By: Gene Tanguay
Don’t overlook cash. It is often overlooked and yet the most critical component of financial statement analysis. Cash ratios are essential to credit scoring and to greatly mitigating credit risk. Incorporate in-depth, highly proficient and sophisticated cash ratios into your credit scoring model to assess cash retention, cash generation and cash burn rates. Cash scoring ratios demonstrate a high correlation in a customer’s ability to meet its ongoing debt obligations, capital expansion and future working capital requirements from the company’s operation. Cash scoring analysis is the true indicator of a company’s solvency as it depicts the sources and uses of funds generated from the income statement and balance sheet activity to determine the financial viability of a company. Save your company from a detrimental financial decision or provide an integral decision making tool to justify credit extension to a customer using cash scoring analysis.
Traditional credit scoring focuses primarily on the income statement and balance sheet with a lack of emphasis on the statement of cash flow. A strong credit scoring system can reviews 75 financial ratios or more including over 30 cash ratios. It should be based on a direct review of thousands of trade/financial accounts. Utilizing a comprehensive credit scoring system, with about 75 financial ratios, provides a company the ability to assess customer risk from all different industries with the same credit scoring model and achieve operational efficiency.
Credit scoring, with a strong emphasis on cash flow analysis ( as outlined in examples below), essentially sets credit limits for viable customers, provides prudent risk ratings, increases sales, profits and cash flow, decreases bad debts and improves decision making, resulting in lower operating costs.
Scenario One: Income statement shows a large net loss stemming from non-cash items such as a write down of assets, restructuring charges and early extinguishment of debt resulting in no credit limit.
Solution: Use the statement of cash flow to demonstrate positive cash flow from operations and no cash burn rate. Operations are profitable outside one time charges, consequently, major support for a credit limit.
Scenario Two: Highly leveraged company with total debt to equity in excess of three to one causes extensive concern that customer will not be able to meet their current debt obligations. Credit limit is declined.
Solution: The statement of cash flow reveals the company is generating significant cash flow from operations, with no cash burn rate, enhancing cash reserves to meet payments for accounts payable, short term debt obligations of principal and interest; consequently, justification for credit extension.
Scenario Three: Manufacturing firms who have long lead times to drive products to markets (slow inventory turnover) exacerbated by slow turnover of accounts receivable can exhibit cash flow problems and slow pay vendors. As a result, company may not have credit extended to them.
Solution: The company is generating strong cash flow from operations derived from normal operations to offset cash shortfalls created from slow accounts receivable and inventory turnover. Also, the company has strong cash flow from operations to cover its investing and financing activities. As a result, the customer has ample cash resources to meet vendor payments, thus major support for a credit limit.
Scenario Four: It is possible for a company to be showing profits from a one-time sale of a division or early extinguishment of debt or a satisfactory working capital ratio but yet there could be a potential major cash flow problem.
Solution: Upon closer inspection it is revealed that the company is incurring a net loss from normal operations. Also, the customer has slow turnover of accounts receivable and inventory, strong cash burn rate and a significant diminution in its cash balance correlating with potential severe cash flow problems and bankruptcy, thus major support for revocation of credit limit.
Scenario Five: Regarding bad debt reduction, watch for large or small companies that have mature business products with little sales growth, eroding gross margin, weaker cash flow due to lower profit margins and deteriorating customer base. A culmination of the above facts precipitates a company to increase its borrowing and leverage its position.
Solution: A strong credit scoring system is designed to catch these red flags and revoke credit limit privileges when liquidity, cash flow, profitability and leverage are all negatively impacted leading to a potential bankruptcy.
Credit scoring with financial statements is not completely inclusive of all credit risk; for example, it does not aid in prediction of losses due to natural disasters, fraud or inadequate audit reports. However, it should be based on thousands of credit reviews to greatly strengthen the risk scoring classifications and ultimately the credit operation. Credit scoring through financial statement analysis presents the best model to evaluate credit risk. It can be used as a standalone credit decision making tool in 80-90 % of the credit decisions.
All other scoring modules that exclusively use metrics such as: pay performance, management history, strength of competition or customer base, years in business, lien and suit searches, fall short of the pertinent information contained in financial statements. But there are certain situations where other data outside financial statements is important. For example, other sources (D&B, trade/bank references) need to be consulted when there are no financial statements, borderline credit decision, and new customers to ascertain if a company is a legitimate business or advise of any prior bankruptcies.
In summary, credit scoring with financial statement analysis benefits include the following: increase sales, profitability and cash flow, reduce operating expenses and mitigate bad debt.
Due to SOX compliance measures it is most difficult for public companies to commit fraud which heightens the integrity of credit scoring model. Credit scoring with financial statement analysis should be based on 75 or more financial ratios representing thousands of companies from small to large, different industries and all parts of the world. It should be low priced, has financial scoring analysis that assesses customer strengths and red flags plus credit limit recommendations. Also it is recommended that this credit scoring model has the flexibility to fit customers from a variety of industries including: retail, manufacturing, biotechnology, software, construction and finance companies.
An excellent credit scoring system with financial statement analysis is designed to average out risk between leverage, liquidity/cash flow and profitability to ascertain the true financial viability of the customer. Don’t overlook cash; cash ratios are essential to risk management.
Author: Gene Tanguay, BA, MBA Founder of Credit Scoring for Success, Former Certified Credit Executive Passed CPA Exam. Expert in accounts receivable credit risk assessment for portfolios up to $2 billion. Performed customer credit reviews up to $500M credit limit. Received management awards for outstanding performance in financial statement analysis. Published credit articles for Credit Management Association and Credit Today. Conducted credit presentations at Hitachi and Advanced Micro Devices.