Establishing and following a sound credit policy can help your business navigate the minefield of business failures, reorganizations, and bankruptcies. The object of a credit policy is to minimize the chances that any single bad debt write-off negatively impacts your business.
If you run a business that sells goods or services to other businesses, it is more than likely you experienced a bad debt write-off at one time or another. The challenge, then, is not necessarily to avoid doing business with a company that may end up in bankruptcy court, but to make sure that if you find yourself extending credit to a customer that ends up in bankruptcy court, your business is not going to experience lasting damage as a result.
Some companies don’t have a systematic credit policy. Their acceptance of new customers can be hit-or-miss and their owners may pride themselves on intuition and experience. Unfortunately, today’s business climate and business people are not as predictable as they may have once been. You need to create a policy that will govern who you take on as a new customer and how much credit you will extend them.
Starting a credit policy
Following a few simple rules can help you avoid making catastrophic mistakes. The rules must be maintained in a credit policy and followed by your sales and administrative teams.
As a company owner, you know your staff members’ strengths, especially those who work on the financial side. The credit policy could also speak to how much freedom you want your people to have in making credit decisions. Expect to spend some time on your credit policy. A document as important as this will take some thought and review by others.
A good launching place to draft your credit policy is to start with a clear statement of its purpose. This statement could include answers to questions such as the following:
- How does your company compare to your main competitors?
- What are your company’s primary goals?
- How do the people in your credit department work toward beating your competition and meeting your goals?
- What is your approach to the future of your company? Slow growth? Risk-averse? Aggressive?
Your credit policy will be your credit department’s go-to manual, the customized resource that simplifies decision-making and speeds up those decisions. If you begin with your goals and assessment of your market, the vision that you articulate for your company will stay in the forefront.
Next, develop a good credit application. Your factoring company can assist you with this. The credit application is your window into a customer’s likelihood of paying you for your goods or services. To protect your business you want all customers to complete a credit application.
In your credit application, ask your customers or prospective customers to provide a picture of their finances. A credit application should include answers to the following:
- The prospective customer’s company name with addresses
- The business owner’s name, phone numbers and email address
- List of their largest vendors, along with contact names, phone numbers and e-mail addresses at those vendors
- Bank and trade references
- Mortgage holder/landlord references and phone numbers, email address
- Credit information
- Personal guarantee and signature
Once you have the names and phone numbers for the different references, contact these vendors, banks, and other sources. Ensure that the references listed are valid and do not raise any red flags for your future business relationships with these customers. Next, if you are extending a significant amount of credit to a business with which you have had limited firsthand experience, request a confidential financial statement from their controller. Your factoring company can assist you with the financial statement analysis if you lack experience or training in this area.
Finally, set prudent limits. Your factoring company can assist you in this process as well. Like your other business guidelines, a good credit policy is a living document that should reflect the economic realities of the time. You want to make sure that the business failure of your customer does not lead to your own business failure. You can manage this type of risk by making some common-sense credit guidelines. Here are just a few:
- Limit your credit terms to Net 30 days.
- Limit the outstanding balance any single customer may have at any given time to a certain percentage of your overall accounts receivable.
- Require that accounts representing over a certain dollar amount provide periodic financial statements.
- Require that accounts representing over a certain percentage of your overall accounts receivable be personally guaranteed by the owner (assuming they are privately held companies).
Having a factoring company is not a substitute for maintaining your own credit policy; however, a good factoring company can assist you by reviewing your credit policy from time to time and making recommendations. Ask to speak to executive management about their philosophy on credit and credit policy.
At Interstate Capital, a leader in factoring since 1993, the experienced underwriting and credit department professionals can help you develop a strong credit policy that can protect you while allowing for your company’s growth. When you factor your invoices with Interstate Capital, we also apply our own proven credit process to protect your company against business loss.
Letters of credit
Occasionally, Interstate Capital’s experts are asked if factoring companies can issue letters of credit. The answer to that question is, of course. Anybody can issue a letter of credit. The better question is who would accept a letter of credit written by a factoring company? Before answering that question, let’s discuss letters of credit in a little more detail.
The two most common types of letters of credit are “standby irrevocable letters of credit” and “documentary letters of credit.” The standby letter of credit is a payment guaranty most commonly found in domestic transactions in which the vendor expects its customer to pay for goods within the credit terms offered and is relying on the letter of credit only as a guaranty by the bank on which the letter is drawn.
The documentary letter of credit is an instrument of payment generally used in overseas transactions in which a vendor is placing goods on a merchant vessel headed abroad and is expecting payment directly from the bank on which the letter of credit is drawn. Simply put, a documentary letter of credit is a primary repayment source for a seller of goods whereas a standby letter of credit is a secondary repayment source, kicking in only if the buyer defaults on its payment obligation to the seller.
Any company can write a letter of credit on behalf of another for the benefit of a beneficiary company. Letters of credit are generally written by banks, which issue them on behalf of their customers. Why is this? Simple. At least until recently, banks were viewed as stable and able to honor their letters of credit if and when called upon to do so.
If a client asks its factoring company to issue a letter of credit and the factoring company is willing to consider the request, it is likely the factoring company’s bank will issue the letter since the vendor may not be familiar with the factoring company’s credit. If the vendor is comfortable or familiar with the factoring company’s credit, it is likely to accept a guaranty as opposed to a letter of credit.
Many factoring companies are willing to write guarantees for the benefit of their clients to facilitate a sale and purchase of goods that will give way to a factoring transaction. Such guarantees are typically less costly than a letter of credit because they are less time-consuming and offer more “outs” than a letter of credit. Vendor guarantees and letters of credit are popular when transactions are “back-to-back,” where the factoring company’s client is able to turn inventory into accounts receivable immediately. Let’s examine this more closely.
Case study of a payment guaranty
Say you sell a phone system to a Fortune 500 company and receive a purchase order for $500,000. Your customer will utilize its own IT staff to install the system, so your job is done when you (or your vendor) deliver the system to your customer.
Now, say your vendor has the phones you need to fill this large order. The phones will cost you $400,000, so if you complete this transaction, you make a tidy $100,000 gross profit. But there’s just one hitch: You don’t have the kind of track record with this vendor that would allow them to ship you (or your customer) an order of this size without you sending payment in advance.
Interstate Capital staff might suggest that we issue a guaranty of payment to your vendor. We would charge you a small fee to guaranty your vendor that we will pay them if you fail to when the bill comes due. Your vendor can check out Interstate Capital’s credit and decide for themselves if we’re good for the guaranty. If so, then off we go. If not, we will get our bank to put up the $400,000 standby irrevocable letter of credit, which will serve the same purpose.
In the meantime, ICC will factor your $500,000 invoice upon verification from your customer that they received the phone system, and we will reserve from the advance a sufficient amount to cover the guaranty or letter of credit. Typically, we will pay your vendor immediately to extinguish the liability. You may also find that you may be able to negotiate a discount with your vendor, perhaps a percentage point or two, if we can pay the vendor within 24 hours of delivery. The discount, if any, reduces your cost of financing the transaction with Interstate Capital. You then receive your gross profit when your customer pays the invoice, minus the financing cost.
Some vendors will not accept a letter of credit or a vendor guaranty. In such extreme situations, Interstate Capital can arrange for the prepayment of the goods, in which case we typically involve a strategic partner that specializes in purchase order financing and inventory financing to handle that end of the transaction. Once the goods are delivered to your customer, Interstate Capital will generally factor the invoice and reserve sufficient funds to pay off our strategic partner. You receive your gross profit after the strategic partner and Interstate Capital are paid, minus the financing cost.
Interstate Capital: Your credit partner
When your company is ready to create a new credit policy or develop a partnership for growth, contact the financial veterans at Interstate Capital.