Recessions increase the number of net-30 on invoices that turn into bad debt, but a simple method can catch them before they become a cash flow problem.
Most commercial customers insist on 30- to 60-day payment terms, also known as net 30 or net 60. Construction business owners accept giving net payment terms to customers because they want to keep them happy. However, giving these payment terms can have financial consequences if not done correctly.
Consider this common scenario. As fears of a recession increase, your customers protect their cash flow by requiring longer payment terms. Customers who previously asked for 30 days may now ask for 45 days or even 60 days. Those who asked for 60 days may seek to stretch payments up to 90 days.
You still need to cover your company’s payroll and other expenses. Since your customers take longer to pay, you may need to use your cash reserve to meet your expenses. However, if your reserve is inadequate, you will have cash flow problems.
There is a bigger issue. Business credit gets worse with recessions, which may curb credit access, slow collections and spur business bankruptcies. Both small and large businesses face many of the same recession risks and some customers who were low credit risks may become high credit risks. This increased risk may leave you with bad debt. The best way to handle this challenge is to avoid giving payment terms to risky customers.
How to determine your customer’s creditworthiness
The easiest and most effective way to determine a customer’s creditworthiness is to use a business credit report. These reports don’t have the same restrictions as consumer reports. Anyone can buy a credit report from one of the credit bureaus. The best-known providers in the industry are Dun and Bradstreet, Experian’s Smart Business Reports, and Ansonia Credit.
Credit bureaus gather company information from several sources and use them to compile their reports. Their most important data comes from companies that share client payment trends. This data is critical because you can use it to determine how your client pays other vendors.
How to read a credit report
Each provider offers reports with different levels of information. While they all use proprietary formats, they provide similar information. Business credit reports can be open to interpretation. They have limitations and are not perfect. Evaluate reports carefully but use them only as one tool to help your decision-making. Focus your attention on these areas:
Suggested credit line: Credit bureaus use algorithms to suggest a maximum payment term line to your client. Use this suggestion only as guidance.
Payment trends: This data lets you know how quickly your client pays other suppliers and if they pay on time or are consistently late. Some reports also show the payment trends for the last three or six months. Worsening trends could suggest the company is tightening its belt or facing cash flow problems.
Largest, average and smallest line: This information shows the size of a client’s largest, average and smallest credit line. It’s best if the credit you extend to your customers is close to the amount of the average line. Avoid offering amounts approaching the largest line, especially if there is a significant difference between the largest and average lines.
Number of reporting lines: This guidance shows the number of vendors reporting payment information for a company. Use it as a measure of confidence—more vendors are always better. Do not consider a report to be reliable if it shows data for only a couple of vendors unless you are evaluating a small company.
Legal filings: This section shows Uniform Commercial Code filings, liens, lawsuits and similar items. Companies in the construction industry tend to have more legal filings than companies in other industries. This legal information is not necessarily an indication that they are in trouble. Examine the liens and lawsuits carefully, though.
How to make large credit decisions
Using a single credit report for a small trade credit line should be fine. However, consider buying detailed reports from different bureaus before offering a large line to a client. Each credit bureau uses its own data sources. Getting reports from different companies gives you a more comprehensive picture of your customer.
Using several reports may cost as little as a few hundred dollars but could easily exceed that. The cost depends on the reports you purchase. Spending a few hundred dollars to help reaffirm a large sale is not a bad investment. However, spending a few hundred dollars to avoid a large, risky sale is an excellent investment.
What to do if your customer is a high credit risk
Every so often, you may see reports that show high-risk profiles, which include companies with limited credit information and companies with negative information. It’s recommended that you avoid offering payment terms in both cases. The risk of financial loss could be high. This decision lowers your risk but will be disappointing to the prospective customer.