To extend or not to extend? Effectively limiting risk and exposure when setting credit limits

TTtHn EXTENSIoN of credit, so basic to any business enter- prise, pivots on trust and risk. The biggest challenge a credit prolessional faces is deciding whether to extend credit to a client, and how to determine the proper amount of risk or exposure to accept. always present when extending credit, so a business must establish a formal credit policy and set credit limits. Credit limits not only improve a company's ability to collect debt, but help it minimize losses on defaulting customers.

Risk Tolerance & ExPosure

A credit policy should determine not only how and when to sell on credit and the terms, but also define when terms should be revisited, and when necessary, the collections process. Several factors influence the amount of e*por.rre a business is willing to take. Factors include cash flow, profit margin, and the ability to collect unpaid debt' Caih flow is critical. When offering credit, the seller has not only paid the cost of providing the product or related service but will receive no cash from the sale to replenish operating capital until the debt is paid. When setting the length of terms, the seller needs to take into account if it haJenough cash flow to cover operations until payment is received.

Establishing credit limits is not an exact science. While some seasoned credit professionals develop a'gut feeling,' others take an analytical approach to reducing risk. In either case, understanding risk tolerance and potential buyer performance patterns are essential. This article looks at what factors a company must consider when extending credit, what is involved in the credit review process, and how to answer the standard question: "Should I extend credit-and if so, how much?"

Extending credit to customers can increase sales' improve customer satisfaction, and help build long-term .uitorn"t relationships. Nevertheless, the risk of loss is

Additionally, a company's profit margin is a major consideration when determining how much exposure is relatively safe. The lower the profit margin, the more conservative the credit policy. Tightening credit, however, may have a negative impact on sales growth unless the company's product or service is in high demand. In a competitive market, a looser policy may be needed to maintain customers even if profit margins are low.

Poor economic conditions also can dampen a company's appetite for risk, but not always. Kelly Bates, global credit director for a U.S.-based supplier, notes their company didn't change its credit policy during the recent economic downtown.

"sometimes we get pushback [from buyers] that other companies extend longer terms," she concedes' "but our llelpful adicles for you and your eustomers. limited quantity - request your kit today at woodbywy.com/decktools! a

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. ...and more practices are consistent. Whether it is a good market or a Poor market, we stick to the same procedures." Bates explains that this still requires knowing their customers, monitoring pay, paying close attention to Blue Book Services credit sheets and ratings, and evaluating any changes that may occur on a month-to-month basis.

Know Your Customer

Knowing your customer's financial stability and track record are crucial. Large or small, a company must have the ability and cash flow to sustain itself. As most credit professionals know, insolvency can strike firms of any size and have a devastating ripple effect.

There are a number of sources to obtain information on a customer's creditworthiness, such as credit agency reports and bank references. Credit agencies can provide informa-

lndustry Pay Trends

Every month, Blue Book services collects accounts receivable data from lumber supplieri throughout the U.S. and Canada. Confidentially maintained, this information is compiled, averaged and analyzed to help Blue Book members make safe and informed credit decisions. The following chart confirms that industry pay hends have been relatively stable for the past five quarters.

tion on a customer's payment history, banking relationships, and financial performance. Bates relies heavily on Blue Book Services for timely information on pay performance and emerging trends.

"We check a customer's background. We look at how long a company has been in business and dive into their financials," she explains. "If what we need is not available, we will go with references, but we take them with a grain of salt." She notes, however, that banks are a good source for references.

When calling a customer's bank for a credit rating, standard questions include how long the account has been open, the average balance, and whether the bank has credit experience with the account. Bates saYs knowing the customer and understanding its reputation in the market are critical to making sound credit decisions. "We go back to the salesperson to find out what theY know about the customer. It gives us a better level of comfort for the risk (we may undertake)."

In some cases, it is advantageous to look at a customer's operating plan. "We request a forecast of how much they intend to purchase, and we keeP the amount of credit in line with the forecast and past history," Bates says' Company policy is to set the credit line "to actual need as long as the financials support it. If there's a spike in their credit line, it's a trigger to us to go back to the salesperson (to find out why)."

If a customer is asking for more credit because the company doesn't have the required cash, Bates saYs, such a spike "forces us to investigate to determine what the risk is."

Not every customer has the financial stability to receive credit. "Most of the time we extend cash in advance terms if they don't meet the criteria," Bates says.

Equal Credit OpportunitY Act

Any business checking the creditworthiness of its customers needs to be in compliance with the Equal Credit Opportunity Act. The Equal Credit Opportunity Act (ECOA) of 1974 applies to all creditors before, during, and after extending credit. Congress passed the Act in response to the difficulty minorities, women, and the elderly had in obtaining credit and requires that creditors "make credit equally available to all creditworthy customers" without discrimination. The Act also includes rules on certain notifications and record retention.

Applications must be worded neutrally, so as not to ask for any prohibited information. Additionally, applicants must receive a credit decision within 30 days. If credit is denied, terms have been changed unfavorably, or an increase in a line of credit had been refused, the creditor must notify the applicant, and he or she has 60 days to request, in writing, the reason for the "adverse action." The creditor must respond to the applicant within 30 days if such a request is made.

Denied application records for applicants with gross revenues of $ I million or less must be retained for 12 months after notification, for 60 days after notification for applicants with more than $l million in gross revenues-or 12 months if so requested by the applicant.

In addition to actual damages, court costs, and complainant attorney fees, violators can face punitive damages of up to $10,000 in individual lawsuits and up to the lesser of $500,000 or l%o of the creditor's net worth in class-action suits.

Conclusion

The decision to extend credit and the terms of credit are different for every business. Company officials should set policies that reflect their own level of comfort with risk and should perform due diligence on cus- tomers' financial stability, reputation, operations and payment performance history.

Bates offers this advice when extending credit: "Know your customer, keep [the sales department] in the conversation when you are deciding to give credit, and stick to the facts. Make a fact-based decision."

- This article was provided by Blue Book Services, established in 1901. a comprehensive online directory and credit information resource for the lumber industry that has been actively involved with NAWLA since 2009. Learn more at www.l umberbl ue book.com.

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