CAT T10 Assessing creditworthiness

This article is in the point of view of a credit controller. Bad debt is the one that we need to avoid of, but the problem is how to avoid the bad debt risk? The very starting point is the time the customers want to be our receivable,i.e purchase from us by credit. We need to make decision whether or not to give credit and how much credit period we can give to the customers. Credit will only be given to particular classes of customer. Therefore we are concerned in assessing the customer's creditworthiness so that we can decide to act on three questions in our mind, who is eligible for credit, why offer credit to that customer and how much credit to offer. The purpose of this article is to give some guidances on how a credit control department assesses the creditworthiness of customer, the methods will be clearly stated in the credit control policies.

We are actually able to get information of customers from external and internal sources. First, I will talk about internally generated information. One of the way is through our favourite ratio analysis. In ratio analysis, we are looking for how much credit we are able to offer to our customers by taking into account our financial position. Therefore, ratios such as profit margin, asset turnover, return on capital employed(ROCE), earnings per share(EPS), price earning ratio(P/E ratio), working capital ratio, gearing ratios, interest cover and debt ratio will help us to analyse our financial position to measure how much funds we can invest into debtors. So for example, debt ratio tells us about our total receivables to total assets, this shows us that whether or not we are efficient in getting the money back from receivables, if the receivables % are a lot lesser than our total assets, this shows that we might be capable of investing more money into receivables to reduce our opportunity cost of holding the cash in hand. Furthermore, we can actually assess the customer's creditworthiness by visiting their premises. Through this, we can find out the capability of customer in returning debt and also check whether the customer is trying to cheat us or not. In addition to this, we might also employ a credit scorer to rate the credit of customers in their premises. The higher the credit score, the more reliable and capable the customers are able to return us the debt. We shall also check our aged receivables analysis which shows the customer's payment in different period and those who always exceed the credit limit we provided shall be taken into account, we might not give them more credit and chase them for their money unless they are in the position of growth, then we might consider again. Finally, we should review the credit record of the customers in the past period, those who can return us money faster are the one we are going to serve first.

Internally generated information is reliable, but we might also concern about getting information about a customer through external sources of information. One of the common way is to get references from bank. Bank can tell us about the customer in less detail, for example, how often the customer lends money from bank or did they always pay back in time, we cannot ask for the bank balance of the customers, that's for sure, but these little information could help us to identify the ability of the customers, if they often lend money from bank, this may show that giving more credit to the customers may have risk of default. We can also get some information from suppliers of the customers. But there is a problem with this, there is a risk of collusion between customers and their suppliers to cheat our money, so we have to be careful about this. We can also get information about the customers from the credit rating agencies. Credit rating agencies are basically research companies who research and rate the creditworthiness of the customers, the best is rated as AAA. From here, we can decide how much credit we can give to a certain customer. But there are also problems in the agency report, it may not up-to-date, too old and no track record, so we also need to take into account about it.

Although sometime the external information may have problems, but we still need to consider about it since the internal information is not enough to judge the creditworthiness of customer because most are past records except customer visits. One thing to note here is that we can't get every information that we want about the customers from external references because of data protection act. Some countries, such as UK's Data Protection Act 1998 makes certain restrictions about the use of data about individual customers and the use of their personal data. This act attempts to protect individual, not corporate bodies. Therefore we cannot just ask the bank for customer's bank balance, these are protected.

In my opinion, credit controller should make good use of both internal and external source of information about customers. Sometimes customers can't pay us because their business is growing and they need more money to do investment and therefore may not pay us in time, we can allow them more credit in this situation as this does not show they are not creditworthiness. Sometimes, we might consider to allow for early settlement discount for the customers whose creditworthiness is not good to encourage them to pay earlier and also building up our relationship so that they will pay back us in time in future. So although the creditworthiness is not too good, we should not just ignore the customer, there may be of some reason they cannot pay us in time. Taking into account all the above issues, you are then only ready to be in assessing creditworthiness which is part of the credit management which is done by credit controller. For those who are taking exam for CAT T10, the above information are the one that you need to understand but not really need to be so detail.