To Extend, or Not to Extend?

The extension of credit, so basic to any business enterprise, pivots on trust and risk. The biggest challenge a credit professional faces is deciding whether to extend credit to a client, and how to determine the proper amount of risk or exposure to accept.

Establishing credit limits is not an exact science. While some seasoned credit professionals develop a ‘gut feeling,’ others take an analytical approach to reducing risk. In either case, understanding risk tolerance and potential buyer performance patterns are essential. This article looks at what factors a company must consider when extending credit, what is involved in the credit review process, and how to answer the standard question: “Should I extend credit—and if so, how much?”

Extending credit to customers can increase sales, improve customer satisfaction and help build long-term customer relationships. Nevertheless, the risk of loss is always present when extending credit, so a business must establish a formal credit policy and set credit limits. Credit limits not only improve a company’s ability to collect debt, but help minimize losses on defaulting customers.

Risk Tolerance & Exposure
A credit policy should determine not only how and when to sell on credit and the terms, but also define when terms should be revisited, and when necessary, the collections process. Several factors influence the amount of exposure a business is willing to take, factors including cash flow, profit margin, and the ability to collect unpaid debt.

Cash flow is critical. When offering credit, the seller has not only paid the cost of providing the product or related service but will receive no cash from the sale to replenish operating capital until the debt is paid. When setting the length of terms, the seller needs to take into account if it has enough cash flow to cover operations until payment is received.

Additionally, a company’s profit margin is a major consideration when determining how much exposure is relatively safe. The lower the profit margin, the more conservative the credit policy. Tightening credit, however, may have a negative impact on sales growth unless the company’s produce or service is in high demand. In a fiercely competitive market, a looser policy may be needed to maintain customers even if profit margins are low.

Poor economic conditions also can dampen a company’s appetite for risk, but not always. During the recent economic downtown, Charlotte, NC-based Chiquita Fresh North America, LLC didn’t change its credit policy, which remained net 10 days.

“We felt we had best practices in place,” says Kelly Bates, Chiquita Fresh’s global credit director. “Sometimes we get pushback [from buyers] that other companies extend longer terms,” she concedes, “but our practices are consistent. Whether it is a good market or a poor market, we stick to the same procedures,” Bates says, but explains this still requires knowing their customers, monitoring pay, paying close attention to Blue Book Services’ Credit Sheets and scores, and evaluating any changes that may occur on a month-to-month basis.