Building a framework to evaluate customer credit is essential to protecting your business from financial risks. This blog series covers the different methods of assessing customer credit, key metrics to track, and invoice behaviors that may indicate financial distress — so that you can begin to build a customer credit framework that highlights and even predicts future risks to your business.
How to Analyze Payment Behaviors
While reviewing financial statements and analyzing data from third-party credit bureaus provides valuable insights, they still do not paint the whole picture of your customers’ credit. If you want additional visibility into your customers' financial stability, pay close attention to the way they pay your company. This is a great way to assess customer credit first-hand, without relying on them or outside services to provide relevant financial data.
Payment behaviors are often overlooked but can be used in evaluating the financial strength of a company or even signal a financial downturn. As a point of reference, good payment behavior is exemplified by payments made on a consistent basis, that are paid in full for billed work, and are paid on time according to term dates. If your customer's payment behavior doesn't include these characteristics, you should investigate why.
5 Payment Behaviors to Monitor
So what should you keep an eye on? In our experience there are five key behaviors which may indicate that something is amiss with your customers’ financial standing:
1) Slow Payments
Are an unmistakable signal to point out, identifying the early signs of sluggish payment behavior can help you stay proactive in detecting changes to a customer's financial strength. Looking at your customer's payment behavior data over time will help you notice negative trends or slowdowns in behavior that may not be immediately obvious.
In the graph below, you’ll notice a trend line that starts to show slower payments beginning in March, stabilizing but still slower than before, and then dramatically decreasing. If you start to see a significant downturn in the timeliness of payments from your customer, like in the example below, we suggest picking up the phone and getting a better idea of their situation.
2) Invoice Discounts
Often referred to as dilution in the financial services industry, a discount represents how much of an invoice is paid versus the face amount billed to a customer. It's common for companies to receive a discount if they opt to send a payment earlier than the due date, but when this isn't the case, you should start to take caution. If there are multiple instances of your invoices getting partially paid without reason, start following-up with your customer to see where they stand.
In the graphs below you’ll see an example of normal, paid-in-full, payment behavior. The green dots show a full payment. In the heavy dilution example, you’ll see that the customer is showing incomplete payments (yellow and red). This warrants further investigation, especially if you don’t know why only partial payments are being received.
3) Skipped Invoices
Receiving payments for invoices out of sequence may not seem like a sign that would raise the alarm, however, this type of payment behavior can lead to invoices getting paid partially or perhaps not at all. Customers by nature will pay invoices sequentially, per the issue and term dates. If you begin to receive payments for invoices out of order, pay close attention to how your customer is performing as this is an early warning sign of financial fatigue.
In the example below, you’ll see several invoices that were created in November but were paid at vastly different dates. Why were some paid within 20 days while others took over 50 days for payment to be received? it is definitely worth additional scrutiny if this behavior becomes more frequent.
4) Large vs Small Invoices
Payment behavior can also vary based on the size of an invoice, with smaller invoices paying faster and larger invoices remaining outstanding for more extended periods. If your customer pays all invoices with similar Days Sales Outstanding (DSO) but then begins to slow down the payment of only large invoices (as in the example below), you should begin to pay closer attention. Keeping note of any changes in your customer's payment behavior can help you plan for times when cash flow may not be readily available.
5) Batch Payments
Batch payments occur more frequently when dealing with customers who take a “pay-when-paid” approach. It's important that you look through to the end payor and examine any changes in payment characteristics to identify credit risk signals on their end as well. While receiving lump payments is great for an immediate influx of cash, customers who change their frequency of issuing batch payments can leave your business with increased exposure for prolonged periods.
Putting it All Together
Monitoring payment behaviors is just one element of understanding your customers. In Part I of our Essentials of Customer Credit blog series, we covered what financial statements can tell you about a business’s credit and the key metrics you should focus on. In Part II, we explored what third-party credit bureaus do and what insights they provide about your customers. Using these methods in tandem can help build a financial mosaic that highlights existing and potential risks to your business.
Ensuring that your business has access to consistent cash flow can either make or break your potential for future success. With that in mind, here are three takeaways that you should always consider when assessing your customer's financial strength:
- Start with financial statements and third-party credit data.
- Pay close attention to the way your customer pays you. Digging deeper into your payment data will help paint a clearer picture of your customer's financial standing.
- If questionable payment behavior arises, have an honest conversation with your customer.
Looking for more advice on avoiding financial distress with your customers? Download LSQ’s Guide to Navigating Customer Credit.
Where to Turn to For Help
If gathering the necessary data to make an informed credit decision appears daunting, you're not alone. LSQ helps businesses by providing real-time accounts receivable data for them to make better decisions. LSQ offers working capital solutions for businesses of all sizes and across various industries. With over eight million invoices processed and payments collected from more than 130,000 unique customers, we can alert your business anytime questionable behavior arises—keeping you ahead of the curve.
Our state-of-the-art receivables management platform, Dashboard, provides businesses with credit insights and 24-hour access into their accounts receivable data. Offering a wide array of reporting, mobile uploads, and credit decision technology—Dashboard takes away all of the heavy lifting that goes into making an informed customer credit assessment. Contact us to see how we can help your business.