Trade credit is one of the most popular financing options in the construction industry. When construction clients use trade credit, they can buy materials and services without having to pay upfront. They instead pay at a later date depending on the payment terms agreed upon by the parties involved.
Using trade credit is convenient, so more and more companies are opting to take advantage of this financing solution. However, trade credit also comes with risks, especially on the side of the creditor. If you extend trade credit to clients, you must be ready to face the risks of late payments and non-payments.
Companies that extend trade credit usually vet their clients right from the credit application process. Some make instant decisions, while others take some time before credit approval. The key is to strike a balance between doing a meaningful risk assessment versus taking too long to approve or reject a potential client.
Trade credit approval process
If you are trying to decide how fast it should take your company to approve or reject a trade credit application, you first need to understand the trade credit approval process. There are generally three steps involved:
Data gathering
The first step is always to gather pertinent information from your potential client. What is the company called? What services do they provide? How much money does the company have? What is their credit score?
Some of these pieces of information can be gathered directly from your client. For instance, a simple application form can tell you all the basic details about a contractor or subcontractor. Other details such as the credit score and financial statements must be run by you or must be submitted by the clients.
During the data gathering step, keep in mind that your goal is to collect the necessary information to help you assess the risks associated with a potential client.
Risk assessment
The second step involves assessing and analyzing the risks of lending money to the client. The construction sector is notorious for late payments and other forms of payment delinquencies. Depending on how stable your company is, you need to determine how risky it would be for you to provide labor or services to a certain client before receiving full payment.
Risk assessments can be done in different ways. Companies that extend trade credit typically look at a potential client’s credit score and consult trade references. You can also ask for financial statements to understand how much a potential client can afford to borrow without derailing the health of their cash flow.
When conducting risk assessments, you want to be able to do it as quickly and as efficiently as possible without sacrificing the quality of analysis. You do not want to take too long to assess a client’s creditworthiness because that could push a potential client away. At the same time, you do not want to rush your decision because you might end up losing money to a high-risk customer.
Credit approval/rejection
The third step is approving or rejecting a credit application. If you approve a trade credit application, you also set the payment terms and other conditions that come with the agreement. You need to set the payment deadlines as well as the credit limits, and you need to decide whether you will impose late payment penalties or other fines.
At this stage, you may also want to be upfront about your mechanics lien practices. Let the potential client know that you are ready to file a mechanics lien against the property of interest in case you do not get paid.
Rejecting a trade credit application can be done to high-risk customers. Alternatively, you can still approve them and mitigate the risks by setting high late payment fees or assigning a low credit limit.
Criteria for construction credit approval
Good credit score
Ideally, you want your potential clients to have a good credit score. For business loans, a good credit score is generally anything above 680. Having a good credit score means a client pays loans on time and does not borrow close to or beyond their credit limit.
Good debt-to-income ratio
The debt-to-income (DTI) ratio is a key performance index or KPI that tells you how much debt a client has compared to their income. A good DTI is generally around 36%, which means that a company’s monthly debt payments are equal to or less than 36% of its monthly gross income.
Positive trade references
Trade references are other businesses that a potential client has worked on. A trade reference can be a vendor, a supplier, or another company that has provided labor or materials to your potential customer. Ideally, a client’s trade references are able to give them positive feedback, especially as regards their payment practices.
Trade credit approval requirements
Running a credit report
Running a credit report is important to have a gauge of a potential client’s credit score. Some lenders even base their decisions solely on a company’s credit score, so you definitely want to consult a credit score before approving a trade credit application.
Consulting trade references
Talking to trade references is also imperative if you want to assess a potential client’s reputation, especially when it comes to paying on time. Newer businesses may not even have an established credit score. In this case, consulting trade references will be extremely helpful for your risk assessment.
Reviewing client’s financial health
Having access to financial statements is another important requirement, especially if you want a thorough understanding of your client’s financial health. Knowing the details also allows for some flexibility. For example, you can ask a client for a large down payment or a personal guarantee, if needed.
How long does trade credit approval take?
Ideally, trade credit approval should be instant. There are software technologies available that can perform credit risk assessments and set the appropriate credit limits in a snap, so long as you provide all the required information.
Even without the help of sophisticated technology, it is still important that you make trade credit approval as quick and as efficient as possible. The best practice is to make decisions on trade credit applications no later than 24-48 hours.
The speed of trade credit approval will depend on how stringent you are with your credit approval processes. Some companies require lots of information, while others only need a few. Some companies also have a dedicated credit team, while others have one or two people processing all trade credit portfolios.
The key is to figure out what works best for your company and to standardize your practices via a trade credit policy. If your best practices are put on paper, and if there is a fixed set of requirements and criteria that must be met by your potential customers, you can make your trade credit approval processes as efficient as possible.
Why is faster trade credit approval important?
- A fast trade credit approval process can result in more sales.It is important to keep in mind that you are not the only company offering trade credit to your clients. There are numerous material suppliers out there who are selling suppliers on trade credit. If your credit approval process takes too long, a potential client can easily jump ship to a different supplier and take their offer instead.
- A fast trade credit approval process means you have a solid trade credit policy.When your trade approval process is efficient, it proves that your trade credit policy is robust. It means that your practices are standardized and that your credit team knows and understands how to put your policies into practice.
- A fast trade credit approval process implies a good relationship between the credit and sales departments.The sales team and the credit department of a company can clash, especially when the latter shut down new sales due to credit risks. If you are able to come up with a speedy credit approval process, it means that the two teams are able to collaborate effectively and that their respective standards are properly integrated.
How to make trade credit approval faster
Standardize your credit approval process.
Standardizing your credit approval practices is highly important. If your procedures are clear and effective, it leaves little room for guesswork, and it helps the credit team makes correct decisions. Without a standard set of procedures, the trade credit approval process could take longer than necessary.
Implement a robust trade credit policy.
The trade credit policy serves as the key guide to making the credit approval process as efficient as possible. For your trade credit policy to be robust, it should reflect the goals and objectives of your company. For example, some companies aim to approve all clients regardless of risks, while others choose to be pickier. There is no single best credit policy as it should be tailored specifically to your business.
Take advantage of available technologies.
There are available technologies that can do credit risk assessments for you. You can also use technology to run credit reports and even send preliminary notices to protect your payment rights. Using technology to your advantage gives you an edge and improves the efficiency of your processes.
How to create or improve your trade credit policy
- Consolidate your company’s internal practices.The trade credit policy should reflect the company’s entire mission and vision. It should be created with the needs and policies of other departments. For example, you should always consult the sales team when writing your credit approval requirements. You want to understand how your processes and standards will affect them, and you want to address potential issues before they happen.
- Determine a set of standards for approving trade credit applicationsDifferent companies have different requirements for trade credit approval. Some companies only require the basic information needed to run a credit report, while others ask for financial statements and other documentation, especially for bigger sales. Your trade credit policy should have a clear set of credit approval standards that work best for your company. These standards must be communicated to the credit team so they can be properly implemented.
- Be comprehensive when writing your trade credit policy.The trade credit policy is not only about trade credit approval. For the credit policy to be comprehensive, it should also cover other aspects of credit management, such as payment collection. If a client does not pay on time, for instance, the credit policy should outline your next steps. Some companies might hire a third party to collect the money; others may file a mechanics lien right away.
How to conduct a credit risk assessment
There are three important resources that you can consult when conducting a trade credit risks assessment: the credit report, the payment track record, and the financial statements.
Credit report
The credit report shows not only the client’s credit score but also other records such as mechanics liens and other legal encumbrances. A company may have a decent credit score, but they can also be dealing with a huge volume of mechanics liens, which is not a good sign. Even though a credit report may not necessarily tell the full story, it is a key resource that will give you an insight into your client’s payment habits.
Payment track record
A client’s payment track record can be gleaned by consulting trade references. When you talk directly to other vendors and suppliers that have worked with your potential customer, you will have a better sense of how prompt they are in paying and how easy they are to communicate with. Consulting trade references could help you catch red flags that are not necessarily found in credit reports.
Financial statements
Financial statements are also a good resource for risk assessment. It shows how much money comes in and out of your client’s pocket, and it tells you how much money they can afford to borrow based on their spending habits. You can also use financial statements to forecast a client’s cash flow, which can help you decide when to set credit limits and determining payment terms.
Trade credit risks
Even though trade credit is a popular financing option among construction companies, it still
comes with the risk of non-payment. Clients could end up not paying for the
materials or services they bought, and this could have a significant effect on your cash flow.
Other than non-payments, late payments are also another big risk when extending trade credit to clients. When payments do not come on time, you might end up struggling to cover your immediate expenses, such as payroll and other operating costs.
There are many ways to protect yourself from these trade credit risks. However, there is no guarantee that you will not end up dealing with late payments altogether, no matter how strict you are in vetting your clients. The construction industry has a high degree of insolvency, and so it would be difficult to completely avoid late or non-payments.
One effective way to recover payment from delinquent clients is to record a mechanics lien. You are strongly advised to serve the necessary preliminary notice and notice of intent to lien to protect your lien rights.
Credit approval best practices
Follow your trade credit policy.
A trade credit policy means nothing if it is not implemented properly. You need to train your people about your trade credit policy, and you need to follow the principles and procedures outlined in your credit policy. Policies are imposed for a reason, and your credit approval process will become more efficient if you have put your trade credit policy into practice.
Work with other departments.
The credit department must not work on its own without regard for other teams. You should work hand-in-hand with the sales team, for example, so you can establish a smooth workflow that does not conflict with the company’s goals. Keep this in mind when crafting your trade credit policy to avoid potential conflicts.
Be efficient.
Being efficient is easier said than done. You can be more efficient by setting internal standards and sticking to them. Make sure that you have a list of requirements and procedures for credit approval, and make sure that everyone in the credit team is aware of them. It would also help if you regularly evaluate your processes so you can identify weak points and improve them.
Further reading