Covering Credit Digest

By Michael Dennis and Steven Kozack
Source: www.coveringcredit.com


Topics:
1) The Limitations of Customer Financial Statement Analysis
2) Using Objective and Subjective Data to Establish Credit Limits
3) Ideas for Using Email More Effectively as a Debt Collection Tool

1) The Limitations of Customer Financial Statement Analysis

By: Steven Kozack

These are some of the limitations of financial analysis that credit managers must be aware of when they are reviewing a customers financial statements:

• Past financial performance, good or bad, is not necessarily an accurate predictor of future performance.

• Financial statements do not tell you about changes in senior management.

• Financial statements do not tell you about the loss of major customers.

• Financial statements do not tell you about the competitive environment in which the company operates.

• Financial statements do not disclose the company's future prospects, or the results of its expenditures on Research and Development, or new product introductions, or new marketing campaigns, or new pricing strategies, or the customers recent decision to enter or exit a particular market segment.

• The more out-of-date a customer’s financial statements are, the less reliable they are as a risk management tool.

• Without reading the Notes to the financial statements, credit managers cannot get a clear idea of the risk they are evaluating.

• Unaudited statements may or may not follow Generally Accepted Accounting Principles, and if they do not follow GAAP relying on them could be a serious mistake.

• Financial statements can be altered legally by adjusting certain types of reserves.

• Financial results can be improved by reducing or eliminating discretionary expenditures - even if this cost cutting is at the expense of long-term growth and profits.

• Foreign financial statements do not follow GAAP. In some cases, local accounting rules are so different from GAAP accounting rules that it is easy to make the wrong decision after reviewing the foreign financial data.

• Unaudited statements may be inaccurate, misleading, or even deliberately fraudulent - and if they seem too good be true, they may be just that.

• To see the big picture, it is necessary to have at least two consecutive periods of financial statements for comparison. Trends will only become apparent this way. The corollary is that it is not enough to know a customer's financial weaknesses. It is also important to know whether the customer’s financial performance is weak but improving or weak and deteriorating.

• Audited statements do not guarantee accuracy.

• Even audited financial statements are subject to a degree of manipulation.

• Off balance sheet financing is lawful, but can have a devastating effect on a customers financial health.

• The fact that a company is publicly traded and its financial statements are readily available does not guarantee that the company in question is financially stable and creditworthy.

2) Using Objective and Subjective Data to Establish Appropriate Credit Limits and Terms for Customers.

By: Michael Dennis

After studying a customer's financial statements, it is important for the credit manager to develop a "feel" for the customer's overall financial health. To be comprehensive, the financial review should include both objective data analysis and a more subjective review of the information gathered. Objective analysis involves traditional methods of number crunching and data analysis. The subjective evaluation ends when the credit manager can answer these questions:

Overall, how is this customer doing financially?
And
Does extending credit to this customer in the dollar amount requested pose an acceptable or an unacceptable risk?

The objective analysis would include a review of all of the following items:

• The nature of the audit opinion given by the company/customer's independent CPA audit firm.

• Any unusual accounting methods used by the customer

• Any unusual information found in the notes to the financial statements

• A study of any significant contingent liabilities as reported in the Notes to the financial statements

• A review of the customer's bank loan covenants, as well as an in depth analysis of any reported loan covenant violations --- including discussions with the bank about their response to the loan covenant violations.

• Due dates or balloon payments due on long term debts

• Financial ratio analysis, and trend analysis

• Anything unusual found in comparative analysis

• Financial profitability analysis, Financial leverage analysis, Liquidity analysis, and Financial efficiency analysis

Each item listed above is important in the subjective interpretation of the customer's overall financial health. In particular, it is key to interrelate and correlate the financial strengths and weaknesses of the company under review.

This analysis, combined with information about the customer's payment history, trends in the customer's industry, changes in the overall economy, and changes in demand for the customer's products and services can and should be used to develop a holistic understanding of the customer's prospects, as well as the opportunities and challenges facing the customer.

Only after both objective subjective data have been reviewed and evaluated can the credit manager make a reasonably well-informed decision about whether to extend credit [or continue to extend credit] to the customer or applicant.

3) A Few Comments about the Bankruptcy Filed by The Wherehouse

By: Steven Kozack

One of my consulting clients had a large [low six figure] A/R balance outstanding with The Wherehouse when this company filed for Chapter 11 bankruptcy protection earlier this month. I looked at my notes to see what advice or comments I had offered to this client about The Wherehouse and I found a memo that contained these points…

• Any open account sales to this customer must be considered high risk

• Notwithstanding the statements made by the secured creditor that it plans to work with the debtor, I remain concerned that a bankruptcy filing may occur in January 2003, at a point in time where cash on deposit combined with relatively low inventory levels would make a bankruptcy filing more attractive to a secured creditor.

• In similar situations, I have also seen bankruptcies occur not as a result of action taken by the secured creditor, but as a result of a cascade effect that starts when a major trade creditor reduces or withdraws its line of credit to the customer, and other trade creditors follow suit.

• Everything I read about projections for the upcoming Christmas season suggest that sales would be lackluster.

• The availability of copyrighted music on line will for the foreseeable future continue to damage sales for companies including The Wherehouse.

I take comfort in the fact that senior management was made aware of the risks associated with selling to this company, and chose to continue to sell to this company. I have no argument with this decision because senior management, aware of the risks, made an informed business decision about continuing to supply this important customer.

One final comment: The risks associated with selling to The Wherehouse were such that it would have been inappropriate for the credit department to have made this critical decision unilaterally. Specifically, the account was too important to simply cut off, and the risk was too significant for the credit department to ignore. I believe this is an excellent example of a scenario in which the credit department MUST involve senior management in the decision making process.