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Appropriate Customer Credit Limits

The combined effect of slow-pay and no-pay customers can be devastating on your company’s cash flow. Right now, resolve to reduce this cash drain on your company by setting appropriate dollar credit limits on all your customers.

Yes, that means actually determining the right amount of credit for each and every customer. And yes, that’s a big order. If you figure the potential savings to your company, however, you will find the time and resources necessary to complete this project. Here’s how to determine the amount of credit your customer can afford to pay:

Get Information Needed for Decision

1) Credit Application – Include a “credit amount requested” and “trade references section” on your customer credit application. Don’t have a credit application? You need one now! (Call if you want us to fax a sample.)

2) Financial Statements – Get them from any company wanting more than $10,000 in trade credit. (State this policy clearly right in your credit application.)

3) Credit Bureau Report – This report will tell you how much credit the company has with other vendors and their payment promptness trends. It often contains valuable sales, profit, balance sheet, and management info as well. You may even be eligible for a group discount with certain credit reporting agencies through your state petroleum association. Check with them.

4) Customer Sales Estimate – For new customers, have the salesperson estimate expected monthly dollar purchases. (Remember, however, that sales people tend to be a bit optimistic!)

Analyze Information Obtained

1) Compare “credit requested” amount on the credit application to estimate of dollar purchases per billing cycle provided by salesperson. Is customer’s requested amount reasonable?

If the amount entered by the customer is much higher than the anticipated purchases, discuss this with the salesman. If less than the sales estimate, use the customer’s lower figure as the amount of credit you will try to qualify the customer for initially.

2) Check all major trade references. This can be from the list the customer provided (which of course will usually be all “good” references) and from the credit report. Most importantly, where does this customer currently buy their petroleum products, what amount is that credit line and how are they paying?

3) Analyze the company’s available cash position. (Remember that cash is what pays your invoice!) First, check with the company’s bank to see the amount of cash on hand in their checking account and any investments. Ideally, your trade line should not be any larger than their average cash balance, unless they have availability on a working capital line of credit.

For customers needing $10,000 or more in credit, check the ledger cash balance on their financial statements. It should be no less than your anticipated trade line. If it is, then you must make sure there is an available credit line to pay you.

For all accounts, check the trend in cash reported on the credit bureau balance sheet. Be careful of a declining cash position, particularly when coupled with increasing trade payables. These two events together are a big red flag that the company is in a cash crunch. They may be changing fuel suppliers because they can’t pay their bill! A company with these trends should be a COD account. They are a bad debt waiting to happen.

Finally, look at the company’s balance sheet net worth. You should never extend more credit to a company than the owners have invested.

Establish Credit Limit

You are now ready to set a dollar figure on the company’s credit limit. The maximum credit should never be more than:

·        anticipated maximum usage

·        cash readily available for payment

·        company’s net worth

Now, test your credit skills with these credit request scenarios:

Case One – Smith Construction has indicated they want a $15,000 line of credit on their application. Your salesperson indicates they will buy $20,000 of fuel in a billing cycle.

Smith submitted financial statements that show $10,345 cash through last year-end and $12,005 cash now. Their bank reports an average cash balance of $10,530 this year.

They have a bank line of 225,000 with $152,000 owing at last year-end and $147,500 owing now. The company’s net worth is $334,000 now, and profit for the year is $75,000. Last year they had a loss of $51,000. All financial trends and ratios appear to be improving.

Their credit report shows mostly prompt payment with one chronically delinquent account in the high four figure-range. All trade references provided indicate prompt payment.

Appropriate Credit Limit: $15,000

We ignore the salesperson’s optimistic estimate and underwrite the credit based upon the customer’s request. Although the cash balance is less than the line request, the company has availability on their line of credit to make our payment.

Case Two – Now, let’s say that everything for Smith Construction is the same except they have no credit line.

Appropriate Credit Limit: $10,000

Our credit decision is now limited by the availability of cash, best estimated by the company’s average checking account balances this year.

Case Three – Let’s reverse the financial statements and say that last year there was a $75,000 profit and this year there is a loss. Reverse the balance sheet information as well.

Appropriate Credit Limit – $0.00 until the reason for loss is determined and an informed decision can be made.

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