If you sell a product or service, the likelihood is that you don’t get paid upfront and in full. Creditworthiness is the term used to describe how worthy a current or potential customer is to receive credit from you – and how much credit you should extend.
Credit is important because it helps businesses grow. Instead of waiting for upfront cash payments, businesses can improve their sales and revenue by extending credit to customers. Credit supports economic growth and is a critical tool for supply chains. In addition, the interest payable on credit also contributes to the financial growth of businesses.
In order to protect their business interests, companies need to know with whom they’re doing business. Extending credit to the wrong customer – or extending the wrong amount of credit – exposes a business to unnecessary risk.
If the customer isn’t able to repay their debt on time, this leads to late payment. In turn, suffering from late payment can affect a business’s working capital and create cash flow problems. This is particularly true if late payment leads to bad debt, which may need to be written off. Cash flow problems can also have a knock-on effect across the supply chain, threatening other business’ stability too.
Creditworthiness is determined by a number of factors. For companies, this includes issues such as solvency – for example, how big is the company’s debt compared to its equity? What is its liquidity like? Is there sufficient cash flow to meet current and future obligations? Does the company have a history of prompt payment? What is its projected sales trajectory? How is the wider sector or industry faring? How many customers does it have? This is because companies with many customers are considered more creditworthy than firms that depend on a small pool of clients (and so are exposed to greater risk).
It’s important to remember that creditworthiness isn’t static – in today’s business world it can change rapidly. This is why a customer’s creditworthiness should be monitored throughout the customer life cycle.
For individuals, creditworthiness is determined primarily by repayment history. Missed or late payments are kept on record for at least six years. So are court judgments for non-payment of debts, bankruptcies and individual voluntary arrangements. Decisions are also influenced by anyone financially linked to the individual. For example if they have a shared credit account, the other person’s creditworthiness is also taken into account.
Individuals, companies and even countries all have a credit rating which influences how much credit they should receive. Creditworthiness is based on extensive financial data which is combined to create a credit rating ranging from A to D. An ‘AAA’ rating means the customer is extremely creditworthy. A D-rating means the customer has no credit standing. In the UK, consumers are given a numerical score instead of a letter score.
Individuals will have their credit rating assessed if applying for a loan or credit facility, such as a mortgage or credit card. Similarly, businesses will have their credit rating assessed if applying to a bank or financial lender for a business loan. Countries’ credit ratings will be used by foreign investors to guide them as to the investment grade of the country’s sovereign debt, for example.
There are three key credit rating agencies around the world – Moody’s, Standard & Poor’s and Fitch – and they score both governments and large companies. Private credit ratings in the UK are compiled by three main credit rating organisations – Experian, Equifax and Callcredit.
Credit ratings benefit both the borrower and the lender. The lender is able to decide which customers are creditworthy, while borrowers are assessed on their creditworthiness through a fair, uniform system. Credit ratings also protect borrowers from accessing too much credit and exposing themselves to financial difficulty.
Accessing a professional credit report is the strongest way to evaluate a customer’s creditworthiness. However, you can also supplement this information with your own research.
Speaking to industry contacts and consulting credit forums about the creditworthiness of a customer is a valuable way to learn more about their reputation. You can also consult the Prompt Payment Code; signatories have agreed to uphold strict payment rules, so this is a good indication of credit behaviour.
Looking at a customer’s financial records can help determine creditworthiness. You can access this information through the Government website Companies House. It’s important to compare the last three years’ financial reports to understand the wider context of business performance. And, of course, check media reports online to give you another level of insight.