December 31, 2020
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Performing Due Diligence: Credit Checking a Business
Everyone is familiar with credit scores and credit reports. How good your credit score is determines whether or not you will qualify for a mortgage, a car loan, or even a credit card. This of course makes sense, as banks don’t want to give away money to people who will be unable to pay them back. However, in the same way that we have personal credit that determines our ability to make purchases, businesses also have credit that can be used to determine their ability to pay for merchandise and services. Unfortunately, business credit isn’t as clear cut as personal credit. For one, there is no universally used credit score out of 850 like there is for individuals. There also aren’t three major credit bureaus that serve up the same data, but a large number of credit reporting agencies that all specialize in different fields and provide different types of reports with different data points. Finding the right credit agency or credit agencies to meet your needs not only is a difficult task, but can become prohibitively expensive. However, not offering businesses credit when they request it can result in lost sales.
Secured vs. Unsecured Debt
Before we dive any deeper into credit reports, it is important to understand the difference between secured and unsecured debt. As the names imply, secured debt comes with some security in case something goes wrong. Unsecured debt comes without any security, meaning that should something go wrong, it is unlikely that it will get paid back.
With personal credit, reports include mortgages, car loans, credit cards, student loans, and unpaid bills such as medical bills and maybe even rent. All of these factors contribute to a consumer’s overall credit and their overall ability to pay back debt. Banks and other financial institutions are willing to lend this money because more often than not, collateral is tied to any money they are borrowing. With a mortgage, the bank is holding the home as collateral, while the bank is holding a car as collateral in the case of a car loan. Then you have student loans which can not get wiped out by bankruptcy. In the case of rent, not paying rent can lead to eviction. That leaves pretty much just credit cards as the only type of consumer debt that isn’t secured, and this is the reason why credit cards carry APR’s that are 5-10 times higher than that of a mortgage or a car loan.
In the world of business, secured and un-secured debt is more strictly defined. Debt is secured if there is a UCC-1 filing against a business which places a lien against certain or all assets, but that business must agree to this and there will be wording in their contract with the bank in regards to this. This of course is a requirement of getting a bank loan or line of credit, so any credit given by a bank is secured. When it comes to utility bills, this debt isn’t secured, but the utility has the option to stop servicing the business if they don’t pay, which would most likely put them out of business. For vendors who offer payment terms to a business, whether they sell merchandise or a service, the debt is unsecured. They are simply relying on the honesty and financial well-being of a business in order to get paid. The danger here is that in the event of a bankruptcy, any funds made available through liquidation must first go to secured debtors, before anything goes to unsecured debtors. Typically, in a scenario like this, there is very little, if any, money left that can go to unsecured debtors, and they are fortunate if they receive pennies on the dollar in this sort of event.
What Qualifies as Business Credit?
For a bank that is offering secured debt, they are going to look at a company’s financial statements to determine how much they can safely lend to a customer. Typically, banks will set conservative credit limits as they will want to make sure that they come out whole in the event that a business needs to be liquidated. However, if you are selling to a business on payment terms, most likely you will not have access to their financials, and even if you did, you wouldn’t have the time it takes to thoroughly analyze them every time you make a sale. Banks can take months to make a decision, but if a vendor takes that long to make a decision, then a business will simply find a different vendor to purchase from.
So as a vendor, you do not want to consider secured debt such as bank loans or even utility bills when making a decision, but rather you want to focus on trade payments. Trade payments are how businesses pay their vendors for the merchandise and services that they received. They would include moneys owed to manufacturers, distributors, freight companies, advertising agencies, and anyone else who sells to the business. Of course, the most valuable data would come from sources in the same industry as you. So, if you are a furniture manufacturer, you would be much more interested in how a business pays other furniture manufacturers than in how they pay trucking companies.
Selecting the Right Credit Agency
Selecting a credit agency to obtain a personal credit report from really just comes down to whichever one is cheaper. The reason for this is that all the credit card companies, banks, and other financial institutions report to all three of the major consumer credit agencies, so there it is unlikely that there would be any differences between any of their reports. However, in the business world this is not the case. While every credit reporting agency is willing to collect data on every business out there, there is no credit agency out there who has data on everyone. The reason for this is that credit reporting agencies collect their data from their customers and may supplement that with data they purchase from third parties (data which is collected from the third parties’ customers), and therefore only have data on the businesses who do business with their customers. A credit agency that is extremely popular with freight carriers would be an excellent choice to work with if you drive a truck, but not a very good choice if you are a clothing designer. While word of mouth from others in your industry may be a good way to select a credit agency, you will find that oftentimes selecting the right company comes down to trial and error. It is important to note that there is no credit agency that will have data on everyone of your customers or potential customers, so you may want to work with more than one credit agency.
Another thing to consider besides who is reporting data to an agency and the businesses that they have data on, is the quality of the data in the reports. Does the report only show what is currently outstanding, or does it provide you with a month-by-month breakdown of what was outstanding for the last 12 or 24 months. With small businesses, it is quite possible that they only have one vendor who reports to a credit agency, and they may only purchase from them once or twice a year. In this situation, a credit agency that only shows what is currently outstanding will most likely provide you with a blank report. A month-by-month report is also important for understanding how quickly a business pays. Just because they have receivables that are current this month, doesn’t mean that they will pay them on time, it simply means that they were billed less than 30 days ago. A month-by-month breakdown allows you to see payment trends and how long it takes a business to pay their bills.
Besides breaking down payments month-by-month, another way credit agencies can break down the data is by industry or even debtor. Simply giving you a total of what is outstanding on a monthly basis doesn’t really give you any idea of who that money is owed to. If that money is owed to a bank then it isn’t a trade payment and so long as the business is paying monthly installments, they are current on the entire loan. You need to understand how a business is paying other vendors in your industry, and you need to get an idea of how much credit each vendor is extending them so that you know how much credit you can extend to them.
Finally, like all things in the world of business, price is going to be a major determining factor in which credit agency you decide to work with. Subscribing to credit agencies and pulling reports isn’t cheap, and may not even be worth it for smaller orders as it can easily blow your profit margins. Some credit agencies offer pay as you go options, while others offer packages of so many reports per year. Of course, the more reports you buy, the better the rates become and the more negotiating power you will have. Some agencies may also require that you share your data with them, while others may offer you a better price if you share your data. However, just like anything else, you get what you pay for. A credit agency that offers lower prices, probably has lower quality data and reports than a company that charges more. While some of the more well-known companies may simply charge higher prices based on their name and reputation, but may not actually provide you with better reports.
What About Credit References?
Requesting credit references is another popular way to go, but isn’t fool proof. First of all, you are relying on other businesses, whom you have no relation with, to provide you with these references. These businesses are not required to give references, and, some even have policies that they do not provide credit references. Normally when you send out three reference requests, you would be lucky to get one response within a week.
It is also important to realize that a potential customer will only provide you with references that they know will come back looking good. If they didn’t pay someone, they aren’t going to provide them as a reference, but will instead only include the companies that they paid well. This can be a big problem with selective payors. Selective payors will pay their main vendors promptly all the time, but will pay less important vendors poorly, and while this will show on a credit report, it won’t show if they only give you credit references.
The other problem with credit references is that you need to check out the references as well. Unfortunately, there are some dishonest businesses out there who will provide references that are either friends or family, and they may even use a real company’s name, but provide you with their brother’s cell phone number or email address. So anytime you get credit references, it is important that you investigate them to make sure that they are legitimate.
As a result, while credit references may be acceptable for small orders, it would be irresponsible to grant a business a large credit line based only on credit references. Credit references are best to be used when the credit agencies don’t have any data, or don’t have enough data on a business that has placed an order with you.
Is there an Alternative to Credit Checking?
Credit checking can be a very expensive and time-consuming process, but luckily there are alternatives to performing the credit checks yourself. By working with an accounts receivable factoring company, they will handle all of the credit checking for you. Accounts receivable factoring companies work with many different vendors so as a result they are pulling lots of credit reports and providing lots of data to the credit agencies. This allows them to not only negotiate better pricing with the credit agencies, but they can afford to work with a handful of agencies providing them access to more and better data. If they have multiple clients selling to the same business, then they only need to pull a single report, which also helps in reducing costs. Factoring companies also have their own data that they can rely on which further reduces their costs, and oftentimes are already familiar with many of your customers. Most factoring companies don’t charge their clients for credit checking, it is simply included as part of their overall service.
Factoring companies also offer another advantage, and that is motivation to pay quickly. If a business doesn’t plan on ordering from you again for another year, they will have very little motivation to pay you promptly. Since many small vendors don’t report their data to credit agencies, they will also have no repercussions for paying you back slowly. However, if you put your receivables through a factoring company, not paying for your product in a timely fashion can result in orders from other vendors getting held up or their credit line with them getting slashed. Factoring companies also report their data to numerous credit agencies, meaning that failing to pay a factoring company could impact their ability to purchase from vendors who don’t even use that factoring company. As a result, most businesses show a lot of respect towards factoring companies, and tend to pay them better than they pay vendors who do not use factoring companies.
How Does Factoring Work?
Accounts receivable factoring is a simple process in which you sell your receivables to a factoring company. Upon receiving an order, you submit it to your factoring company for credit approval. It is at this time that you factoring company will perform all the necessary credit checking. Typically, your factoring company will get back to you with an answer within an hour. Once approval is given you can go ahead and either ship the merchandise and or provide your service to your customer. You will then invoice your customer as usual and send a copy of the invoice to your factoring company. At that time, your factoring will then fund you for the receivable, meaning not only did they perform the credit checking for you, but they are also speeding up your cash flow by 30 days or more. After that, your factoring company will handle all of the collection work for you, meaning that you no longer need to follow up with customers in order to get paid. Furthermore, if your factoring company offers non-recourse factoring, then it means that your receivables are fully insured against non-payment.
Of course, there is a cost to factoring, but the fee for factoring a receivable is very similar to a credit card processing fee. However, you will save money as there is no longer a need to subscribe to expensive credit agencies and you no longer need to have employees spending time following up with customers when invoices become due. So, offering net 30 day payment terms costs no more than accepting a credit card for payment, you get paid just as quickly, and in the case of non-recourse factoring, also eliminates the risk.
How Do I Start Factoring?
Getting started factoring is easy, and can be done in as little as 24-48 hours. If you would like to learn more about how factoring works and get set up factoring, please give DSA Factors a call today at 773-248-9000 or email us at info@dsafactors.com. DSA Factors is a family-owned business that has been factoring for over 30 years, and has the ability to meet all your credit checking and funding needs.
