How to Check the Creditworthiness of Customers

Extending credit to customers is a great way to improve trade and encourage business growth. However, doing so can come with the risk of late or non-payment.

Without proper creditworthiness evaluations, risks of late or non-payment is much greater. When handled effectively, assessing the creditworthiness of a customer is a proactive way to protect your business against late payments and bad debt.

In this article, we’ll help you understand how to check the creditworthiness of customers, so you minimise the risk of late or non-payments. Need advice? Learn more about our Credit Risk Management solutions.

In this guide

What is creditworthiness?
The 5 Factors of creditworthiness
How to assess the creditworthiness of a customer
What to do if you suspect a customer is a credit risk
Our credit risk solutions

What is creditworthiness?

Creditworthiness is a measure of how likely someone is to repay borrowed money on time. It's determined by factors like financial health, credit history, and industry trends, helping lenders assess the risk of offering credit to an individual or business. The main aim of assessing creditworthiness is to determine whether the customer is able to fulfil debt obligations on time, mitigating risk.

Why assessing creditworthiness is crucial

The assessment for creditworthiness generates a clear understanding of the risk for a business to offer credit. Extending credit to customers with lower creditworthiness can pose risks to cash flow, revenue and overall business performance.

In the post-pandemic survey by Quickbooks, 60% of SME business owners reported facing cash flow issues. This data underscores the risks. When businesses face cash flow challenges, they might struggle to repay their debts on time, leading to delayed or non-payments for the credit extended to them. By assessing a customer's creditworthiness and financial health upfront, companies can ensure a healthier and more predictable cash flow for their own operations.

The 5 Factors of creditworthiness

You can work out the risk of a customer’s creditworthiness with the 5 factors of creditworthiness, also known as “the 5 Cs of creditworthiness.” The 5 Cs act as a general framework for determining whether a business customer is capable of repaying the amount they will borrow. The five Cs are:

Character

Character refers to the customer’s financial situation and behaviours. For example, assessing character involves assessing the customer’s credit history and score. For companies, this will tell you how long they have been in business, how often they make their payments on time, if they’ve ever declared bankruptcy, along with other financial information.

Capacity

Capacity directly looks at a customer’s ability to make repayments. Cash flow statements, business debt and payment history can help you analyse if they’ll be able to make repayments. Positive cash flow indicates the ability to cover expenses and debts promptly, enhancing the likelihood of timely repayments. On the other hand, high levels of debt may strain the ability to meet new repayment responsibilities.

Capital

Capital represents the total fund and assets owned by a business. It includes both financial and non-financial assets. You should review a potential customer’s bank records and financial statements in order to understand what state their capital is in. If they have investments in fixed assets and other avenues, it’s crucial to evaluate these too. A regular increase in capital suggests they have high creditworthiness.

Collateral

Collateral is used as protection in case debts are needed to be settled and the customer can’t or doesn’t pay. This includes fixed assets such as a business’s inventories, corporate bonds, or real estate. It’s often a crucial factor when extending credit. These assets could be liquidated to pay off a debt if needed and minimise the lender's risk.

Conditions

Conditions that could impact your customer’s business need to be considered. This includes economic, political and regulatory conditions that could affect them being able to repay what they borrow. A customer would be at a higher risk if they are in an unstable geopolitical location which could be facing high economic instability which could result in them losing revenue and being unable to keep up repayments.

How to assess the creditworthiness of a customer

Use big data to assess customers

Companies are harnessing big data technologies to enhance the effectiveness of their credit checks. This allows companies to aggregate vast amounts of data from various sources, including financial transactions, social media, and public records.

With this, companies can create predictive models that assess credit risk based on historical data. Since this relies on a deep understanding of risk modelling, many companies choose to outsource credit risk solutions. At Sagacity, our Credit Risk Management solutions can help you assess a potential customer’s financial information so you’ll know if they're suitable for your business.

Analyse a business' credit report

Another effective method to assess a customer's creditworthiness involves utilising a business credit report. This comprehensive report offers insights into a company's ability to meet payment obligations based on their payment history and public records available. It provides a highly accurate profile containing financial data like annual sales, invoice activity, credit limits over multiple years, legal judgments, collections activities, and a business credit score. A strong indicator of a business’s financial stability is their credit score. The base FICO® Scores range from 300 to 850. A higher score (typically above 700) generally indicates lower credit risk. Conversely, a lower score may suggest higher credit risk.

It's crucial to note that credit reports offer a snapshot of information available at a specific time, which might not reflect the most current state of the business. Data could be up to a year old and might not represent real-time changes which can significantly impact their creditworthiness.

Evaluate the debt-to-income ratio

Another method to assess a customer's creditworthiness involves calculating their debt-to-income ratio. This calculation reveals the proportion of a company’s debts in relation to its earnings. To work out this ratio, divide the company’s monthly debt payments by its gross monthly income, both of which can be found in the financial statement.

A lower number generally indicates better financial health. However, what is considered a good debt ratio will vary across different industries. It’s important to understand the specific baseline ratios within an industry.

Ask for references

When evaluating creditworthiness, companies frequently seek trade references before granting credit to a customer. These references might involve the customer's bank and other businesses or suppliers currently providing trade credit to that customer.

Important things to get answers for include:

The duration for which the business or supplier has offered credit to the customer
The credit or purchasing limit set for the customer by the business or supplier
Details regarding the customer's recent purchase, including the purchase date and total amount
The frequency of late payments or instances when the account has been overdue

Most customers will only provide you with good references so it’s important to consider that they may be omitting examples where they did not fulfil their credit obligations. Because of this you should try to get several references so you can see they at least have a good record.

Conduct credit investigations

You should review multiple sources when evaluating the creditworthiness of a customer. This should include:

Customer history: credit history details how long each account has been open, amounts owed, amount of available credit used, number of recent credit inquiries and if repayments were made on time.
Credit policies:firm-specific framework tailored to your business whether it’s a loose credit policy where you’re willing to extend credit to higher risk clients for larger returns or tight credit where you only take on safe customers.
Accounts receivable ageing report: shows if they have outstanding invoice balances.

What to do if you suspect a customer is a credit risk

Before credit has been given

Before extending credit to customers, it's crucial to establish a robust credit risk strategy for your business. This entails creating well-defined policies and optimising collection strategies to effectively minimise the risk of potential bad debt.

Our Credit Risk Management solutions can offer supportive guidance throughout this process. From facilitating customer on-boarding to assisting in the implementation of strategies tailored to their credit risk level, we aim to help you define policies, ensure compliance, and optimise collection strategies.

After credit has been given

If you are worried about your customer being unable to pay after you have offered them credit, you should consider placing them on a watch list. This involves close monitoring of them with regular contact at shorter intervals throughout the credit period to remind them of invoices that are due. Proactive measures like this can help identify potential payment delays early on.

When the invoice is overdue

If an invoice has not been paid on time, it’s crucial that you act quickly to try and recoup what you’re owed. Accounts receivable measures are essential to efficiently address the situation. This involves:

Simplifying payment processes: removing billing obstacles for customers and utilising user-friendly payment portals and automated reminders.
Optimising invoicing tools: streamlining operations with advanced invoicing software, benefiting from features like automation, customisation, and real-time tracking.
Proactively assessing creditworthiness: evaluating creditworthiness with a focus on credit reports and financial ratios, addressing potential risks and issues related to overdue payments.
Implementing transparent credit policies: implementing clear credit terms and policies, regularly reviewing and adapting terms based on market conditions.
Strategic segmentation: segment customers by credit risk, tailoring credit terms for a nuanced approach.

Learn more in our guide to accounts receivable management.

How Sagacity can help minimise credit risk

A customer's creditworthiness should be fully assessed before offering any form of credit. Non-payment from a customer or even a late payment could potentially get your business into trouble if it affects your cash flow.

Credit risk strategies can be adopted at anypoint of the customer lifecycle whether it’s from their initial enquiry, in life management, or during billing and collections stage. We've got decades of experience in credit risk management working with clients across many different industries. We’re able to help you define your policies and processes, optimise collection strategies, and monitor your customers profiles with our easy to use software.

Get in touch with our team today to see how we can help you improve your credit risk management strategy and processes. Explore our services to lower the risk of non-payment and bad debt today: