Chapter 2

Credit 101: Defining and Applying Credit Concepts

In This Chapter

Defining credit

Understanding the competitive forces at play in credit extension

Establishing and practicing sound credit policies

Using the five Cs of credit to your advantage

Formally speaking, credit is an agreement to pay for goods or services at a future time. A creditor allows the debtor to receive goods or services without immediate exchange of payment and thereby assumes a risk of not being paid. But if we can be less formal, perhaps you’ve quipped “I’d rather owe it to you than cheat you out of it.” Or if you’re a fan of classic cartoons, as Popeye’s friend says, “I’d gladly pay you Tuesday for a hamburger today.”

Dun and Bradstreet, one of the oldest names in the credit and collection industry, defines credit as “man’s confidence in man,” and sometimes the simplest definition is the best. After all, at their heart, credit transactions are extensions of trust and defaults are the betrayal of that trust.

Whether you regard credit as a valuable business tool or as a necessary evil, to succeed in modern business you need to understand it. Virtually all commercial and consumer transactions are presently conducted on credit terms, and credit transactions amount to trillions of dollars annually. Even when the economy is strong, operating your business without buying and selling on credit terms is no longer practical. How many of your customers are willing to pay immediately? Probably not many. With this chapter as your guide, you can implement credit terms in your business in a controlled, practical manner. By improving your pre-tax profits, you may improve your company’s credit status and your ability to borrow from banks.

Extending Credit in a Nutshell

Because most customers consider the terms for repayment of debt as a critical factor when choosing vendors and suppliers, your creativity in the extension of credit to your customers can increase your sales. Beyond the simple distinction between commercial credit and consumer credit, common forms of credit include the following:

Trade credit: Extending credit for the sale of goods or services, usually with no collateral. This option is also called open account credit.

When credit managers extend trade credit, they factor in risk. If your credit policies minimize your risk up to the break-even point, but you take greater risk after that point and your customer can’t pay in full, you may observe, “At least we broke even on the sale.” But you’ll survive an occasional break-even transaction.

If your company has a 20 percent profit margin, and your customer makes a $10,000 purchase, you break even when you’ve collected $8,000. Although you put your profits at risk, the risk posed to your business is much lower before the break-even point than after that point — your profits are at risk, but at least you’re not losing money. The biggest risks arise when you recover less than $8,000 and don’t even cover your costs. Your profit margins have a significant impact on the risk of extending credit. If your profits are only 2 percent rather than 20 percent, to minimize risk you must implement very conservative credit policies.

When you set your policies, consider what amount is truly break-even for your company and whether increased credit risk after that point helps or hinders your finances and business goals. Your willingness to accept the risk of break-even transactions or losses affects your credit extension policy for both new and existing customers.

Is your company sales-oriented or credit-oriented, and how does that affect your credit policies? A typical sales-oriented company takes greater credit risks than a credit-oriented business, extending credit to a customer who may be deemed too risky by a credit-oriented company. On the other hand, the more stringent, less flexible credit policies of a credit-oriented company will cost it some sales. (We discuss extension of credit in this chapter and Chapter 3.) While there are valid business reasons for choosing a sales-oriented approach over a credit-oriented approach, the increased credit risks can increase the challenge for your company’s credit and collection personnel.

Cash credit: Credit extended for loans of money.

Cash credit involves no product or service. Money is the stock in trade. Every dollar not recovered from the customer is, quite literally, a dollar lost to the bottom line or profit of the business.

With no margin for error, applications for cash credit often require detailed financial statements, a personal guaranty, and collateral such as a lien on real estate, on personal property, or on goods under the Uniform Commercial Code. See Chapter 3 for a full discussion of the use of guaranties, secured transactions, and how to obtain and perfect a lien.

Credit cards: Exactly what you think they are.

Although you can find an array of store credit cards for purchasing products on credit, huge credit card companies (such as Visa, American Express, and MasterCard) dominate the industry. Accepting payment through a major credit card company is similar to an extension of cash credit, because no product or service is directly associated with this form of lending. Even so, you may find that offering your own credit card is a desirable way to attract and maintain customers.

These categories of credit can overlap. Many hybrid forms of credit continue to develop to suit the needs of businesses and their customers.

Risk is the key factor. Even short-term extensions of credit expose you to risk. The extent of your risk depends not just on the financial strength of the debtor, but also on the debtor’s attitude and basic willingness to honor the debt when it comes due. To put it another way, your degree of risk depends largely on whether your debtor is motivated to pay.

How to Use Credit as a Sales Tool in Your Business

When a customer abuses credit, you may be tempted to tighten up your policies so that customers must have perfect paying habits to qualify for any credit extension. However, the more you restrict credit, the more your sales volume drops off. Don’t lose track of the importance of credit as a sales tool, moderate your temptations, and be prepared to take some risk.

As with anything else in sales, sometimes creativity and flexibility land the sale. You probably haven’t given it much thought, but you can be very creative when extending credit to your customers. The following factors play into the use of credit as a sales tool:

Attractive price and credit terms: Though price may seem wholly different from credit, in sales they can work in harmony. Reducing prices is always attractive to customers and serves as bait to gain more business.

Similarly, certain credit policies, such as offering discounts or extended credit terms, potentially reduce customer costs. Even small concessions can be very enticing, particularly in a difficult or competitive economic climate.

Value-added extras: Adding some extras can make your company stand head and shoulders above your competitors. Examples abound, including

• Material storage: You’re willing to store materials at your expense until your customer needs them.

• Concern: Your concern with the customer is so deep that you have employees devoted exclusively to her account and needs, perhaps even to the extent of having them frequently visit or work at the customer’s location or attend her meetings.

• Recommendations: You make recommendations that improve your customer’s bottom line. You don’t charge for your ideas but rather work to build a reputation of providing great ideas to improve your customer’s efficiency or the use of his products or services.

• Attitude: Your general attitude and willingness to provide extras without additional charge elevate you in the eyes of your customers.

• Loyalty, real or forced: Your relationship with your clients results in their trusting your products and service, or ties your businesses together in ways that benefit your customers and make it difficult for them to change suppliers. For example, after your computer is linked to your customers’ computer so that they exchange data, you’ve established a forced loyalty because of their reliance on the information exchange. Your company and theirs are in a groove of supplying needed information back and forth.

Even if your customer considers your products to be a commodity, one of your never-ending lists of value-added features may make your product more appealing than the next guy’s. Although some extras have a measurable dollar value, others generate customer loyalty and feelings of goodwill.

Competition: How much competition are you facing? Check to see how much competition really exists in your market. If you have very little competition, you’re in an excellent position! You can dictate terms and can refuse credit extensions any time you feel the risk is too high. For that matter, if you have no competition at all you can require cash in advance of delivery and enjoy the best possible cash flow.

But most businesses aren’t monopolies. Not even close. If you’re in the opposite situation, or even somewhere in the middle, your sales team will be disappointed (to put it mildly) if you fail to consider extending reasonable credit terms.

Giving customers what they’re looking for: Even if your customers can easily turn to your competitors, you may be in a privileged position because of high customer demand for your specific goods or services. Factors that may give you an edge include

• Presentation: Never underestimate the power of presentation, whether it is a special sales approach, interesting product packaging, or other creative features that make your services or products pleasant to the eye.

• Quality: The more competition in your industry, the more likely your customers are to demand high quality in addition to low prices. If you can give them both, you may have a leg up on your competitors.

• Prompt service: Offering prompt and high quality service is a common bragging point. Make sure your customer service is up to par and that it exceeds the service offered by your competition in some specific ways. One now-famous pizza company grew by leaps and bounds by promising “delivery in 15 minutes or it’s free,” a win-win for customers whether they prefer prompt delivery or are hoping for free pizza.

• Experience in the industry: Depending on what industry you’re in, average longevity may be just a few years! Your experience in your industry serves as shorthand for the skills, knowledge, and similar attributes so valuable to your customers.

• Reputation: Word-of-mouth referrals generate an enormous amount of business. Your good reputation, usually built on a foundation of reliability, honesty, and a strong work ethic, help you promote and build your business.

• Complaint resolution: Customer complaints inevitably crop up from time to time even for the best and most reputable companies. How you handle a complaint can make the difference between salvaging your relationship with a customer and never receiving another order.

• Access to people: Although returning phone calls is a basic business courtesy, it’s also a sign of respect for your customer. It sends a very strong signal that you’re responsive to customer inquiries and demands. Something that can harm even the best of business relationships, and quickly tarnish the best of reputations, is the five word lament, “He never returns my calls.”

Calling the Shots: Establishing a Sound Credit Policy

Sticking to your policies is the key to success. Some variations are fine from time to time, such as extending terms for prompt-paying, loyal customers, but you fare much better overall by adhering to your practical, sound credit policies. Credit policies help you minimize losses by establishing

A set of requirements before a customer is granted a line of credit

A plan for following up on missed payments

A protocol for initiating collection proceedings for highly delinquent bills

Creating a written credit policy

Write a set of credit policies based on what works for you and the practices of your industry. Consider the items in the following sections when forming your credit policy. Although no policy is foolproof or applicable to every situation you encounter, if you’re diligent and thorough the policy you create should serve you well.

Your credit policy should consider and include the items listed below. You can find specific guidance to these items, and additional examples of how to apply them, throughout this book.

Strategies

Based upon the needs of your business, industry trends and practices, and what your competitors are doing, develop strategies that relate to each step of the credit and collection process, including

How to evaluate creditworthiness, when to issue credit and on what terms, and when to modify credit terms. We describe this process in Chapter 3.

Protocols for taking and verifying orders, tracking deliveries and receipt of goods, providing customer support, and monitoring payment. You can find more information on good billing practices in Chapter 4 and monitoring your accounts in Chapter 5.

When to treat a delinquent payment as a debt, what in-house collection measures to take, and when to refer collection to an outside professional. Consult Chapter 7 for discussion of when a customer becomes a debtor.

Initial terms of sale

Your initial terms of sale are applied to any new customer and limit the extension of credit while you get to know the customer. The durations may change depending on your industry and needs, but an example may provide

Cash or COD to start for 6 months

Limited credit terms after the introductory cash/COD period for another 6 months

Full credit terms after 12 months

Full credit terms and discounts

You usually provide more credit options, and perhaps price and credit discounts, to your customers with good, more established pay histories. For example:

Invoice due in 30 days

Established customers (12 months of regular purchasing and good pay history) eligible for 2 percent discount if taken within 10 days after invoice date, or else balance is due in 30 days

Electronic payments and communications

What systems are in place, or can be put into place, for connecting electronically to your customer, whether for financial transactions or for orders and billing? Some options may include

Direct deposit of funds

EFT (Electronic funds transfer)

Computer to computer functions: invoicing, statements, pricing, and so on

Electronic connections and coordination can convenience both you and your customer, perhaps with orders, billing, and payments occurring in close to real time.

New customers

When a new customer approaches your business and requests credit, your policies should consider the nature of the customer’s business enterprise, and you should be cautious about extending credit. The following procedures, offered in outline form, are typical:

Individuals

• Obtain a credit report.

• Follow the initial terms of sale per your standard policy.

• Keep the customer on a short leash, and cut the customer off immediately (suspending deliveries and services) if any invoice is 30 days past due until the balance is up-to-date.

Newly formed companies (less than a year old):

• Obtain a credit report.

• Require a credit application in writing (filled out and signed by the customer, or filled out by you or your designee and verified by the customer as accurate).

• Review the customer’s financials.

• Get the personal guaranty of president or principal owner.

• Follow initial terms of sale per your standard policy.

• Cut the customer off immediately (suspending deliveries and services) if any invoice is 30 days past due until the balance is up-to-date.

Established companies (in business longer than one year, with good payment history on credit reports):

• Obtain a credit report.

• Require a credit application, in writing (filled out and signed by the customer, or filled out by you or your designee and verified by the customer as accurate).

• Review the customer’s financials.

• Review for possible personal guaranty of president or principal owner.

• Evaluate whether to extend full credit terms, or limited credit for a specified period.

Reestablishing existing customers

If you haven’t worked with a company for a while (whatever the reason) or if a red flag event causes you to reevaluate their credit,

Follow the same procedure for established companies with which you have no prior relationship (discussed in the preceding section).

Update all file information, confirming ownership, address information, and so on.

Large orders, regardless of new or established customer:

Whether an order is large for your industry, for the customer placing the order, or for the size of your own business, you need to protect yourself.

Consider additional guaranties or securing liens.

Consult with professionals, such as your lawyer or CPA.

Summary of credit documents

The basic documents that comprise your credit file on any customer include

Credit report (see Chapter 3)

Credit application (see Chapter 3)

Financials (see Chapter 3)

Personal guaranty (see Chapter 3)

UCC or real estate lien documents (see Chapter 3)

Promissory note (see Chapter 5)

Aging sheet (see Chapter 4)

Credit evaluation using all available data

Monitor your customers and credit policies on an ongoing basis, based on

The five Cs of collection (see “Applying the Five Cs of Credit Collection” later in this chapter)

Instinct

Industry trends (so you stay competitive)

Study and verification of customer data

Your estimated exposure (dollar volume)

Your current level of accounts receivable and the levels of past due accounts, if any

Profitability from customers buying on credit terms

Credit versus other alternatives: letters of credit, electronic funds transfers

Handling past due bills

Your approach to past due bills may change depending upon your experiences with a customer, and the customer’s financial condition. As an example, a simple policy using 30-day terms may provide the following:

Before a new customer’s invoice is due: A polite reminder call confirming receipt of proper paperwork and that the relationship is off to good start.

At 10 days past due (40th day): A second copy of the invoice, stamped with red “Did you forget. . .” stamp, and invoices for late charges and interest added to the account. Cut off deliveries.

At 20 days past due: A third invoice and second statement, both with URGENT stamps in red.

At 30 days past due: An initial demand letter and follow-up call(s) to determine why the payment is late. Verify all data from the credit application: address (physical address, no P.O. boxes or mail drops), phone, company ownership, and so on.

At 45 days past due: A second demand letter; start serious collection calls. Credit reporting. (See Chapter 11 for the pros and cons of reporting delinquencies to credit bureaus.)

At 60 days past due: Increase intensity of calls and letters.

At 90 days past due: Top priority; strong calls and use of in-house collections staff to fullest.

At 120-150 days: Top priority; small claims court/outsourcing to professional collection agency.

Dealing with disputes

Disputes can be minor or they can be explosive. You want to identify them early and establish protocols that minimize the chances that they’ll harm your business. You do this through your

Customer service policy

Minor dispute resolution policy

Major dispute resolution policy

Settlement policy

When establishing your settlement policy, keep the following points in mind:

Try to resolve disputes promptly.

If your customer can’t pay in full, work out a payment plan.

Keep good records. Make sure that copies of all documents relating to settlement go into your customer’s credit file, including promissory notes, possible liens, guaranties and settlement stipulations in pending litigation matters, and confessions of judgment.

Get it in writing. Any settlement, agreement, or resolution you reach with a customer should be put in writing, signed, and dated by your customer.

We describe techniques for resolving disputes in Chapter 9, and after you reach a resolution, Chapter 10 tells you how to seal the deal.

Outsourcing collections

If you’re unable to collect a debt through your own efforts or those of your staff, you need to consider other means of collecting. You can read more about outside professionals and when to use them in Chapter 13, but here’s a basic list of your options:

Case file review — is your documentation complete?

Collection agencies.

Collection litigation in small claims or a regular court with or without a collection attorney.

Reviewing your credit files and policies

Creating good credit policies is a crucial first step, but over time you find that both your and your customers’ needs and expectations change. You also need to make sure that your information on your customers is accurate and up-to-date. Here are some tips for making sure your credit policies are still effective:

Review and update your credit policy documentation every two years. Check for date changes, irrelevant or obsolete terms, and so on. Be sure to evaluate and update your strategies as well.

Look for mistakes or problems with your extensions of credit. Do you have too much risk, unauthorized purchases, wrong addresses, bad checks, or any other problematic issues? Keep an eye on industry trends and changes in the economy and adapt your credit policies accordingly. Work hand in hand with sales to stay on top of changes in each customer’s order volume and frequency to spot problems early. Chapter 5 tells you how to identify potential problems.

Implementing your written credit policy

When you implement your written credit policy, remember the two keys to success:

Adopt or formulate a written plan that you and your employees use as a guide.

Keep the policy up to date. Make changes, both as needed and when needed, based upon unique situations, the need to be competitive, or your discovery that a component of your plan just isn’t working.

Make all changes in writing. Notate the change, the date it was made, and what the change was.

By doing this, you create a permanent yet flexible documents establishing a sound and workable credit policy. Because your employees must follow those provisions, you gain a sense of continuity in handling credit matters — you can literally go by the book.

Customizing Your Credit Policy to Meet Your Needs

Extending credit involves more than just giving your debtor some time to pay the debt. You can customize credit to meet the needs of your company or of your customers. The examples described in this section aren’t exhaustive, but they can give you a sense of how you can benefit from flexibility and creativity.

Providing a discount

Discounting credit rewards prompt payment, and you can offer it as an alternative or in addition to any price reductions the customer may earn. The two forms of discount serve different purposes: the price reduction tells your customer you appreciate him, and the credit discount rewards him for paying quickly. Although most customers prefer a price reduction to a credit discount, both are useful for building relationships with good customers. (And, of course, your ability to offer discounts depends on your profit margins.)

Credit discounts are written in a simple code. A credit discount reading “2 percent 10 net 30” gives your customer a 2 percent discount off the price on the invoice if he pays the bill in 10 days. Otherwise, the customer must pay at full invoice price within 30 days. Customers with a good cash flow will pay on the 10th day and enjoy the 2 percent reduction on the invoice. The numbers may vary, but the concept remains the same.

Customers with a mediocre cash flow often try to take the discount even when they pay the invoice after the discount period expires. Businesses often view discounts as entitlements: The customer takes the discount and treats it as a price reduction regardless of when the bill is actually paid. Creditors sometimes respond by adding the unearned discounts back in the statements of account or future invoices, a practice that can create confusion in the balance due. When a delinquent account consists exclusively of unearned discounts, very few professional collection agencies will accept it for collection, so be sure to clearly reinvoice the shortage amount, the amount wrongfully deducted as a discount after the discount period ran. A new invoice is generated for this unearned discount and, if it remains unpaid, that amount also appears on the next statement of account.

If you decide to let the customer get away with the discount by failing to reinvoice it, you’re setting a precedent: You’re telling the customer taking the discount beyond terms on this or any future invoices is just fine. You may regret doing that, particularly if this customer takes advantage of it on all future invoices and, worse yet, spills the beans to other customers who suddenly take unearned discounts as well. At that point, you no longer have discount terms; instead, you have wholesale price reductions!

Adjusting credit extension to your industry

The unique circumstances of your industry, the nature of your goods or services, and the frequency of your deliveries or bills all tie into your credit decisions.

Consider, for example, perishable goods. Deliveries of food items are usually handled on a very short leash, with very short credit terms. Time to object to product quality (spoiled milk) is intentionally kept very short. When a product should be inspected immediately upon receipt, don’t give the customer a long opportunity to object to its condition. The same goes for goldfish and all sorts of other spoilage items you can think of — problems can arise with perishables, but set a time frame that prevents your customer from trying to hold you responsible for somebody else’s mistake.

When you’re working with perishable goods, you may be delivering your products once or twice per week. Although the size of your deliveries affects how often you bill, if the deliveries are substantial you don’t want to increase your risk by having two (or more) deliveries outstanding before your customer makes a payment.

In contrast, some industries work on (and expect) very long credit terms. If you’re selling coiled steel, the coil is shipped to your customer on a truck, a small section is cut off and tested for quality, and the coil goes into the warehouse for eventual use. It doesn’t spoil like food or die like goldfish. Credit terms of 30 to 90 days are the norm for shipments of steel, as opposed to just a few days for food and fish. Different strokes . . .

Adjusting credit terms to the quality of the customer’s paying habits

Better customers earn better credit terms. No surprise there. Extending favorable credit terms when you have minimal risk is good business strategy. Customers appreciate the vote of confidence, and you generate loyalty. Win-win.

The opposite applies to poor payers. Don’t take on significant risk with a customer who pays slowly. Slow payers can turn into no-payers. Consider keeping poor payers on COD terms. If your sales department insists on credit extension to a customer that’s a poor credit risk, insist on the protection afforded by such documents as personal guaranties, liens, and confessions of judgment, as we discuss in Chapter 3.

Adjusting the level of your accounts receivable

Textbook receivable turnover (collection time) may be 30 days or so, but many factors affect your actual collection rate. When your receivables reach a level of being uncomfortably high or aging is uncomfortably long, tighten credit terms at least to marginal accounts. When receivables reach critical levels, adjust terms for all customers. If you use your accounts receivable as collateral for working capital, banks may refuse to loan money to your company as the receivables become

Too high in relation to other items on your balance sheet

Too old, especially if they appear to be uncollectible

Uncontrolled if it appears that your credit policies are being ignored or otherwise mismanaged.

Even though your sales may suffer a bit as customers seek other vendors with better credit terms, keeping your receivables under control preserves your sanity. Work together with your CPA to arrive at levels of comfort (and discomfort) for accounts receivable.

Setting credit extensions based upon ability of customers to pay

Although two customers may be paying according to terms (promptly), the customer with the strongest financial strength or longest time in business may be entitled to more leeway on credit extension. Certainly, within reason, reward a good customer who always pays her bills on time despite a spotty balance sheet. But a promptly paying customer with a strong financial condition (see discussion on financial statements in Chapter 3) or longevity should be rewarded by receiving your best pricing and credit terms.

Setting credit terms based upon interest and late fees

As an alternative to adjusting credit terms, some lenders prefer to provide equal credit terms to most who apply. As problems arise with a particular customer, they may add contractually imposed late fees and interest or cut off credit altogether. Credit card lenders deal with a huge volume of customers and rely on a standard contract and credit terms rather than any customer-by-customer credit term evaluation. They impose higher interest rates and fees on their higher risk customers, such as slow paying customers or those who have recently filed for bankruptcy. This large-scale categorization of customers works well for them.

Avoiding discriminatory practices

State and federal laws, including the Equal Credit Opportunity Act (ECOA) impose strict guidelines that you must follow in the extension of credit. For example, a spouse of a credit applicant can’t be required to sign a personal guaranty if the applicant would have otherwise qualified for the extension of credit. For a full discussion of these important laws and regulations, see Chapter 6.

Knowing Your Customer and Lending Accordingly

When you extend credit, the type of legal entity you’re extending credit to is key to determining how much credit to grant. From a collection standpoint, there’s a huge difference between lending to an individual or sole proprietorship and lending to a corporation. Many business entities, including corporations, provide a significant shield against collections, allowing their owners or shareholders to avoid any personal responsibility for their unpaid debts.

Before extending credit, you should know what type of legal entity your customer has chosen. In fact, identifying exactly who (or what) your customer is is just as important as knowing how long the customer has been in business, how much credit he’s requesting, who he’s purchasing from (trade references) and who he’s banking with. Generally speaking, with the notable exception of sole proprietorships (where the business and owner are one and the same), a legal entity may

Have separate assets owned in its name

Sue and be sued in its own entity name

Insulate its owners from personal liability (except for the general partners of a regular or limited partnership)

Find out the differences in the legal entities you’re selling to so you avoid any misunderstanding as to who owes you the payment. Then make sure you’re extending credit to an entity you actually want to have credit terms.

When you evaluate credit applicants, always require a formal credit application. The information your customer provides on its application makes it clear who the applicant is and the nature of the legal entity involved, which, along with other vital information from the credit application, allows you to properly evaluate the prospect. If the customer refuses to take the time to fill out your credit application form, your credit policy should require you or your designee to contact the customer by phone or in person to obtain that information. You can complete the application form yourself and then have the customer verify, sign, and return the form or acknowledge its accuracy in writing. An e-mail acknowledgement is fine. Chapter 3 details how to use credit applications.

Common legal entities

Common legal entities include:

Sole Proprietorship: A business owned and operated by an individual, without limited liability or any of the other features of a corporation.

General Partnership: A business entity where the owners share personal liability for the debts and obligations of the business.

Limited Partnership: A form of partnership with general partners, who manage the partnership and are personally liable for its debts, and silent partners, whose liability is limited to the value of their interest in the partnership.

Corporation: An artificial entity or “legal person” that under normal circumstances shields its owners from liability for its debts.

• S Corporation: A business corporation with no more than 75 shareholders and one whose shareholders pay taxes on corporate income at regular income tax rates.

• C Corporation: A corporation that may have an unlimited number of shareholders and that is taxed on its income as a separate entity at a corporate tax rate.

Limited liability company (LLC): An entity similar to a corporation that ordinarily shields its owners (usually called members) from liability for the debts of their business.

In addition to the liabilities described for proprietors and general partners, personal liability may also arise in the context of other legal entities. For example, an individual may become liable by

Signing a personal guaranty or suretyship agreement.

Managing a business as a member of a limited liability company in the very rare occasion that the documents creating the LLC require personal liability.

Continuing to run a corporation that has been automatically dissolved by the state.

Making purchases on behalf of a company that has not yet incorporated.

Commingling personal money with business money or thinly capitalizing the business from the start.

What does that mean for your credit decisions? The following sections give a bit more detail on the legal significance of the most common legal entities.

Individuals and personal guarantors

A person who applies for credit, or who signs a personal guaranty of payment for another entity, should be evaluated for credit purposes based upon his personal assets and income. In the event of default on the debt, he is personally liable and, should it become necessary, his personal assets and income are exposed to collection action.

Proprietorships

Good news: The owner of a proprietorship is personally liable for any default on credit terms extended. By definition, a proprietor is the owner, and the business isn’t a separate legal entity, so she has personal liability.

Partnerships

Good news: The owners of a general partnership are personally liable for money owed. Although the partnership entity is a legal entity that may stand alone financially, own property in its name, and sue and be sued in its own name, the general partners (owners) are personally liable to you.

Watch out for versions of partnerships called limited partnerships that involve general partners (who are liable personally) and limited partners (who aren’t personally liable because they’re just investors under the law). Your credit application is a helpful tool in determining the kind of partnership you’re selling to.

When the owners are personally liable for their business obligations, whether because the legal entity they use makes them liable (like a general partnership) or because they signed a personal guaranty, you shouldn’t assume that you’re safe. When a business fails, the (previously) wealthy owners often go down with the ship and end up filing for personal bankruptcy protection. This tendency is especially true if they’ve relied on the income from the failed company to support their lifestyle, and don’t have other businesses interests or sources of income.

Corporations

When you sell to a corporation, only the corporation is liable for your debt. Whatever assets the shareholders may have, a corporation is a separate, stand-alone legal entity, and you’re extending credit to that entity, not its owners (shareholders). The shareholders only become personally liable if they sign a personal guaranty.

You must exercise extreme caution when extending credit to a corporation, especially one that is fairly new (formed within the last five years) or hasn’t established a track record for the timely payment of bills. Your fortunes are determined by the success or failure of the corporation, and if it fails you may very well never be paid.

Other legal entities

State laws allow for a wide variety of legal entities and, as you process credit applications, over time you’ll probably encounter most of them. You may encounter joint ventures, a cooperative venture between two or more legal entities, or the professional limited liability company (PLLC), a form of LLC used by professionals such as doctors, lawyers, and accountants.

States have different laws governing what entities are permitted and the exact scope of their legal protections. To protect yourself, evaluate these entities in the same way you would evaluate a corporation. Assume that the owners have no personal liability and extend credit based upon the creditworthiness of the legal entity standing alone.

Putting your knowledge into practice

Say you’re about to start doing business with a famous, wealthy, well-respected person. Or more accurately, that person’s newly formed corporation. Their wealth and fame leads you to extend considerable credit. The next thing you know, you find yourself down in the dumps when the corporation goes out of business leaving its debts unpaid, and the “respected” person behind the company has neither the responsibility nor the inclination to pay your bill. Famous people can fail in business, just like anybody else. Remember that over 90 percent of all new businesses fail in the first five years, and some of those businesses are — er, were — owned by successful and highly respected folks.

On the other hand, in the event of default, having a customer with personal liability translates into more assets to attach to satisfy their debt. Consider Mary’s Bike Shop, a proprietorship business operating in the retail bike business. The proprietor, Mary Smith, hasn’t created a separate legal entity for her store. If her business fails, Mary’s creditors can make claims against her personal assets if the liquidation of the store inventory isn’t enough to cover her business debts.

Assume that, for a number of years, you supplied bikes to Mary’s store. She’s a good customer, and over the years she earned a line of credit. Suddenly, payments on her account start dragging out, and her aging went from 30 days (good pay) to 60 and then 90 days. Calls to Mary generate all sort of excuses for nonpayment such as, “What do you expect? You know how the economy is now!” You start collection procedures, leading all the way to a collection lawsuit and judgment. When the court officer visits Mary to enforce your judgment (the process of collecting judgments is described in Chapter 19), Mary’s business assets from the bike shop, most likely her inventory of bikes and bike parts but also fixtures such as display cases, can all be attached and sold. But a balance on the judgment remains even after all of the business assets are sold. Because Mary was a sole proprietor, her personal assets can be attached to satisfy her remaining debt, potentially including her vehicle, her home, her personal bank account, and other personal assets.

But what if in fact Mary’s Bike Shop is a corporation? You know Mary’s good for the money, but she has no personal liability if she’s incorporated. Her corporation may not be worthy of a line of credit, and if you don’t protect yourself you may be looking at a collection problem.

Use credit applications to track changes in your customers’ legal organization. On her first application for credit, Mary checked the box “proprietorship,” and you recorded that information in her credit file (which you maintain on all your customers, discussed in Chapter 3). If a later application indicates a change of entity, or your sales people — your eyes and ears in the field — pick up information suggesting an entity change, note that information in the file. Treat this change as a red flag event that may be critical in the event of a default. Bottom line: The newly incorporated Mary Smith may no longer be personally liable for debts if she gives your company some form of notice of that change, even if you fail to detect it.

Applying the Five Cs of Credit

Any decision to extend credit to a customer is loosely based on what are commonly referred to as the five Cs of credit: character, collateral, capacity, capital, and conditions. These concepts may seem vague, and sometimes they’re more of a gut check than something you can objectively measure, but they provide a reality check on whom to trust and when to trust them.

Assessing character

Whether it’s an individual or a company, your customer exhibits a personality. From a credit prospective, you evaluate your customer’s integrity, particularly in terms of bill paying. Has this customer exhibited integrity in the past? If the customer says the check is in the mail, is it really?

Customers who lack character should be required to provide more proof that they’re worthy of credit. For example, you may require updated financial information every six months or every year or verify their status with outside credit reporting agencies every six months. Chapter 3 describes the effective use of credit applications and financial statements.

Evaluating collateral

When you take a lien, you stake a claim to certain assets of your customer, and become their secured creditor. The property you take the lien against, such as inventory, equipment, or machinery is your collateral. If your customer stops paying its bills, you may pursue the assets that are subject to your lien in order to satisfy their debt.

After you’ve staked your claim to those assets, when your customer stops paying you can either take those items back with the cooperation of your customer or you can seek a court order to take the items back (a process referred to as claim and delivery or foreclosure) to minimize your losses. Chapter 3 has a complete discussion of how to take a lien on either personal property or real property.

Determining capacity

Capacity is the sufficiency of cash flow to cover debt. The ability of a business to pay debt generally fluctuates depending on budgeting skills and the steady flow of enough cash to cover debts as they mature and become due. Unforeseen expenses can throw a monkey wrench into even the best-laid budgets, so the acid test for capacity is actually whether your customer can generate an adequate cash flow to pay its obligations even with fluctuations in the marketplace, sudden drops in orders from its customers, and similar unexpected difficulties. Part of the answer to this question may lie in the customer’s capacity and willingness to borrow money to supplement cash flow when the purse strings tighten up. What matters to you, though, is whether your company will receive payment even if your customer is having temporary cash flow concerns.

A simple way to estimate capacity is to use the quick ratio, your customer’s liquid assets (cash, marketable securities, and receivables) divided by its current liabilities. As you’re trying to estimate the company’s ongoing ability to pay bills, the quick ratio doesn’t consider a customer’s inventory or prepaid expenses. If your customer’s quick ratio is over one (100 percent), they’re probably a good risk. If it’s less than one, you should investigate further before extending credit.

Examining capital

When you look for capital, you’re not literally looking for a stack of cash in your client’s bank account or under his mattress. You take a look at the quick ratio (discussed in the preceding section), and whether your customer has a positive net worth. (You want him to be in the black.)

A company’s net worth is made up of capital that has been paid into it over the years, along with any that has been generated through profitable operations (retained earnings). Ideally, you can compare two or three financial statements next to each other to spot trends in net worth. You’re looking for your customer’s net worth to increase each year, meaning that capital is being put into the company — that the company is profitable and is keeping some of its earnings rather than paying them all out to shareholders as salary or dividends, or both.

Reacting to conditions

An excellent practice to follow when extending credit is to consider the general conditions of your industry, as well as overall economic conditions. Although good customers may pay their bills timely even in poor economic conditions, when industry or general economic conditions take a downward turn you must monitor payment trends for even your best, most reliable customers.

When conditions are good, customers have lots of money and customer demand. Orders are high, and you’re willing to take some additional risk to maximize your profits, so more goods are shipped out on credit terms. If conditions worsen, payment patterns from your customers will also worsen. As soon as this scenario happens, tighten up your credit policies. Chapter 4 discusses in detail how your aging sheets reveal customer payment patterns that suggest reduced creditworthiness or warrant red flags for action. For example, if a customer who always pays on time suddenly runs 30 to 60 days past terms, reduce its credit limit. You may harm your sales to this customer, because customers facing reduced credit may seek alternative sources of products or services.

In difficult economic conditions, competition from other companies in your market affects how much risk you’re willing to take. If your goods or services are scarce or unique, you can more easily impose credit terms that better protect your business. If you sell commodities, such that your goods are available from many suppliers, your customers are unlikely to have much loyalty and probably look to any source for the cheapest price and the best available credit terms. The less unique your product, the more you must deal with market pressures that may force you to extend more credit than you’re really comfortable with.