A credit application is critical to assessing and managing business risk and to identify those customers who you may not want to extend credit to. Despite this, most companies either do not use a credit application form or they do not use them consistently enough. Often times this is a direct result of not knowing what to include in the form in order for it to be effective. A more comprehensive application will give you a better idea of where the customer stands with credit worthiness and gives you more confidence in making the right decision.
There are a number of things that you can put on your credit application depending on how detailed you would like to get, but on a basic level you should include the following:
- Name of business, address, phone and fax number
- Names, addresses and Social Security numbers of principals
- Type of business (corporation, partnership, proprietorship)
- Number of employees
- Bank references
- Trade payment references
- Business/personal bankruptcy history
- Any other names under which the company does business
If you want to get more in-depth with a customer to glean more information about their financials, asking for a financial statement or purchasing a commercial credit report will prove helpful. Below are some calculations that can aid in your decision that can be calculated from information off financial statements or credit reports.
Financial ratios: Run the following financial ratios to help determine the financial health of the potential borrower:
- Debt to equity ratio: this indicates what proportion of equity and debt the company is using to finance its assets.
- Debt to asset ratio: This defines the total amount of debt relative to assets.
- Current ratio/liquidity ratio/cash asset ratio/cash ratio: this measures a company’s ability to pay short-term obligations.
- Quick (acid test) ratio: Determines whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory.
- Operating cash flow ratio: this measures how well current liabilities are covered by the cash flow generated from a company’s operations.
- Working capital ratio: this indicates whether a company has enough short term assets to cover its short term debt.
Cash flow: Does the borrower have a healthy cash flow from operations, investing, and financing activities? Their cash flow will impact yours, so you want to make sure they have money coming in.
Debt levels: Find out how much debt the potential borrower has, and decipher how much they can afford based on the other financial information you’ve seen. If they look like they’re in over their heads, you may want to be careful about offering credit.
Industry evaluation: What is the normal debt/liquidity level for companies similar to this borrower’s size in their industry, and how do they measure up?
A few very important things to remember about using a customer credit application form:
- Credit applications can and should be used for new customers as well as existing customers.
- Just because a customer was once worthy of credit does not mean they are today.
- Always ask customers who are requesting additional credit to fill out a new credit application, so you have the most relevant information on which to make this decision.
Do you have a credit application in place? If not, or if you do not think yours is effective, we invite you to use our credit application template to make sure you are getting all of the information you need to make good credit choices and get to know your customers.