Ideas for extending credit to a new business.(Credit Basics)

From time to time, credit professionals will receive a credit application from a newly formed company. In some cases, the company in question is well financed, the owners or senior managers have a wealth of experience in the industry and, as a consequence, the company has a certain amount of credibility with customers and vendors.

However, a more difficult situation arises when the applicant is new to the business and has no trade references, a non-borrowing bank relationship and reports that the company has no financial information to share with creditors. The question to then consider is this:

How can vendors sell to this second type of credit applicant while controlling and limiting credit risk? Limiting risk in this scenario will not be easy. Some of the more commonly used tools, or tools used ill combination to mitigate credit risk are shown below (in descending order of importance as an effective risk management tool):

* Ask this new customer to arrange for its bank to issue a documentary letter of credit. A documentary L/C substitutes the creditworthiness of the issuing hank for that of the buyer. The seller will be paid if it presents conforming documents to the issuing bank within the deadlines established under the letter of credit and under the rules established for administering letters of credit (called the UCP 500).

* Ask the customer to arrange for a standby letter of credit. A standby letter of credit is a secondary payment mechanism. A bank will issue a standby letter of credit on behalf of its customer to provide assurance of the debtor company's ability to pay a specific creditor named in the L/C. Normally, neither the seller nor the buyer expects that a standby L/C will be drawn upon. Standby L/Cs are used only if the debtor company fails to pay the creditor company.

* Require the customer to pay COD on small orders and cash in advance on large or custom orders ... with the understanding that after three to six months of purchasing on COD and CIA terms that the customer will be considered for open account terms. A note of caution: It may seem counter-intuitive, but selling on COD cash terms can result in bad debt losses. Common carriers do not allow their drivers to accept cash payments, so COD cash terms means that payment is due on delivery in the form of a cashier's check or money order. If the driver accepts a payment in good faith, the carrier would not be liable if it turns out that the check or money order were counterfeit.

* Become a secured creditor by asking the debtor to pledge one or more assets to the seller, and then perfect the security interest in the pledged collateral. By definition, a secured creditor is one that holds the pledge to assets of a debtor that secures either payment of a debt, or the performance of another obligation.