Learn how to create and maintain an effective credit safety net to get you through challenging times and help you to seize opportunities.
I. Introduction
By establishing and maintaining strong business credit, you’ll secure access to cash and trade credit in times of need, such as a temporary cash crunch. Think of this as your credit safety net. An unforeseen cash shortage can be caused by a variety of factors, including growing A/R balances, increased inventory needs, or a late payment from a crucial client. Don’t assume it won’t happen to you. No business is immune to an “act of God,” and it can be difficult to forecast when an expensive piece of equipment might break down. In short, this safety net will help fund your working capital in times of need.
“A credit safety net provides a cushion for the business and peace of mind for the business owner,” says Ken DiFatta, senior vice president at Regions Bank. “Businesses of every size need to think about this, but it may be even more crucial for small businesses, as larger companies probably have a more detailed cash budgeting process. Plus, for smaller businesses, not having a safety net may have a more negative impact on your overall success.”
To establish your credit safety net—your ability to access cash in times of need—take steps to build your business credit by creating a strong relationship with your financial partner, monitoring your business credit like you do your personal credit, and paying bills on time, if not early. Make sure your company has a favorable business and social profile, as lending partners may also review this when evaluating your credit request. Additionally, create and maintain healthy relationships with your trade partners, and get any special terms you’ve negotiated in writing; enforce your own company credit policy, and do your research before extending credit to clients; and use credit cards and purchasing cards strategically.
It takes time and scrupulous planning, but the effort will be well worth it if and when your company encounters unforeseen cash flow needs.
II. How to build business credit
Your business credit score affects your ability to secure a loan and your terms and interest rate. Usually, business credit is based on a measurement system of one to 100, and on this type of scoring model, you ideally want to score a 75 or higher. S.E. Day is a financial expert, radio host, professional speaker, and bestselling author of the Legally $teal series and Mastering the Business Credit Maze. He believes that few business owners truly understand business credit. “You need to be well aware of what it takes to build business credit and how to protect that business credit once it’s established. Most business professionals aren’t,” he says.
Day suggests taking certain steps from the inception of your company, such as choosing the right corporate structure and maintaining a viable corporate address and phone number. You’ll also want to register with a credit reporting agency, such as Dun & Bradstreet, which the Small Business Administration recommends for establishing a business credit file. Additionally, follow these guidelines to help build your credit and, ultimately, procure your credit safety net.
1. Start building business credit early
Establishing credit takes time; business owners should begin the process as soon as possible. Michelle Dunn, an author and columnist who consults frequently with business owners on how to create credit for a new business, believes you should start thinking about building a credit safety net when you write your business plan. “In my experience, a credit safety net would help any business make more money, increase profits, and grow,” she says.
Most likely, you’ve spent years establishing personal credit. Treat your business credit the same way. If you wait until you need it, it will be too late.
2. Establish good personal credit
Most small business owners have borrowed money personally, if not yet on the business. Potential lending partners will review your personal credit score when assessing your request for a business loan, so build and maintain favorable personal credit.
Company equity is one of the best sources of liquidity for a business owner in the case of an emergency. If you’ve invested in your business, it may be tempting to pay yourself back immediately, but banks look favorably upon company equity. Banks also expect you to live within your means. “Don’t drain your business cash flow to support personal obligations,” warns DiFatta. “We see this mistake happen frequently. A small business will look profitable and strong, but when we do a global analysis that includes personal debts of the business owner, that cash flow may not look as healthy.”
3. Create a relationship with your bank
“A satisfactory depository relationship can assist banks in determining potential credit worthiness,” notes DiFatta. Banks may consider how you’ve handled your personal and business deposit accounts and note such factors as account balances, overdrafts, and NSF activity (or lack thereof).
But it’s not just about the money in your account—it’s also about your relationship with the banker. “Good communication with all of your financial partners about the types of scenarios that would cause you to draw on your line of credit or utilize extended trade terms is very important,” says DiFatta. “Open communication and transparency are key in building that credit safety net.”
4. Produce trustworthy financial reports
The ability to produce quality financial information about your business is also important to financial partners. As your credit needs increase, audited financial statements from a certified public accountant may also be necessary. Most likely, potential lenders will also want to review your personal tax returns.
You may need to invest in internal financial software so you can produce quality interim reports. It’s not likely your emergency needs will emerge right after you’ve received updated tax returns. If it’s midyear, banks will want an up-to-date report on your performance. Make sure you have the ability to provide quality balance sheets and income statement information year-round.
5. Make payments on time or early
If your business has never borrowed money before, start small. Use the funds appropriately, and make your payments on time or early. You can increase the size of the loan or your credit card limit as your needs change and your credit standing improves. “A good pay history on business credit cannot be overemphasized,” says DiFatta. “Building a great track record of prompt payments is incredibly important.”
Day suggests making payments with a company check 10 days before the due date whenever possible, and only using 30 to 40 percent of your credit limit. He also reminds business owners that store credit cards are typically issued by a bank; and for example, your Staples and Home Depot account could be managed by the same bank. If you’re late with one account, it looks bad for the others.
6. Use business credit appropriately
One of the aspects of credit that business owners struggle with the most is using their credit facilities appropriately, observes DiFatta. “A working capital line of credit should not be seen as a blank check for any business need,” he says. “It should be seen as a way to support your A/R and inventory needs.”
If you need to purchase new equipment, finance it based on the life of that asset, with a term loan, for example. When banks are reviewing a line of credit for appropriate usage, they’ll look for lines that exceed the margin of working assets.
Banks can provide guidance lines of credit specifically for equipment purchases. “Unlike a new credit request, if the guidance line of credit is preapproved with certain terms, the credit may be approved at the annual renewal of your working capital line of credit, even if you don’t need it yet,” says DiFatta. “If the need arises later in the year, the credit has already been approved. All you need to do is provide the bank with the invoice. Then the equipment is funded under the guidance line and immediately put on appropriate repayment terms.”
DiFatta stresses that the strong and healthy communication that is so important to a banker/lender relationship is a two-way street. Lending partners are also responsible for adequately communicating how loans should and should not be used. As a business owner, make sure you understand these intricacies and that you know whom to call if you have any questions.
7. Monitor your business credit
Just as you monitor your personal credit, take steps to safeguard your business credit. Business credit reporting agencies offer credit tracking tools that allow you to monitor your financial risk and protect yourself from fraudsters. “These services are sometimes free, but even if they cost money, they are typically cheap and well worth the investment,” says Day. “Building business credit isn’t a sprint, it’s a marathon. It takes times, and tools like this can help.”
III. Understanding Trade Credit
Create and maintain healthy relationships with your vendors. If trying times arise, you may be able to negotiate extended terms. But keep in mind that just because you and your supplier have agreed to new parameters doesn’t mean that your vendor is accurately conveying this update to credit reporting agencies. “A vendor’s specialization is its business—not banking and credit. They may not necessarily understand how this all works,” warns Day. “A vendor might tell you your invoice is net 60, but they may have failed to communicate this exception to the accounting team.”
This is important, as financial partners will assess whether or not your vendor accounts are in good standing when considering your request for a loan. Sometimes a vendor’s reporting is outsourced or automated via a software service. In those instances, your account may also be reported as late, regardless of the new terms you’ve negotiated. Talk to your vendors about their reporting abilities and explain your concerns. And make sure to get everything in writing. If there is a discrepancy, you’ll be able to show your banker that the vendor has, in fact, granted you an extension of terms.
“Again, good communication is key,” says DiFatta. “Be proactive and forthright with your banker or loan underwriter. He or she can always make the decision to mitigate the risk of a credit score or red flag.”
IV. Purchasing Cards
In addition to using credit cards responsibly, consider purchasing cards as a means for elongating your business’s cash cycle, thus bolstering your credit safety net. Purchasing cards allow owners or employees to make purchases from approved vendors, and users are not charged interest. “A lot of our customers use them for travel and entertainment. They offer great control features to manage what types of expenses can go onto the cards, and you can customize this per employee,” says DiFatta. “I’ve also seen customers use them to buy inventory. In those scenarios, it really stretches out their cash cycle because the vendor gets its money immediately through the card, but our customer is only billed monthly.”
V. Understanding your business profile
Potential financial partners will assess your credit history and your vendor relationships, but they’ll also take the time to review your business profile, which is a document you create to summarize your mission, financials, and ability to generate revenue. The business profile is a marketing tool for potential investors or clients, as well as for lending institutions evaluating the health and potential of your business. Remember, banks want to ensure that any loan they extend will be repaid. Your business profile is a chance to demonstrate your reliability, stability, and transparency.
Day advises business owners to take this document seriously. To stay organized, he suggests creating a one-sheet that contains all of your business vitals, from address to banking information. This will help you stay consistent when you provide this information, whether it’s on a credit application or a marketing document. Day also urges business owners to monitor their social profile. Potential financial partners may review your online presence and note negative feedback, such as a complaint to the Better Business Bureau.
VI. Create a credit policy for clients
To help mitigate the risk of encountering an unforeseen cash shortage because a client can’t pay, create and enforce your own credit policies. “Business owners should create this credit plan at the very beginning, just as they did their business and marketing plan.” says Dunn. “A credit plan will protect your business’s biggest asset – its cash.”
Make sure this plan is in place before you start extending credit to customers. “Best practices include checking every customer’s credit history before extending credit, offering early pay discounts, charging a late fee or interest, and staying on top of accounts that start to become past due,” she says.
In general, business owners should approach business credit the same way they do their personal credit. Cultivate it early—before a need arises. Monitor it frequently, and take relationships seriously—with your clients, your lending partners, and your vendors. Business credit is a number, but a business credit safety net is unachievable without relationship management, clear communication, and transparency.
