One of the best ways to avoid finding yourself in a complicated debt collection situation is to thoroughly screen your customers before extending credit to them. Giving careful thought to the background of your customers can provide more insight that you might initially think.
When it comes to assessing how creditworthy a customer may be, a good starting place is The Five C’s of Credit. Assessing where your customers fall in regard to each of these categories can go a long way towards avoiding having to turn your outstanding debts over to a bill collection agency.
Assessing the character of a customer, like most aspects of extending credit, is primarily a judgment call. How well do you know the person applying for credit? When you see them in public, how do they represent themselves? Is their appearance respectable? Do other people seem to respect them or do people talk about them when they leave a room?
It can be hard to gauge a person’s character when you don’t know them very well. The trick is to take in as much information as possible and make a weighted determination based on that information. How they present themselves in public can also go a long way towards enlightening you as to their character.
Capacity refers to a customer’s ability to repay a debt. Even the most trustworthy customer will struggle to repay you if his business is not bringing in any revenue. You want to make sure that you are only lending funds to customers who have the income stream to repay you when the time comes.
Depending on the amount of credit you are offering the customer, it may be a good idea to require them to produce documents that demonstrate their capacity to pay their debts. This might include a business or personal income statement or W-2 form.
Capital refers to the net worth of the person or business to which you are extending credit. Businesses that have a high net worth are far more likely to pay their debts on time. If they are responsible enough to build up capital, they will likely be responsible enough to pay you.
Net worth can be documented on a company’s balance sheet. As a creditor, you may want to require your customers to submit documents demonstrating that they have the capital to ensure you will be repaid if something happens to their business income.
Collateral is like a junior version of Capital. Collateral is the assets the customer has that you could potentially take to compensate for payments. This generally involves any equipment or inventory that the business you are considering extending credit to may have.
Depending on the Character, Capacity, and Capital of the customer you are dealing with, you may want to specify something as Collateral before extending them credit.
Conditions are the agreed upon terms of the creditor-debtor relationship. This can include interest rates, payment schedules, and Collateral. As with anything in business, it is always best to have these Conditions spelled out from the very beginning of a relationship. This will help to avoid having to resort to hiring an attorney for debt collection down the road.
While there are no concrete numbers to go by when it comes to assessing whether or not to extend credit to a customer, more knowledge can lead to a better informed decision making process. Learn as much as you can about the customer and then use that knowledge to assess the likelihood that they will repay you.