When taking on a new client, your business is also taking on risk. What if your client doesn’t pay their bills? To minimize risk and ensure timely payments, it’s important to evaluate the creditworthiness of any business customer.
At the Numbers Coach, we recommend using these 7 key metrics to evaluate your customer and assess your business’s potential risk:
- Credit Score and History: A strong credit score and positive credit history indicate a reliable payment track record. Review their business credit report for any defaults, late payments, or bankruptcies. For a business, this is typically found through Dun & Bradstreet ratings or other business rating agencies such as Moody’s.
- Liquidity Ratios: Metrics like the current ratio (Current Assets / Current Liabilities) and quick ratio ((Current Assets−Inventory) / Current Liabilities) assess the customer’s ability to meet short-term obligations. Ratios above “1” generally indicate good liquidity.
- Debt-to-Equity Ratio (D/E): This ratio measures the level of financial leverage, calculated as Total Liabilities / Shareholders’ Equity. Lower ratios suggest the customer isn’t overly reliant on debt, reducing credit risk.
- Payment History: Review their payment behavior with other suppliers. Consistent on-time payments signal financial reliability.
- Financial Statements: If possible, get a set of financial statements for the past three years: ideally, a Balance Sheet, Income Statement, and Cash Flow Statement. Analyzing these statements will help you evaluate their ability to pay.
- References and Trade Insights: Obtain references from other vendors and industry insights to gauge the customer’s reputation and stability.
- Z-Score: If you can get financial information from your customer, then running it through a Z-Score calculation can be a helpful measure to ensure they are financially viable.
Using these metrics, you can make informed decisions and reduce your company’s exposure to bad debt.
Questions on any of these calculations? Feel free to ask the Numbers Coach.