Assessing counterparty financial capacity to mitigate risks in advance payments

1 August, 2025 | TNTP LAW | Legal newsletter

In civil and commercial contracts, especially those involving substantial transaction values, parties often agree on advance payments. In practice, however, the recipient may fail to fulfill their contractual obligations, resulting in disputes and financial losses for the paying party. Therefore, assessing the counterparty’s financial capacity must be considered a critical risk-control step prior to contract execution. This article outlines key criteria for evaluating a counterparty’s financial position to better safeguard the legal rights and interests of parties in civil and commercial transactions.

1.Definition of advance payment

An advance payment refers to a sum paid in advance by one party (typically the payer) to the other party (typically a portion of the total contract value) to enable performance of the contract obligations by the payee.

2.Legal risks arising from failure to assess financial capacity

Making advance payments without adequately assessing a counterparty’s ability to fulfill contractual obligations entails considerable legal risks, including:

The counterparty fails to perform their obligations and refuses to return the received amount;
The counterparty is insolvent, subject to enforcement measures, or undergoing dissolution or bankruptcy proceedings. In such cases, even if a favorable judgment or arbitral award is issued, enforcement may be infeasible due to lack of attachable assets;
The principal contract is declared invalid, and no agreement exists regarding the legal consequences of the advance payment, allowing the payee to delay reimbursement.

3.Criteria for assessing a counterparty’s financial capacity

Legal status and commercial standing
Verify the legal status of the enterprise through its Enterprise Registration Certificate and the information published on the National Business Registration Portal;
Verify whether the enterprise is undergoing dissolution, bankruptcy, temporary suspension of operations, or is subject to enforcement measures;
Assess the legal status of the legal representative and their capacity to enter into contractual obligations.
Financial documents and liquidity assessment
Request financial statements for at least the past two fiscal years;
Give priority to audited financial statements or those certified by an independent accounting firm;
Analyze key financial indicators: total assets, equity, debt-to-equity ratio, cash flow from operating activities, short-term and long-term liquidity ratios.
History of financial obligations and commercial creditworthiness
Examine whether the counterparty has a history of payment default, has been subject to legal proceedings or enforcement related to commercial contracts;
Verify reputation through feedback from past clients, partners, or credit institutions;
Assess the counterparty’s compliance with tax obligations, social insurance, and other financial liabilities.
Ability to provide security and commit to refunds
Determine whether the counterparty can provide a bank guarantee, escrow deposit, or collateral proportional to the value of the advance payment;
Assess the legality and enforceability of the collateral in the event of a dispute;
Clearly stipulate the handling of advance payments and specify the legal consequences arising from any contractual breach.

4.Financial due diligence methods

Depending on the contract value and the level of risk involved, enterprises may apply one of the following financial due diligence approaches:

Basic due diligence: Review legal and financial documents provided by the counterparty, combined with cross-checking data with relevant state authorities;
In-depth due diligence: Engage an independent third party to conduct a financial audit, credit risk assessment, and review the counterparty’s history of financial obligations;
Negotiated security measures: Where potential risks are identified, the paying party should consider requiring guarantees, escrow arrangements, or milestone-based disbursements.

5.Sample clause on advance payment in contracts

To minimize the risk of disputes concerning the repayment of advance payments, parties to civil and commercial contracts are advised to incorporate clear, detailed, and enforceable provisions governing the management of such payments and the legal consequences in the event of contractual breach. A well-drafted clause may include the following elements:

The value of the advance (either a fixed sum or a percentage of the total contract price);
The timing of the advance payment (e.g., prior to or upon contract execution, or in accordance with specific implementation milestones);
Post-advance performance obligations (e.g., performance must be completed within a defined timeframe);
Repayment obligations in the event of breach (e.g., failure to perform or partial non-performance);
Security measures to safeguard the advance (e.g., escrow arrangements, bank guarantees, or pledges of assets).

The assessment of a counterparty’s financial capacity must be regarded as an indispensable step prior to making any advance payments under a contract. This process not only serves as a means of financial risk mitigation but also enhances the effectiveness of contractual performance. Enterprises should establish internal procedures for conducting due diligence on their counterparties based on clearly defined criteria, especially in the context of high-value transactions. In parallel, it is essential to develop robust contractual clauses addressing repayment obligations, guarantee mechanisms, and legal remedies applicable to breaches concerning advance payments. Proactively managing risks from the pre-contractual stage contributes significantly to strengthening legal risk management, minimizing disputes, and safeguarding the enterprise’s legitimate interests.

The above is the article titled “Assessing counterparty financial capacity to mitigate risks in advance payments”, provided by TNTP for your reference. We hope this article proves useful to you.

Respectfully,