No sale is really a sale until the money is in. And often the receipt of that money is delayed because most businesses now operate on credit rather than a “cash and carry” basis.
Every time your company extends credit, it takes a risk that the payments will be late or, in worse cases, never show up at all. Thus, it’s critical to minimize that risk by taking two basic precautions:
- Run a credit check to identify any potential problems you might expect from a particular customer, and
- Set credit limits at a fair risk level based on the customer’s FICO Score® and what’s reasonable given the facts and circumstances. (See “The Risk Percentile” at right.)
But you don’t necessarily have to rely on FICO Score® or any other widely accepted credit rating to minimize financial exposure and manage your accounts receivable. Using your financial statements and customer information (including payment histories), you can administer your own in-house ratings to determine how tight or loose you need to be with credit in order to meet sales, profits and debt-management objectives.
What you call these ratings isn’t important. The primary issue is what they mean and how well you and your leadership team understand them.
Here are six examples of in-house credit ratings:
1. Quality accounts. This top rating goes to customers with no identifiable risk and a cash flow from primary and secondary sources that’s sufficient to service the debt. These accounts have well-established, realistic payment plans; a long-term relationship with your company; and a history of paying invoices on time. Look for a verifiable financial status, a cooperative attitude and a debt load that’s reasonable in relation to net worth.
2. Acceptable accounts. This quality rating is given to customers that are start-ups or relatively new companies, as well as those lacking sufficient secondary sources of payment. These customers have a satisfactory cash flow to pay their bills and loans, and they have a soundly structured payment plan in place. They also show good character and have lived up to previous credit agreements.
3. Accounts to watch. Here’s where you start to categorize deficiencies. Reasons for giving an account this rating include a first-time operating loss, a sales drop, an unsatisfactory payment plan or a developing uncooperative attitude. These customers show the potential for further risk, though a restructuring of the debt could eliminate the soft spot. Pay close attention to anticipate developing credit problems.
4. Substandard accounts. Customers that merit this ranking have a documented poor payment history, a weak financial condition or a cash flow that doesn’t cover its debt. If the weaknesses continue, your company could experience a loss.
5. Doubtful accounts. These have the same inherent weaknesses as “substandard accounts,” but collection in full is questionable.
6. Loss accounts. These customers are at “the bottom of the barrel.” That doesn’t mean the accounts have no recovery potential, but full collection is unlikely.
These are just some examples of commonly used in-house ratings that can improve the efficiency and efficacy of a business’s accounts receivable process. Work closely with your CPA and other business advisors to establish a sound credit policy and generate financial statements and other reports that accurately reflect the state of your accounts receivable.
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