No sale is really a sale until the money is in. And often the receipt of that money is delayed because most businesses no longer operate on a cash and carry basis, so customers buy on credit.
Every time your company extends credit it takes a risk that the payments will be late or, worst-case, non-existent. So the standard procedure to minimize those risks is to take two basic precautions:
- Run a credit check to identify any potential problems you might expect from a particular customer, and
- Set credit limits at a fair risk level based on the customer's FICO Score® (see right-hand box) and reasonable for the customer.
But you can also assign your own company credit ratings to help further minimize your company's exposure and to help manage accounts receivable. The ratings help determine how tight or loose your company needs to be in order to meet goals in sales, profits and debt-loss.
What you call these ratings isn't important. The primary issue is what they mean and how well your managers understand them.
Here are six examples of in-house credit ratings:
- Quality accounts. This top rating goes to customers with no identifiable risk and a cash flow from primary and secondary sources that is sufficient to service the debt. These accounts have well-established, realistic payment plans, a long-term relationship with your company and a history of paying all invoices by their due date. Look for a proven financial status, a cooperative attitude and a debt load that's reasonable in relation to net worth.
- Acceptable accounts. This quality rating is given to customers that are new, start-up businesses, or those who don't have sufficient secondary sources of payment. These customers have a satisfactory cash flow to pay their bills and loans and the payment plan is soundly structured. They show good character and that they have lived up to all previous credit agreements.
- Accounts to watch. Here's where you start to categorize deficiencies. Reasons for giving an account this rating include a first-time operating loss, a sales drop, an unsatisfactory payment plan, or a developing uncooperative attitude. These customers show the potential for further risk, although a restructuring of the debt could eliminate the soft spot. Pay close attention to anticipate developing credit problems.
- Substandard accounts. Indications that a customer merits this ranking include a poor payment history, a weak financial condition, or a cash flow that doesn't cover the debt. If the weaknesses continue, your company may experience a loss.
- Doubtful accounts. These have the same inherent weaknesses as "substandard accounts," but collection in full is questionable.
- Loss accounts. These customers are at "the bottom of the barrel." That doesn't mean the accounts have no recovery potential but full collection is unlikely.
These are just some of the ratings you can use to help make your accounts receivables more efficient with fewer losses.
The Risk Percentile
FICO Score® stands for 'Fair Isaac Company Score' and is the standard credit rating, which ranges from 300 to 900.
The score was developed by the Fair Isaac Co. and is generally the standard in North America for benchmarking consumer risk.
The score is percentile-based and dependent upon how the rest of the country fares. It's meant to indicate the risk level a consumer might represent and to predict the probability of future payment performance.
A score in the range of 700 to 725 is often considered average.