How Can a Business Minimise Bad Debts? 6 Controls Before Credit Is Extended

Minimising bad debts is all about managing risk. Even better is not letting bad debts happen in the first place. The best way to manage risk is to follow a checklist before extending credit.

Use six controls before opening credit accounts. Gather a credit report, search online and in the courts. Ask trade references, but always get a signed credit application. Have pre-set terms and limits. Start doubtful new customers on cash on delivery.

One bad credit customer is a terrible thing. They are a burden on cashflow, a cause of worry and they take attention and time from good customers who will actually pay. Slow pays affect cashflow, which can be the cause of insolvency. And as the old saying goes, prevention is better than cure.

Check of the Customer’s Credit

The first control is a check of the customer’s credit. Most often, suppliers will start with a business credit report. These are run through a bureau like Dun & Bradstreet. Look for defaults and court judgments. Did you know you can pull a credit report on the owners of the business, if it’s a sole proprietorship or they’ve signed a personal guarantee for the credit? Corporate officers who did not sign personal guarantees are not fair game under the FTC staff view.

The second control to use is credit references. A credit reference is of no value if no one asks. Get at least three on a credit application. But actually phone the references, and ask questions that matter. Have a conversation that covers pay history, any late or non-payments. Ask if the referee would extend the credit again.

Third, spend five or ten minutes Googling the client. Google is a great source of gossip. Unpaid suppliers often complain online. Check court records for lawsuits. Get more out of a customer search. Find out who invoices go to, not just the customer’s sales team. Find out if your client sends just one check a month, and how that hits your cash flow. Say they pay at 60 days. Can your cash flow handle two months unpaid?

Signed Written Credit Application

The fourth way to minimise bad debts is to run every credit request through a signed written credit application. A signed application for credit is just a foundation unless it comes with legal supports. The application should define when the customer is in default, list the security against the debt, spell out the personal guarantees, spell out collection costs and state what interest charges you add to overdue accounts. A well constructed credit application asks for bank references and requests financial statements in addition to trade references. If your credit standards require a personal guarantor, fair enough, but never make it the spouse.

A UCC-1 filing for that security is normally effective for five years. However, a UCC-1 can be renewed, but not before six months before it expires. If you sell equipment on credit, make sure you hold a purchase-money security interest. A security interest comes first, ahead of conflicting ones, if you write down the deal and register it (perfect it) on delivery or within 20 days after.

One provision in terms has become crucial to avoiding payment fraud. Scammers use hacks to get into email accounts. They email customers telling them the bank account changed. Include a special clause in all terms that rules out any request for a bank change that was made without written confirmation.

Credit Limit

The fifth control on avoiding debt problems is setting a limit on how much the customer can buy. Set a proper credit limit at the outset, stick to the limit and sell no more until the account gets paid down. For payment terms, net 30 or net 60 are typical. Once credit terms are set, management must approve any new limits. Ask the accountant to adjust the cashflow report for client payment delays. Work out how much cash is coming in from payments and other income, and when it arrives. Use the report to spot risks like slow pays early. Consider an insurance policy that can cover the cost of trade credit losses. But always speak to a professional to work out what cover you need, and what cover to take.

The sixth control is to manage risk customers upfront and not wait for trouble. If you have doubts about the customer’s credit worthiness, then start slow. Consider COD at the start or ask for 50% up front. Give a short, seven-day intro payment term. Make them prove themselves. Then extend the term if they demonstrate they pay when due. If your answer has to be no, say no within a reasonable time. And if the applicant asks in writing for the reasons within 60 days, give a written explanation.

No system works perfectly. Even after doing everything, some customers still won’t pay. So make sure you have remedies if your customer doesn’t pay and build the follow-up process before you set up the sales. For tax purposes, keep the IRS rules in mind. Take a deduction for a worthless or partly worthless bad debt only when the debt has already counted in income. Write the deduction in the year it becomes worthless. Take a bad debt deduction after taking reasonable collection steps.