatory filings by the customer to the Securities and Exchange Commission. This information can be used to supplement and compare any information provided directly to the company by the customer.

It is critical that the financial information provided by a customer for review is fully audited, and not the result of a review or compilation. These lesser reviews do not ensure that the customer’s books have been thoroughly reviewed and approved by an independent auditor, and so may potentially contain incorrect information that could mislead the credit department into issuing too much credit to the customer.


I have just shown that there is a variety of ways in which a company can prudently examine credit to its customers, as well as different terms under which that credit can be paid back. A variety of analytical tools can be used to determine the most appropriate level of credit that should be granted to a customer. The key factor running through all of these tasks is that the customer credit function requires constant vigilance and careful management to ensure that credit losses are reduced, consistent with corporate credit policies.

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