How to perform customer credit checks

Published on 27 October 2021

Updated on 6 May 2024

A customer credit check is an action that you, a lender, bank, insurance company or other service provider should perform when they need to assess the credit risk of a customer company. This credit check consists in evaluating information regarding your customers’ existing and past credit, payment habits and types of loans, and provides a kind of customer health score that can help you decide the credit terms you can safely grant to them. 

You may already perform a customer credit check on potential or new customers but remember: even a reliable business partner of many years can run into financial difficulties, so you should be applying the customer credit check process on all your customers regularly, especially when thinking about increasing credit to existing clients or extending credit to new customers.

But how to run a credit check on a customer?

The first step of the customer credit check process is collecting the right information about their creditworthiness. An audited financial statement is the gold standard data for understanding your customers' financial position. This is especially important in how to run a credit check on a potential customer, but there’s a challenge: not all privately held customers may be willing to share their financial statements with you upon request.

Fortunately, there are several other sources of information:

• Credit bureaux
  They offer company credit reports for sale to qualified lenders. A credit report provides a profile about the business, financial data like annual sales, invoice activity and credit limits over several years, legal judgements and collections activities, and a business credit score. The business credit score is a measure of a company’s financial stability and can predict how likely they are to pay on time. Typically, the score is between 1 and 100, with a score of 75 or higher considered excellent.
  It is important to note that credit reports are based on information made available by the provider according to a snapshot in time. It means that the information may be upwards of a year old and may not reflect real-time developments in the company's creditworthiness. It may be necessary to combine credit reports with additional credit assessment tactics, such as risk data analysis that comes with a trade credit insurance policy.

• Trade references
  Additionally, you can ask your customer for trade references. They can include the customer’s bank, as well as businesses or suppliers that already extend trade credit to that customer. For example, you can ask how long the business or supplier has extended credit to the customer, how many times they were late to pay, etc.
  However, be careful about bias when reviewing these references as the customer is likely to have provided information on companies they pay on time and omit companies that they don't. And be conscious that collecting this information can consume a great deal of time as you are dependent on receiving timely replies.
  

• Chambers of commerce
  Chambers of commerce and other local business organisations can also attest to the customer’s reputation in the industry and provide ‘soft knowledge’ about your customers’ values and involvement in the communities where they operate.

• Trade credit insurers
  Another source of information can be your trade credit insurer. Trade credit insurance offered by an international expert such as Allianz Trade includes a customer credit check process. Our proprietary intelligence network analyses daily changes in corporate solvency representing 92% of global GDP and attributes a health score to all companies via a risk grading. This customer health score helps you make accurate credit decisions.

When you think about how to assess the credit risk of a company, and in particular how to run a credit check on a potential customer, it’s important to have a solid approach. These are the key items we review in the customer credit check process:

• Country and region: analyse the economic, political and business outlook in the company’s geographic area for both the short- and mid-term.
• Administrative information and leadership: consider the type of legal entity of a company, look at how long it has been in business, and take into account the leadership’s record and vision
• Sector: check evolutions within the company’s sector and how the company is doing compared to competitors.  
• Customers and suppliers: analyse their clients’ financial health and whether they are dependent on raw materials with fluctuating prices.  
• Production lines and operations: check the state of a company’s machinery and the status of the company’s workforce (for example, full-time versus casual contracts).
• Financial results and payment history: look at the company’s financial results in the last fiscal year, including their turnover, gross profit and profit margin. You should also check the company’s financial and strategic outlook for the future. And importantly, what is a their liquidity and short-term debt outlook?

There are several key warning signs of pending insolvency which you should take into account particularly when running a credit check on a potential customer.

1. Declining profitability 
Turnover and profit are a measure of solvency because the higher the profits, the more stable the company. So it’s an important element in your customer credit check.

2. Insufficient cash flow or liquidity 
Does the company have sufficient business liquidity  to refund short-term debts? When a business has many suppliers with long-term payment terms, or when it has no cash resources, the continuity of this company is seriously compromised because chances are if a supplier demands payment of a debt, the company can’t afford it. This has a negative effect on the solvency of a company.

3. High debt-to-income ratio 
This calculation shows you what portion the company’s debts make up its earnings. To determine the ratio, divide the company’s monthly debt payments by gross monthly income (available from the company’s financial statement). The lower the number, the better. However, good debt ratios  vary from industry to industry so it’s important to understand what those baseline ratios are.

Credit checks do not always produce favorable results. If a customer credit check comes back negative, you should send a polite, tactfully worded note to the customer indicating that you are unable to extend credit.

For example:

"Thank you for contacting us regarding your interest in doing business with our company.

Unfortunately, we regret to inform you that due to the state of the economy and the uncertainty inherent in our business we are unable to grant your credit request at present. We will inform you when our credit policies change, and we sincerely hope that this does not affect our business relationship."

Even if the numbers don’t add up as well as you’d like when you assess the credit risk of a company, other factors may incline you to take a risk. Perhaps the company’s market segment is poised to do well, perhaps the company has been focused on expansion and profitability has taken a temporary hit. Or perhaps this is a new customer whom you don’t know very well yet but think they might be worth doing business with.

In these kinds of cases, consider using a pro-forma approach as you run your customer credit check process by asking for immediate payment of your invoice for the first few transactions. In this way, you accrue evidence that will indicate whether the customer is strong enough to handle credit in the future.

Remember: trade credit insurance can provide you access to the most accurate information on customers, prospects, industries and countries, and help you assess the credit risk of a company. It takes the guesswork out of your company’s credit process, giving you the confidence to safely grow your business at home or abroad.

Learn more about how we can support your credit decisions and get your money back in case of late or non-payment by contacting our local teams.