While revenue is trending up for the majority of companies, it's not always the same story with margins and profitability. Inflationary prices over the past few years may have added to revenue, but operating expenses and inventory costs have risen as well. In fact, S&P Global reports that default rates are at historical highs, with many companies having their credit downgraded as a result.
However, you do not want to paint everyone with such broad brushstrokes. Defaults are still expected to stay around 5%, which means there are plenty of companies and industries that are doing just fine. The key for your business is to insulate yourself from financial risk as much as possible by evaluating customers and businesses when you decide to extend credit.
We'll provide you with a comprehensive overview of corporate creditworthiness, including a definition of what is creditworthiness, how to determine the creditworthiness of a customer, and what information you can get from different types of business credit reports.
What is the Creditworthiness of a Business?
A business is said to be creditworthy when it appears capable of meeting its financial obligations in a timely manner. Lenders and businesses use creditworthiness to determine whether to make loans and extend credit along with what terms to offer.
Why is Credit Evaluation Important?
A credit evaluation helps you understand the business creditworthiness of a customer to help you make better decisions about extending credit offers. With a thorough analysis of a customer's financial history, you can identify any red flags that could indicate a higher probability of default.
This produces significant benefits for businesses, including:
Reducing Financial Risk
- Minimizes bad debt write-offs
- Reduces exposure to payment defaults
- Lowers collection costs and efforts
- Improves cash flow predictability
- Protects profit margins from bad debt losses
Making Better Business Decisions
- Enables informed credit limit setting
- Helps determine appropriate payment terms
- Allows customization of service/product offerings
- Supports strategic customer selection
- Guides resource allocation decisions
Improving Operations
- Streamlines accounts receivable management
- Reduces time spent on collections
- Enables more accurate cash flow forecasting
- Improves inventory management
- Strengthens overall financial planning
Improving Customer Relationships
- Sets clear expectations
- Prevents awkward payment discussions later
- Establishes professional business boundaries
- Creates transparency in business dealings
- Allows for proactive relationship management
Creates a Competitive Advantage
- Enables expansion into new markets
- Supports strategic pricing decisions
- Allows for competitive payment terms where appropriate
- Improves overall business sustainability
- Strengthens negotiating positions
Supports Business Growth
- Facilitates controlled business expansion
- Enables a safe increase in the customer base
- Supports entry into new markets
- Allows for calculated risk-taking
- Provides a foundation for scaling operations
With a thorough evaluation, you can make more informed decisions about credit risk to protect your cash flow and your business more effectively.
What Are 5 Key Things Considered When Determining Creditworthiness?
While each company will have its own criteria for assessing business creditworthiness, most lenders use some form of the five Cs when doing their evaluation. The 5 Cs are:
- Character
- Capacity
- Capital
- Collateral
- Conditions
Character
When evaluating the character of a company or customer, you are looking at someone's reputation and track record for repaying debts. While it's no guarantee, someone who used credit responsibly in the past is less risky.
Taking a look at credit scores on business credit reports, along with payment history can help you evaluate character.
Capacity
A customer's capacity reflects their ability to repay a loan, typically by comparing income against debts. The customer's debt-to-income (DTI) ratio helps define the borrower's ability to repay a loan without straining their financial resources.
Mortgage lenders, for example, prefer to see a DTI that is 36% or less before approving new financing.
Capital
Another measure of business creditworthiness is capital. In mortgages, this would include the amount of downpayment a borrower is willing to put down. For business, this might include deposits, escrow, or cash up front.
Many businesses require deposits for large orders, new customers, or those with a limited or shaky financial history.
Collateral
Borrowers often use collateral to secure loans. This reduces the risk for lenders as they can repossess the collateral in case of default and sell it to recoup their losses.
While it happens more with business loans, keeping an eye on what customers have pledged to others can be important—especially if you are concerned about repayment. You can check Uniform Commercial Code (UCC) filings, which are public notices that a creditor has a legal interest in someone's assets.
Conditions
The conditions regarding the loan or credit can make a difference. In other words, how the credit will be used makes a difference. A business looking for inventory to meet existing purchasing orders, for example, is more likely to increase its cash flow and be less of a credit risk.
Conditions also reflect the terms of the credit. You might offer better terms for customers with superior credit or require higher interest payments or faster payments for those with poor credit.
How to Determine the Creditworthiness of a Company
Specifically, how do you evaluate the creditworthiness of a business?
Start with a business credit report. There are three credit bureaus that provide company credit reports:
- Dun & Bradstreet
- Equifax
- Experian
Each uses slightly different criteria and methodologies to evaluate business creditworthiness. A score summary gives you a high-level analysis of how companies pay their bills and forecasts the probability that it will remain in business.
Here is a breakdown of the types of information you can get from each type of report.
Experian score summary
| Business identity | Risk dashboard | Risk dashboard | Business description |
|---|---|---|---|
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Dun & Bradstreet score summary
| Viability | Data Depth | Company Profile |
|---|---|---|
| The risk of the company going out of business as well as its viability compared to similar businesses. | The amount of predictive information available on the company. |
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Equifax business score summary
| Business identity | Credit Summary | Financial Stability Risk | Public Filings |
|---|---|---|---|
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Experian premiere profile
| Credit Risk | Financial Report | Trade Payments | Derogatory Events |
|---|---|---|---|
| For Publicly Traded Companies:
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Dun & Bradstreet comprehensive report
| Scores | Financials | Operations | Derogatory Events |
|---|---|---|---|
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We also have a guide to help you understand which credit report is best suited for you. You can also contact the team at Command Credit, and we can help you find the right fit.
Other Key Metrics to Analyze
As you can see, each of the credit reporting agencies analyzes a significant number of factors to produce scores and forecast likelihoods. These are the easiest ways to check on business creditworthiness and make sure you are not taking unnecessary risks when extending credit.
If you want to get more detailed, you can get or ask for financial reports, such as P&L statements and balance sheets which can help you analyze a broad range of items, such as:
- Cash flow
- Working capital
- Liquidity rates
- Debt-to-equity ratio
- Debt service coverage ratios
- Return on assets (ROA)
- Return on equity (ROE)
- Operating margins
- EBITDA margins
- Asset turnover
- Inventory turnover
Best Practices for Evaluating Business Creditworthiness
Putting in place consistent credit policies and employing a few key practices can help you make better decisions.
Evaluate Credit Scores and Risk Scores
Risk scores add another layer of insight, particularly when they're industry-specific. These metrics help predict both the likelihood of default and the potential severity of loss. Modern credit evaluation has evolved to include sophisticated predictive scores that can forecast future performance based on current trends and historical data.
However, scores alone don't tell the complete story. They must be interpreted within the context of industry benchmarks, regional factors, and the business's size and age. Seasonal fluctuations, particularly relevant in certain industries, should also factor into this interpretation.
Evaluate Credit Scores and Risk Scores
Risk scores add another layer of insight, particularly when they're industry-specific. These metrics help predict both the likelihood of default and the potential severity of loss. Modern credit evaluation has evolved to include sophisticated predictive scores that can forecast future performance based on current trends and historical data.
However, scores alone don't tell the complete story. They must be interpreted within the context of industry benchmarks, regional factors, and the business's size and age. Seasonal fluctuations, particularly relevant in certain industries, should also factor into this interpretation.
Ask for Trade References
Trade references show actual business relationships and payment behaviors. The key is to gather a diverse set of references—typically three to five—from various sectors and transaction sizes, with a focus on long-term business relationships.
When contacting these references, ask specific questions about:
- Payment history
- Transaction volumes
- Any payment challenges
Probe for information that might not be apparent in formal credit reports, such as how companies communicate if there is an issue. The goal is to identify consistency—or lack thereof—across multiple references, painting a more complete picture of the business's reliability.
Keep in mind, however, that businesses providing trade references are likely to give you ones that will provide a good report. So, balance what you learn along with what you find in credit reports.
Take Business and Industry into Account
To fully assess business creditworthiness, you need to understand individual circumstances and the industry environment. Pay attention to the company's competitive position and customer concentration, as these factors can significantly impact long-term sustainability.
Industry analysis adds another crucial dimension. Every industry has its own cycles, trends, and regulatory challenges. Understanding these factors helps predict how external forces might affect a business's ability to meet its obligations.
Technological disruption risks and market competition must also be considered, as they can rapidly alter an industry's landscape.
Evaluate Your Overall Credit Portfolio
You need to evaluate your overall credit portfolio as well to see how your customers align with your risk tolerance. This broader perspective helps balance risk exposure across your customer base. Portfolio analysis should examine customer concentration, industry diversification, and geographic spread to identify potential risks.
Effective portfolio management involves setting appropriate exposure limits and implementing controls that align with your organization's risk tolerance. This might mean adjusting credit limits strategically to optimize your overall risk-return profile.
Monitor for Changes to Business Creditworthiness
Credit evaluation should be ongoing. Modern credit management demands automated monitoring systems with alert triggers for significant changes in payment patterns, financial statements, or public records.
Regular reviews should be scheduled, but the system should be flexible enough to respond to unexpected developments.