Credit Application Importance

April 4, 2008

Credit immediately increases the buying power of a consumer. Imagine an individual with not-so-good credit gets a credit card with a $5,000 limit, or that you approved a modest credit limit to a firm with which you recently started working. The good part is that the credit generated an immediate sale, but the negative is that it could potentially result in bad debt.

Gandhi

   Uncontrolled credit could lead to collapse due to overbuying, overexpansion and overselling. The recent problems due to sub-prime loans are a case in point, as many in the stone industry – from importer to distributor to fabricator – can clearly attest.
   It’s a good time to protect your company from major financial problems in the future. Cash-flow problems can be avoided by having a good credit policy in place.
   The purpose of a good credit policy is to make a profitable sale, keeping in mind the business’s tolerance for risk. And since, by extending credit, you’re essentially investing in your customers, you want to know if they are creditworthy. A good credit policy means increasing business with credit-worthy customers.
   Your company’s credit policy involves identifying the market for sales growth – looking at the potential customers that will be turned down if you’re raising the credit standards, or potential customers you could get if you lower the standards. That credit standard depends on the business’s tolerance for risk.
   Liberalizing the credit policy may come from a need to increase market share or penetrate into new territory; when demand is decreasing; or when profit margins are high. Loosening the standards also may be advantageous when the inventory needs to be turned quickly, or when it may have a limited shelf-life or customer appeal.
   Conversely, it may be time to get conservative with credit when a product or service sells without much effort; is made as per customer specification (customized); when the profit margins are thin; and when general economic conditions aren’t favorable.
   Credit application is the foundation of a good credit policy. It facilitates the process of determining whether or not to grant credit and to determine the limit. Credit application collects important information for review and can also be produced in court as evidence of the terms of sale and application of credit /loan. (And, the information should always be treated as confidential.)
   Some important items on a credit application are:

   1. Business Type: Corporation, Partnership, Individual, Limited Partnership. This indicates whom you should sue in case of legal action. If it is a corporation, the Director or CEO or other officer will rarely be held personally liable for the corporation debt. If the business is a partnership, the partners are personally liable for the partnership’s debts. If it’s a limited partnership, the general partner has unlimited liability and the limited partner’s liability is equal to that person’s investment in the firm.
   2. Bank Details. Information on the applicant’s bank accounts may help in case you have to collect on a judgment and attach their finances.
   3. Business Start Date. This gives an idea how long the applicant has been in business. Depending on the industry, a new company may not have established credit history.
   4. Trade References. Feedback here will give an insight on the volume of business, open balances, payment terms and other experiences the other vendor had with the applicant.
   5. Terms and Conditions. This could include the payment terms, late-payment interest, collection charges, attorney fees, return policies, warranties, court jurisdiction, etc. By signing the credit application, the applicant confirms he/she has read the terms and conditions and agrees to the same.
   6. Personal Guarantee. If the business is structured the right way, the debtor can get away without paying a single cent to creditors and yet retain all personal assets. It’s possible to recover business debts from the debtor and accompanying personal assets if you have a personal guarantee from the debtor. The personal guaranty can’t be undermined.
   7. Authorization to release financial information. This is necessary, since the trade references or the banks may not release any information on the applicant unless they have a signed authorization.
   Once the credit application is reviewed and the limit approved, it is important that the account be regularly monitored to see that open balances don’t go over the set credit limit. It’s necessary to regularly review all accounts to determine the adequacy of the credit.
   Keeping track of all accounts – cash-only and credit – is vital. You may come across some accounts that become eligible to be converted from cash to credit terms. And, some credit accounts, because they’re not paying on time, may need to be put on hold, or converted to cash terms.
   Bhavesh Gandhi is a chartered accountant and a law graduate with 15+ years in accounting, audits and administrative work. In the past five years, he’s worked for a leading importer and wholesaler of natural-stone products, handling legal, insurance, claims, collections, administrative and some accounting functions for the company. Hec an be reached at bggandhi@sbcglobal.net.