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Ideas for extending credit to a new business.

From time to time, credit professionals will receive a credit application from a newly formed company. In some cases, the company in question is well financed, the owners or senior managers have a wealth of experience in the industry and, as a consequence, the company has a certain amount of credibility with customers and vendors.

However, a more difficult situation arises when the applicant is new to the business and has no trade references, a non-borrowing bank relationship and reports that the company has no financial information to share with creditors. The question to then consider is this:

How can vendors sell to this second type of credit applicant while controlling and limiting credit risk? Limiting risk in this scenario will not be easy. Some of the more commonly used tools, or tools used ill combination to mitigate credit risk are shown below (in descending order of importance as an effective risk management tool):

* Ask this new customer to arrange for its bank to issue a documentary letter of credit. A documentary L/C substitutes the creditworthiness of the issuing hank for that of the buyer. The seller will be paid if it presents conforming documents to the issuing bank within the deadlines established under the letter of credit and under the rules established for administering letters of credit (called the UCP 500).

* Ask the customer to arrange for a standby letter of credit. A standby letter of credit is a secondary payment mechanism. A bank will issue a standby letter of credit on behalf of its customer to provide assurance of the debtor company's ability to pay a specific creditor named in the L/C. Normally, neither the seller nor the buyer expects that a standby L/C will be drawn upon. Standby L/Cs are used only if the debtor company fails to pay the creditor company.

* Require the customer to pay COD on small orders and cash in advance on large or custom orders ... with the understanding that after three to six months of purchasing on COD and CIA terms that the customer will be considered for open account terms. A note of caution: It may seem counter-intuitive, but selling on COD cash terms can result in bad debt losses. Common carriers do not allow their drivers to accept cash payments, so COD cash terms means that payment is due on delivery in the form of a cashier's check or money order. If the driver accepts a payment in good faith, the carrier would not be liable if it turns out that the check or money order were counterfeit.

* Become a secured creditor by asking the debtor to pledge one or more assets to the seller, and then perfect the security interest in the pledged collateral. By definition, a secured creditor is one that holds the pledge to assets of a debtor that secures either payment of a debt, or the performance of another obligation.

* Purchase credit insurance covering this account. Note: The problem is that the credit insurance company is likely to have similar concerns and reservations about insuring the applicant. Also remember that credit insurance involves "risk sharing" between the insurer and the creditor. Risk sharing includes the use of annual deductibles, per loss deductibles, accounts excluded from coverage, a cap on annual losses paid, small dollar loss exclusions, and exclusions from coverage for disputed balances.

* Similarly, it might be possible to sell the receivables from this new account to a factor, but it seems likely that the factor would have the same concerns as the creditor and the credit insurance company about purchasing receivables from a high-risk customer without recourse. Factoring is the process by which a financial institution, called a factor, buys accounts receivable from a business (the client) at a discount and takes in return an assignment of the accounts receivable. Factoring is done with or without recourse. Factoring with recourse means that if the factor is unable to collect from the purchaser/debtor that the seller (the factor's client) must repay the money advanced to it against that accounts receivable. Factoring without recourse means that the factor accepts the risk that the accounts receivable may be uncollectable.

* Ship merchandise to the customer on consignment. Under consignment terms, the consignor (the supplier) ships goods to the consignee (receiver of the goods) to sell. The supplier retains title to and ownership of the merchandise. The consignee makes payment to the consignor only when the goods are sold. The creditor should perfect a security interest in its inventory to reduce risk.

* Require one or more personal guarantees to be signed by the business owners, and/or officers and directors of the company. Guarantors take responsibility for paying a debt if the company (which is primarily liable for the debt) fails to pay the creditor. Personal guarantees are not foolproof, but they do reduce credit risk--particularly if the creditor can confirm the personal financial strength of the individual guarantor(s).

* Shorten the open account terms and reduce the credit limit assigned. Example: If a customer requested a $10,000 limit and net 30-day terms, a creditor company could (in theory) sell the same amount by changing the terms of sale to net 15 days and the credit limit to $5,000.

* Consider requiring their customers to pay using a two party check ... a check made payable both to your customer and to your company.

* Discuss a profit sharing arrangement with time applicant. Specifically, suggest that the applicant be treated similar to the way you would treat a broker or agent working for your company. Offer to pay the applicant company a commission on all new sales they bring to your company ... but maintain full control of the credit risk management and collection process by billing and shipping and collecting from their customer.

* Require partial payment in advance, or on delivery. For example, require an advance payment sufficient to cover your cost of goods sold. If the manufacturing costs are pre-paid, the potential loss on a sale to this type of high-risk applicant reduced significantly.

It is important to remember that these techniques can be used independently and in some cases in combination. As with every decision made by the credit department, a number of factors influence the decision including: the creditor company's tolerance for credit risk; the profit margin on the sale; the company's market share and competitive position; its sales and profit targets; the size of the creditor company's bad debt reserve; its year to date loss history; and the protection afforded to the creditor company through implementation of any of the risk mitigation strategies listed above.

Michael C Dennis has more than 20 years of credit management experience, and for the last 13 years be has been an instructor for CMA Business Credit Services (California). His wed site is www.coveringcredit.com. He is the author of "Credit and Collection Handbook" available at www.aspenpublishers.com.
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Title Annotation:Credit Basics
Author:Dennis, Michael C.
Publication:Business Credit
Date:Jan 1, 2004
Words:1153
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