Most often when assessing a customer for a potential credit limit I used to look at the balance sheet and the various working capital ratios and base my decision on these inputs. If these were favourable, company had been in existence for a while and the other nonfinancial checks balanced I would not look much further and would be happy to approve the limits.
That was until I worked for a company that met all these requirements but we faced continual cash flow constraints due to insufficient funds in the business. So whilst our financial ratios looked OK we were forced to delay payments to suppliers purely because we did not have enough overdraft to fund the growth and the working capital cycle and we were solely dependent on our customers paying us on time in order to have the funds to pay creditors. It was a constant juggling act and forced me to review my approval process for issuing of new credit limits.
So next time you are looking to issue a new or revised credit limit make sure to make note of the companies bank facilities (this is a disclosure requirement in the financial statements) in conjunction with the creditors and debtors balance. You need to watch for the debtors having paid but the creditors payments being delayed and yet the company is close to the total bank facility. This must be a warning sign to you that no matter the size of the company they could be heading into some stormy waters and worth chatting to your customer about before you approve any credit.
Another interesting point raised in the article below is to also make note of the interest rate being charged by the banks as this gives you the banks perception on the risk profile of the customer.
Looking Closely at Your Customer’s Bank Credit Line
By Lou Figueroa
As many credit professionals rush to get all the pertinent documentation together to evaluate a customer’s creditworthiness, which may include the customer’s financial statements, there is sometimes not much thought given to the timing and amount of the customer’s bank credit line.
A bank credit line (which can also be referred to as a revolving credit facility) is a working capital loan. These are funds that a bank loans to its commercial customers to facilitate their operation, in which accounts receivables are often pledged as collateral. Your customer may have, for example, a $10 million line of credit with their bank, which means they have the ability to borrow up to approximately $10 million at any given time. The amount borrowed and outstanding under a bank credit line is the amount that will be included as a current liability in the financial statements and used when calculating most leverage and liquidity ratios.
When analyzing your customer’s financial statements, it’s important to understand how close the customer is to reaching their maximum borrowing point under their bank credit line. For example, seasonal fluctuations go hand in hand with credit line limits and it’s typical to see the highest amounts borrowed just before and during the busy season when a company builds inventory but has not yet collected on their accounts receivables.
However, if it’s not the busy time of the year and you see the customer being close to the total available on their line of credit, a warning bell should go off. If your customer has borrowed up to their maximum limit during the off season and will not have additional availability on the credit line when they need it, this may be a telling sign that they may stretch out their payments to you to fulfill their working capital needs…
…Other points of concern to the bank credit line have to do with the interest rate on the loan and the footnotes or management discussions. If the borrowing rate is close to the prime rate, we can assume the working capital loan is a standard risk for the bank. Conversely, as the interest rate becomes significantly higher than prime, the risk to the bank or other financial lender will also be perceived to be greater.
Footnotes or management discussions regarding the bank credit line can often be an important point to discuss with your customer. Asking questions about their banking relationship will frequently yield insights as to the viability and credit worthiness of your potential and existing customers.