Steps a Business May Take During the Initial Phases of Credit Extensions to Avoid Collection Problems

Does your business routinely sell goods or provide services to other businesses and allow them to pay for those goods at a later date? If so, your business engages in commercial credit. Commercial credit involves credit extensions between businesses and is a daunting subject for any business owner. However, with the right planning tools, your business may thrive from its credit extension decisions. This article will identify proactive steps that a business may take during the initial phases of credit extensions to avoid future collection problems. Proactive planning may save a business tremendous time, money and other resources.

The early beginnings of commercial credit can be traced back to the Romans that were forced to extend credit to buyers due to obstacles in transferring money through various trade routes. Today, commercial credit transactions have grown into a routine practice for most businesses. The area is not heavily regulated by federal and state laws because it is presumed that most businesses are able to understand the business' rights and are able to deal with credit and collection in a well-informed manner.

  1. The Business' Credit Policy.

    The first step to create or evaluate a business' commercial credit system is to establish a written credit policy for the business. A written credit policy embodies the business' credit philosophies and can be used as a training tool and reference guide for employees. In addition, written policies help ensure consistency in its routine application and reduce the potential for errors. The credit policy should establish the minimum standards for a creditworthy customer. It should define the information that must be submitted from each credit applicant and allow flexibility to meet the particular circumstances of various customers. In addition, the credit policy should outline acceptable credit periods, available discounts for prompt payments and maximum credit limits. In addition, it should address not only the criteria used to grant credit, but the business' ongoing management of its credit extensions as well. Once the business determines its overall credit policy, it can then begin to put procedures in place to achieve the goals of the overall credit policy.

  2. The Credit Application.

    A credit application is the basic source of information for business' credit decisions. Asking the right questions and obtaining good information will allow a business to make a well-informed credit decision. Remember, it is always easier to get information from the applicant in the beginning rather than waiting until trouble strikes later in the relationship. The following items should be included in a credit application:

    1. Title of Document. The words "CREDIT APPLICATION" should be prominently disclosed at the top of the document to avoid any potential for misunderstanding.
    2. Applicant's Full Contact Information. The applicant should specify its full legal name and trade name. Also, the document should request a contact person, the address of the applicant's headquarters, billing address and shipping address. Finally, a fax number for the company is also advised.
    3. Legal Form of Business. The applicant should disclose its legal status (i.e., sole-proprietorship, partnership, C-corporation, limited liability company, etc.). A business name of XYZ Auto does not indicate whether the applicant is a sole-proprietorship, partnership or other form of entity. The legal form of the business is an extremely important piece of information that is often overlooked by many businesses. It significantly affects the applicant's ability to protect its assets from collection.
    4. Relationship to Any Other Company. The applicant should disclose whether it is related to any other company and the identity and address of that related company.
    5. Type of Business. The applicant should disclose the nature of its business.
    6. Historical Background. The applicant should provide information as to the date the business started as well as any state registrations, if any. New businesses will not be able to supply a lot of historical information. Therefore, a creditor will have to rely more heavily on other information such as referrals and industry standards. In addition, the creditor may consider offering modified payment terms to new businesses requiring cash on delivery, an initial deposit or a letter of credit until the new business proves to be financially reliable.
    7. Identity of Applicant's Principals. The applicant should disclose the identity, social security number, title, address, fax numbers and telephone numbers of all principals of the business. This information will be helpful in the event the business requests a personal guarantee from one of the principals to secure the applicant's payment.
    8. Real Estate Interest. The applicant should provide information as to any interest in real estate. It is important to know whether the applicant owns or leases property. The landlord's name should be obtained if the applicant leases its premises. This can be a good lead on the whereabouts of the applicant in the event the applicant defaults on its payments and cannot be located.
    9. Purchasing and Accounts Payable Contact Information. The applicant should specify contact names, addresses, fax numbers and telephone numbers of specific individuals that deal with purchasing and accounts payable.
    10. References. It is strongly advised that the applicant provide at least one bank reference, including a bank representative name, address, fax number, phone number, type of account(s) and account number(s). In addition, the applicant should provide at least three trade references, including contact person, address, fax number, telephone number and account number. The creditor should follow up to verify the reference information. A credit will not be assisted by references that are simply filed away.
    11. Release of Information. Creditors often require an executed release from the applicant allowing for the disclosure of the applicant's financial information. The release should provide instructions to the references to provide the information relating to the date the applicant's account was opened, high credit, current amount due, current amount past due, number of days past due, terms of sale, normal manner of payment, security status of creditor and the type or form of the security.
    12. Authorization to Access to a Credit Report. The application should contain an authorization from the applicant and the principal party allowing the creditor access to the applicant's commercial credit report and the principal party's consumer credit report. The authorization will facilitate the creditor's investigation of the applicant and principal party's credit history by allowing access to the applicable credit reports.
    13. Resale Certificate. If applicable, the applicant should provide the business with a copy of its resale certificate.
    14. Estimated Annual Purchases and Requested Terms. The applicant should provide its estimate of annual purchases on the credit application. In addition, the applicant should disclose requested credit terms such as a credit limit and sale terms.
    15. Financial Statements. The applicant should provide at least two years of financial statements. New business will not be able to provide the necessary financial. It is important for the creditor to obtain enough information from other sources such as references and industry standards to "kick the tires" of the applicant and feel comfortable with the applicant's ability to repay its credit obligation.
    16. Payment Terms. Payment terms can be broken down into two different categories: discount terms and dating terms. Discount terms describe the discount available, if any, for prompt payment. Dating terms specify the payment due date. An example of a payment term is 2/10 - n 30. The number before the forward slash is the discount percentage, in this example, 2%. The number following the forward slash is the number of days within which payment must be made in order to take advantage of the discount. In the example, the customer can take a 2% discount for payment within 10 days. However, in the event the customer does not take advantage of the discount, "n 30" or "net 30" indicates that payment is due within thirty days. The thirty-day payment period begins with the invoice date unless the contract specifies another date.
    17. Interest on Late Payments. Interest on late payments is a legally agreed upon fee charged by a creditor on any payment received after the contractually agreed credit term. The charge is used to discourage customers from allowing their accounts to become long past due. The credit application should clearly state when a payment is considered late and the rate of interest charged on said payments. State laws may dictate the maximum amount of interest that may be charged on late payments. At present, Wisconsin does not have a usury law that set the maximum rate of interest that may be charged in a transaction. However, interest rates may still be challenged as unconscionable. Interest rates of 12, 18 or 24% are commonly found on credit applications and the Court will not likely find them as being unconscionable. A business is strongly advised to disclose the rate of interest on the credit application. Disclosing the rate of interest for the first time on an invoice or statement may be deemed as unenforceable, unilateral modification to the contract.
    18. Venue. Generally contracting parties do not expect legal troubles to arise out of the application. However, at times, it is necessary for parties to take their dispute to a court or arbitration proceeding for resolution. Arbitration is a faster and less costly means of resolution. The application should state the location of the court or arbitration proceeding in the event of a dispute concerning the contract terms. Generally, most applications provide that the county in which a business is located as the venue for a court or arbitration proceeding. Such a provision will make a dispute resolution more convenient for you and may provide the customer incentive to timely pay their invoices.
    19. Attorneys Fees. Generally, each party to a dispute is responsible for its own attorneys fees. Therefore, a creditor has to pay for its attorneys fees if it has to take legal action to collect from an applicant that has defaulted on its debt. To relieve creditors of the burden of attorneys fees, the application should require the applicant to pay the creditor's attorneys fees in the event the applicant defaults on payment.
    20. Guaranty. A creditor may request or require that a third party guarantee the debtor's obligation. The third party traditionally is a principal party or officer of the debtor. The guaranty should be a separate, conspicuous section in the document that provides for the signature of the third party in their individual capacity. The guaranty should be in writing and should guaranty payment of the debt. A guaranty given to the creditor creates an additional source of payment provided that the individual or related entity signing the guaranty has the ability to pay the obligation in the event the debtor fails to pay. However, an effective guaranty often stands an enhanced chance of getting paid.
    21. Signature of Authorized Person. The application should be dated and signed by a principal or other authorized person of the applying company. Make sure that the signing individual has the legal authority to bind the applicant to the terms and conditions listed on the credit application.

    A business should maintain a secure file to keep credit applications, guaranties and other supporting documentation. This information is invaluable to the collection process if the applicant later defaults on its payments. In addition, the creditor should make a copy (front and back) of the first check received from the applicant. A check identifies the applicant's bank information, account number and payment entity, all of which will be helpful in a collection action.

  3. The Credit Investigation.

    Once the applicant has provided the necessary information on a credit application, the business has the difficult job of examining the creditworthiness of the applicant. Ultimately, the goal of a credit investigation is to assess the credit risk associated with selling to a customer in order to optimize sales and profits for the business.

    Businesses struggle with the proper criteria to evaluate a credit application. Often, the Four C's of Credit as a credit decision guide. The importance of each element will vary from customer to customer and are not always weighted equally.

    1. Character. Character refers to the reputation of management along with their history and business experience. The business must evaluate the moral character of the owners or management of the company and their intention to pay trade creditors on time. Past behavior of a company is generally a good indication of future expectations. Therefore, look at how long the business has been under the same control and check for any previous litigation or bankruptcy information. The internet can be a good means of obtaining useful information. For example, the Wisconsin Circuit Court Access website ( provides information on court cases filed in Wisconsin circuit courts. A quick check on this website may uncover useful information on the applicant.
    2. Capacity. Capacity refers to the applicant's ability to continue to operate the business as a going concern. The business must effectively control and manage all aspects of the company's business without compromising efficiency.
    3. Capital. Capital analyzes the applicant's ability to pay debts as they come due. It is best evaluated based on a careful study of an applicant's financial statements and relationships with other creditors. Some businesses evaluate the financial statements of the applicant's principal party or officer.
    4. Conditions of Times. General economic conditions in the nation, in the community and in the industry will exert a modifying influence on the financial analysis of an account. An assessment of the financial capacity of a company should always include an evaluation of trends. Businesses can have a bad year, without resulting in financial difficulty. If a firm has a strong enough net worth it might be able to sustain losses for five consecutive years. Evaluate trends over a three to five year period to get a clear picture of the direction a firm is heading. Obviously, trend evaluation is impossible for a new business. In such situations, the creditor may be wise to require cash on delivery payment terms, an initial deposit or a letter of credit until the new business proves to be financially reliable.

    Commercial credit agencies such as Dun & Bradstreet Corporation or Equifax may have financial information on large credit applicants. The cost of this service varies with the detail and depth of the requested information. However, investigating small business applicants may be difficult. In such situations, businesses may rely more heavily on the applicant's bank and trade references. Other information may be found in analyzing the applicant's industry and its position within that industry.

    Business should keep in mind that credit analysis is only worthwhile if the expected savings exceed the cost. A business can spend considerable time and money conducting a credit investigation. Large resource expenditures on investigations may not be sensible for small accounts. Therefore, some general guidelines are helpful. A more thorough credit investigation is recommended if there is a potential for a long-term business relationship, high credit limits or significant profit. However, small orders may be best serviced by a blanket policy allowing customers credit up to a certain small dollar amount without any credit investigation.

  4. Purchase Money Security Interest

    A purchase money security interest arises when parties agree that the seller may recover the items sold to the customer if the customer defaults on the loan. The purchase money security interest may secure all or part of the purchase price of the goods and provides some protection to the seller.

    Article 9 of the Uniform Commercial Code governs purchase money security interests. It has been adopted, with some modifications, by every state. The security interest is a contract and must comply with state laws governing contracts, most notably, it must be in writing. The seller must give notice of the purchase money security interest to other creditors with prior perfected security interests in the same collateral. The seller will have priority in the goods ahead of the perfected security interests of other creditors.

    The seller may obtain a purchase money security interest at the time of the purchase of fixtures or personal property. However, some businesses do not want to expend the resources or feel uncomfortable taking a security interest in the items until the seller encounters payment problems. Businesses seeking to obtain a purchase money security interest are advised to seek assistance from legal counsel to properly protect their interests.

  5. Invoices and Statements

    Invoices and monthly statements advise the customer of its outstanding balance. The documents should be prepared promptly and accurately to eliminate payment delay and should be sent to the customer on a regular basis. In addition, the remittance address, telephone number and payment terms outlined in the credit application should be clearly stated.

  6. Conclusion

    A business wants to make sales and therefore, may feel somewhat forced to extend credit to its customers. However, if the business does not receive payment for its goods or services, its sales soon turn into gifts. Businesses can significantly reduce credit problems with investigation and prudent judgment during the initial stages of credit approval. Proactive steps can assist a business in finding its proper balance to make successful commercial credit decisions. Today's best customer may be a business' biggest headache tomorrow if the customer gets behind in its payments.