Financial Statement Analysis And Debt Collections

Credit analysis will help avoid future debt collection.
By conducting thorough credit analysis before extending credit to a potential new customer, businesses can reduce the need for debt collections in the future by making smarter credit decisions.

Financial statement analysis is an important element of credit analysis and can help prevent the need for debt collections down the road. Depending on the amount of credit a customer is requesting from a company, the financial statement analysis can be quite extensive. The higher the credit line, the more extensive the financial statement analysis process might be. This section will summarize the typical credit analysis performed by the credit department before the financial statement analysis.

Credit Analysis

In general, several sources of information are used to determine the credit risk of a potential customer and the credit line to extend to the customer. These sources include the company’s credit application, credit agency reports, trade references and banking information. After completing these aspects of the credit analysis, the final step is financial statement analysis which will be discussed in future articles in this series.

The typical credit application which the company asks the potential customer to fill out collects a lot of information about the company including:

  • The company name and address.
  • The organizational structure of the company (i.e., corporation, partnership, or proprietorship).
  • The product lines sold by the business.
  • How the business operates.
  • How long the business has been in existence.

The credit agency reports are a good source of information about:

  • The owners of the business and their backgrounds.
  • The history of the company.
  • Whether or not the company is currently involved in any lawsuits
  • A summary of the company’s financial performance.

Using the above information, a credit department can usually get a pretty good idea of the potential customer’s credit needs and requirements. Analyzing these data can also provide the credit department with a basic understanding of how the potential customer’s business operates and how it would be to become a supplier to the customer.

Banking information is usually requested from potential customers as part of the credit application. When looking at banking information, the credit department should request information about the deposit as well as the line of credit relationships. Below is banking information that should be requested:

  • How long the potential customer has been a customer at the bank.
  • Deposit balances for all accounts (i.e., checking accounts, certificates of deposit, etc.).
  • The dollar amount of lines of credit.
  • The origination date for any loans.
  • The dollar amount currently available on lines of credit.
  • The expiration dates of any lines of credit.
  • Details of any restrictions assigned to loans or lines of credit.
  • Any violations relating to loans or lines of credit.

One important reason to carefully examine bank information is that these data provide a good indicator of a potential customer’s payment history as well as their ability to pay. Any loan violations are also very important signals. Banks can pull a line of credit due to a loan violation. If a line of credit is frozen, this can negatively impact a potential new customer’s ability to pay, making them a less than desirable credit risk.

Most credit applications request references from three or four of the potential customer’s current suppliers. These suppliers are usually asked to supply:

  • The dollar amount of the credit line extended to the potential customer.
  • How long the supplier has been doing business with the potential customer.
  • The dollar amount of the highest credit extended.
  • The current balance of the potential customer with the supplier.
  • A summary of the payment history of the potential customer.

The data collected from trade references should give the credit department a good idea of the credit worthiness of the potential new customer. If the potential customer has not had a good payment pattern with existing suppliers, chances are good that this will be the case with your company as well.

Collection agencies do not usually perform credit analyses. Credit departments are usually where credit analyses occur as they attempt to determine the credit risk of a potential new customer. The more effort put into credit analyses, the less likely there will be a need for debt collections in the future. When a credit department has an accurate understanding of a potential new customer, the correct amount of credit will be extended to them. When a customer runs into difficulties, this is when debt collections become a reality. At this point, internal debt collectors can begin to work to collect the past due invoices, or the credit department can hire a collection agency. No matter who attempts to collect the delinquent monies, the information collected in the credit analysis will be valuable because it will provide the debt collector with the correct contact information as well as other information that may be useful in negotiations. Time spent doing an in-depth credit analysis is rarely time wasted.

Financial Statement Analysis

Debt collection agencies understand how to interpret financial statments
After performing a credit analysis of a potential new client and deciding they seem like a good customer, businesses should conduct a financial statement review to confirm the customer will pay for their purchases.

Conducting a thorough financial statement analysis is an important step in any significant extension of credit and can prevent the need for future debt collections. The larger the credit amount requested by a new customer, the more thorough the financial statement analysis should be. This section will focus on an overview of financial statement analysis.

Once the credit department has examined a potential new customer’s credit application, bank statements, credit agency reports and trade references, an overall impression of the potential new customer should be possible. Does this look a customer the company would like to do business with? If the answer is yes, the final step in the credit analysis process is a careful look at the potential new customer’s financial statements for the past couple of years. Often the financial statements will confirm what you have gleaned from your credit analysis up to this point.

One of the benefits of financial statement analysis is that it enables the credit department to really hone in on the potential new customer’s sources of payment. Every company has four major sources of cash: net profits, converting an asset into cash, increasing liabilities, and increasing equity. A company must bring in more cash than it spends in order to be able to pay off any debt it may owe. In most cases, to make debt payments, which are considered short term liabilities, the source of the cash is from conversion of an asset into cash. Usually this is represented by selling inventory to create an accounts receivable, which will become cash in the short-term. This cash is usually what is used to make debt payments.

When the potential new customer provides the credit department with its financial statements, there will usually be two statements for each year submitted: the income statement and the balance sheet. When a company’s financial statements are prepared by a certified public accounts (CPA), the financial statements will be comprised of an opinion, an income statement, a balance sheet, a statement of retained earnings, a statement of cash flows, and any notes to the financial statements created by the CPA.

Collection agencies typically are not involved in credit or financial statement analyses. This does not in any way suggest, however, that collection agencies are not equipped to analyze and fully understand all financial statements. When a customer becomes delinquent in its payments, a company can either use its own internal debt collectors to perform its debt collections, or it may choose to hire a collection agency. Usually a collection agency is brought in when accounts receivable collections become an unmanageable problem. When a credit department turns over claims to a collection agency, the more information they provide the agency, the better job the agency will be able to do. Financial statements are an important part of the picture when assessing a debtor’s ability to pay. Accurate contact information coupled with a clear picture of a debtor’s financial strength or weakness will give the professional debt collector an advantage when debt payment negotiations begin. Even if a debtor cannot pay a debt in its entirety right away, often, payment terms can be reached which are satisfactory to both the debtor and the creditor. Frequently, accurate information is the key in this negotiation process.

Financial Statement Reliability

Debt Collections can be better facilitated if financial statement analysis is performed before extending credit
A financial statement review conducted by a CPA (Certified Public Accountant) is the most reliable type of credit analysis.

When a credit department is considering a large credit limit for a potential new customer, financial statement analysis is critical to determining the credit worthiness of the customer as well minimizing the need for future debt collections. This section will discuss the reliability of financial statements.

Obviously, for the credit department to make sound credit decisions, the facts upon which the decision is made must be accurate and reliable. In general, there are four different types of financial statements: audited statements, compiled statements, reviewed statements and management prepared statements.

Audited financial statements represent the most reliable of financial statements because they are prepared by a Certified Public Accountant and reflect a very careful examination. Because the financial statements are prepared by a professional accountant, they come with a professional opinion, and therefore provide the credit analyst with the assurance that the financial statements were prepared accurately and reflect the true business picture. The CPA who prepared the statements is legally liable for the opinion which accompanies the financial statements, making the credit analyst very comfortable with the findings as they relate to the ultimate credit decision.

The CPA’s opinion is provided in the cover letter of the financial statements. There are four different levels of opinion, each with a differing level of responsibility taken on by the CPA:

Unqualified opinion — The CPA is willing to take the maximum level of responsibility for the financial statements. In this opinion, you will not see phrases such as “except for” or “subject to.” These phrases are a red flag that the opinion has qualifications.

Qualified opinion — The CPA is willing to take the maximum level of responsibility for the financial statements except for the points listed in the qualifications.

Disclaimer of opinion — The CPA is unable to render any opinion about the financial statements because of serious scope issues. In this scenario, the CPA does not take on any significant responsibility for the financial statements.

Adverse opinion — The CPA states that the financial statements are not acceptable because of noncompliance with Generally Accepted Accounting Procedures (GAAP).

It is not uncommon to be presented with unaudited financial statements from potential new customers. Oftentimes, a CPA will compile these financial statements for the customer, but will not offer any opinion about the statements. Unaudited financial statements prepared by a CPA fall into two categories.

Compilation — The CPA uses the client’s books and records to prepare the financial statements. The compilation does not include any analysis or verification of the accounting methods used in the client’s books and records. Therefore, the CPA takes no responsibility or liability for the financial statements.

Review — The CPA uses the client’s books and records to prepare the financial statements. The CPA performs some analysis and verification of the accounting methods used in the client’s books and records. The CPA offers a limited opinion that the accounting methods used by the client are in keeping with GAAP.

Sometimes the credit department may be presented with management prepared financial statements. This could happen for interim period analysis or if the company is privately held or very small. When faced with management prepared statements, be sure to utilize all the other components in the credit analysis such as the credit application, credit agency reports, banking information and trade references to reaffirm what is learned from the financial statements.

Once a potential new customer becomes a true customer, hopefully, the credit analysis including financial statement analysis gave the credit department a true picture of the customer. Sometimes, however, even customers who seemed credit worthy can run into tough times and end up with debt collections. When this happens, the financial and credit analysis data can still come in handy. When debt collectors become involved, the first step is to put together a debt collection file which includes all credit analysis information as well as unpaid invoices, contracts, etc. All of these data must be carefully examined before any contact is made with the debtor. Bringing a collection agency onboard to deal with delinquent customers can be an attractive option, especially if keeping the customer is a goal. Professional debt collectors can pursue debt collection using more aggressive methods because they are not involved in the ongoing relationship. The agency is a third party working on behalf of the credit department.

Credit Investigation Levels

Debt collections can be avoided by performing the right credit analysis before extending credit.
Different levels of credit analysis should be performed for businesses requesting different amounts of credit.

To what extent the credit department evaluates a potential new customer’s credit risk depends on the level of credit the customer wishes to establish. Thorough credit and financial statement analyses can give a company confidence in a new customer, and can prevent future debt collections at the same time. This section will discuss how the level of credit investigation should change depending on the credit level requested by the new customer.

Every company should develop a credit policy which gives the credit department the necessary steps to take to authorize a specific level of credit to a new customer. The policy should be tiered, with increasing levels of scrutiny required for each increasing tier of credit. The analytical requirements of a credit policy are usually determined by looking at industry norms, the size of the company (how much credit can the company afford to extend) and the willingness of the company to take on risk in an effort to increase its market share.

For smaller potential new customers (for example, a customer who requests a credit limit of less than $25,000), the amount of effort put into the credit analysis will be less than for larger customers. A credit policy in this case could require the credit department to examine the completed credit application, check bank references and ascertain account balances and any available credit, and check trade references to understand credit lines extended, credit line usage and payment history. Once these data are evaluated, the credit department could decide whether or not to set up an open account for the new customer, and what credit line will be extended to the customer.

For larger potential new customers (for example, a customer who requests a credit limit in the $25,000 to $100,000 range), all of the above data could be analyzed as well as checking credit reporting agency data for payment history and examining the past three years of financial statements. This data would provide the credit department with varying sources of similar information, providing an opportunity to crosscheck the customer’s payment history, bank account balances and available credit and the overall financial health of the customer’s business.

When the credit department analyzes the customer’s financial statements, the place to start is with the Accountant’s Opinion. The opinion would bring up any irregularities found in the company’s financial reporting or management actions. The next step is to read all accompanying notes to the financial statements. These notes will help the credit department identify any unusual accounting procedures, ongoing or potential litigation, upcoming large loan maturities that could negatively affect cash flow or other events that occurred during the reporting period which do not appear in the financial data reported.

The final step in the analysis for this level of credit is for the credit department to look at the financial statements themselves. The financial statement analysis includes ascertaining the company’s net worth to see if it strong and stable, comparing the company’s financial data to known industry standards, determining if the company’s working capital position is adequate for the level of credit requested, and confirming the profitability of the company. These data should give the credit department plenty of information to make an informed credit decision.

For even larger potential new customers (for example, a customer who requests credit in excess of $100,000), additional management approvals could be required. The credit manager, credit director and chief financial officer could have different levels of authority to make credit decisions. For increasing levels of credit, different levels of management sign-off could be required.

In this situation, the credit department would conduct all the credit analysis previously discussed, plus an even more in-depth look at the financial statements including calculation of a number of analytical ratios. Typically for this level of potential new customer, the credit department would put together a written analysis of the credit worthiness of the customer in a narrative format including a recommendation of the credit to be extended. This report, along with the data used to arrive at the conclusions could be sent to key management for the final credit decision. Once management has made the credit decision, the customer would be assigned the appropriate credit line and the business relationship would begin.

Collection agencies do not typically perform credit analysis; however, a few professional debt collectors are usually skilled at understanding and gleaning important debt collection information from a debtor’s financial statements. Debt collections can become necessary even with customers who have never had accounts receivable problems before. Tough economies and unforeseen industry challenges can sometimes appear seemingly out of nowhere. When accounts receivable collections get out of control, credit departments may decide to hire a collection agency to help get things back on track. All of the credit analysis done when a customer was under consideration should be turned over to the collection agency along with all past due invoices and other contractual information. The professional debt collector will spend a lot of time looking at the customer’s credit history to determine the best debt collection action to take. The debt collector must be fully up to speed on the client before the first contact is made. This preparation is what makes debt collectors so successful where in-house collectors fail. When looking at the credit worthiness of a new customer, the time spent on the credit analysis is usually time well spent, even if later on debt collection becomes necessary.

Net Income Analysis

Debt Collections can be avoided by analyzing a company's financial statements.
By analyzing a company’s financial data from the past few years, companies can gain a better idea of a customer’s credit reliability. This will help avoid the need for debt collections in the future.

When the credit department analyzes a potential new customer’s financial strength, the financial statements provide a wealth of information. In addition to making credit decisions, careful analysis of the finances of a business may also help prevent future debt collections. This section will discuss the first step in financial statement analysis: understanding the company’s net income.

When the credit department embarks on the analysis of a potential new customer’s business operations, careful examination of the income statement is paramount. Corporations must always seek to maximize the return to shareholders. A good indicator of how well a corporation has achieved this goal is its net income.

The income statement summarizes the revenues and expenses of the company and covers a specific time period. A good way to examine a company’s income statement is to look at trends that occur over time. This technique is called common-sizing the financial statements. By spread sheeting several years of financial data in side by side columns, it becomes fairly simple to understand what has been happening across revenue and expense categories. When a particular category shows significant decline or increase, the trend must be understood.

Another good way to analyze a company’s operating performance is to conduct comparative analysis of the company in question with other companies within the same industry. A lot of industry average data are compiled annually by Dun & Bradstreet. Utilizing this industry average data can give the credit department a benchmark in its credit and financial statement analyses against which the potential new customer may be compared. Sometimes a decrease in a key indicator for a company when compared to the industry will show a similar trend. In this case, it may be possible to blame the industry experience for the decline of the new customer. Other times, the trends will not be similar, which will mean that the customer’s decline needs further investigation.

The credit department will examine each income statement category and look for large changes in performance from one period to the next, as well as variances relative to the industry’s performance. Since net income represents a company’s biggest source of cash, the credit department will want to hone in on whether the customer’s net income was increasing or decreasing and similarly look at sales trend data.

Profitability ratios and how these ratios change over time is another way to analyze a company’s operating performance in recent times as well as into the future. Profitability ratios are of particular importance in understanding a customer’s ability to generate returns given the capital invested. Below are three profitability ratios which can be helpful in making this determination:

Profit Margin on Sales measures the profit a company generates for every dollar of sales. The credit department should calculate the ratio for the past few years to look for trends and also compare the company’s ratio to the industry ratio for the same periods.

Profit Margin on Sales = Net Income
Net Sales

Return on Total Assets determines whether or not a company is efficiently utilizing its assets. This ratio measures the net income generated per dollar of investment into assets. The credit department can compare the customer’s ratio to the industry ratio to see if the customer is investing more capital into equipment than is typical for the industry. If the ratio is unusually high or low compared to the industry, further analysis of the income statement is indicated.

Return on Total Assets = Net Income
Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets)/2

Return on Stockholder’s Equity measures the net income of a company relative to the investment made by the owners of the company. This ratio represents how effectively the company’s management maximized the return to common stockholders of the company, and is an indicator of how attractive the company is to new investors.

Return on Stockholder’s Equity = Net Income – Preferred Dividends
Average Common Stockholder’s Equity

Common-sized financial statement analysis coupled with ratio analysis can give the credit department a solid picture of the financial strength or weakness of a potential new customer. These data and the other date collected for the credit analysis should provide the credit department with a high level of confidence when making the credit decision for a potential new customer as well as determining the correct level of credit to extend.

Making sound credit decisions should help the credit department minimize its need for future debt collections. However, no matter how complete the credit and financial statement analyses are, some customers will become delinquent. When this happens, the time to take action is sooner than later. Studies show that the longer an account goes unpaid, the less likely it is that the debt collector will be successful. The lesson to be learned for the credit department is to keep a close watch on how accounts receivable age. As soon as an account ages to 45 days, an in-house debt collector should contact the customer and find out what is going on. The debt collector can make contact early with a helpful attitude and hopefully motivate the customer to make a payment. By contacting the delinquent customer early, the lines of communication are opened. If things don’t turn around quickly, the credit department can choose to let the in-house debt collectors continue to work the claim, or they may choose to hire a collection agency. Collection agencies are experts in account receivable collections and can often achieve a successful debt collection, especially if the account is not too far overdue. All of the information collected and analyzed for the initial credit decision can be helpful in debt collection negotiations. When turning over a claim to a collection agency, be sure to include all these data in the file.

Financial Strength of a Potential Customer

Debt collections can be avoided through financial statement analysis.
Credit and financial statement analysis will allow you to determine the financial strength of a potential customer. This allows for credit decisions which minimize the risk of future debt collection needs.

The reason why credit departments conduct credit and financial statement analyses is to decide whether or not the company should take on the risk of extending credit to a potential new customer. This risk is what can sometimes lead to debt collections. In order to minimize the need for future debt collections, keeping the risk associated with extending credit to a minimum is critical. This section will focus on examination of the financial strength of a potential new customer.

Most of the information the credit department needs to look at to asses a customer’s financial position can be found on the balance sheet. How much debt a company has relative to its assets will provide the credit department with a view of the capital structure of the company. A determination must also be made of the customer’s ability to service its short and long-term debt. Ratio analysis can be helpful in the examination of a customer’s financial strength.

Total Liabilities to Total Assets is a ratio which measures how much of the customer’s assets have been financed by taking on short and long-term debt. The ratio is a way to measure the financial risk of a company because it compares borrowing to assets. If the amount of debt increases more quickly than the net income of the company, this indicates that external creditors are assuming greater risk when doing business with the company. When looking at the total liabilities to total assets ratio, it is important to compare the past several years’ ratios to identify trends. It is also good to compare these ratios to the industry ratios for like years. When making the comparison to the industry ratio, this will provide a guide for whether or not the company is taking on more debt than is typical in the industry.

Total Liabilities to Total Assets = Total Liabilities
Total Assets

Times Interest Earned measures a potential new customer’s ability to make interest payments on its debt obligations. This is a very important ratio for the credit department to look at because all creditors want debtors who are able to cover their interest expenses. A higher ratio value is preferred because this indicates that the operating income available to pay interest expenses will be significantly greater than the interest expense generated.

Times Interest Earned = Income Before Taxes + Interest Expense
Interest Expense

Collection Agencies do not typically perform financial statement analysis as part of the debt collection process. However, clearly, a financially strong company will be more likely to pay its debts. Therefore, if the credit department hires a collection agency to pursue accounts receivable collections, all of the analysis that was performed to determine the credit worthiness of the customer will be useful to the debt collector. When a debtor has a history of financial strength, this suggests that the debt collector will most likely be able to collect the delinquent accounts, assuming that the debt has not aged significantly. In general, if a debt goes uncollected for more than six months, the chances of collection go way down. Similarly, debt older than one year, is even less likely to be collected. When turning over an account to a collection agency, be sure to include all the credit and financial statement analysis data along with copies of invoices and any contractual information. The professional debt collector will spend significant time learning about the client and its financial history before any contact is made. This research by the collector is a key to the successful debt collection.

Liquidity Position of a Potential Customer

Financial statement analysis can help avoid debt collections.
Analyzing certain financial data and ratios for a potential customer can help determine their credit worthiness.

When a credit department makes a credit decision about a new customer, the basis of the decision is the credit and financial statement analyses. The financial strength, operating performance and liquidity are keys to this decision and to help to minimize the need for future debt collections. This section will examine how to determine the potential new customer’s liquidity position.

A customer’s liquidity position is its ability to meet short-term debt payments with its current assets, and is one of the most important measures looked at by the credit department to make credit decisions. There are two ratios that can be calculated to assist the credit department in its analysis of the liquidity of a potential new customer.

The Current Ratio is a measurement that compares current assets to current liabilities. In general, a ratio of 2 to 1 represents a relatively low risk potential customer for the short-term creditor. In this scenario, the creditor could feel confident in the ability of the customer to make timely debt payments. The lower the value of the ratio, the less desirable the customer is because a low ratio indicates that the customer might have trouble making timely debt payments. A low ratio often is indicative of a cash flow issue and in some cases can even lead to bankruptcy. When analyzing a customer’s current ratio, the future plans of management should be considered, as well as the economic times for the industry and in general.

Current Ratio = Current Assets
Current Liabilities

One thing a credit department must understand is that the Current Ratio can be “adjusted” by the customer’s management. Therefore, the current ratio alone should never be used to make credit decisions. All the information gathered for the credit and financial statement analyses must be taken together to create a complete picture of the potential new customer.

The Quick Ratio is another measure which can be used to test the validity of the Current Ratio because it does not include inventory in the asset number. The reason why inventory is excluded is because inventory is typically the least liquid of all the current assets. If the value of the Quick Ratio is close to the value of the Current Ratio, this is a good thing and means that most of the current assets truly are liquid.

Quick Ratio = Current Assets – Inventory
Current Liabilities

Another two financial ratios analyze a company’s return on investment. The ratios utilize data from both the balance sheet and the income statement to calculate Return on Investment and Return on Equity. A key benefit is that it examines how the company generates it profits, specifically looking at product sales and asset turnover. The method pinpoints the relationship between asset turnover and profit margins. In general the higher the profit margin, the lower the turnover and vice versa. The method also points out weak areas.

Return on Equity = Net Income
Equity

Return on Assets = Net Income
Assets

When looking at potential new customers, the credit department is not usually thinking about future debt collections. However, all of the work done to analyze the credit worthiness of potential new customers should help to minimize account receivable collections. Ratio analysis is an important part of the financial statement analysis because it helps the credit department analyze the customer’s ability to make debt payments. When a customer’s Current Ratio is very low, the potential for debt collection goes up. When accounts receivables go delinquent, the credit department can use in-house debt collectors to work the claims, or a collection agency can be hired. Often this decision comes down to available manpower. If staff is available, the credit department might decide to keep the debt collection in-house. If staffing is tight, a collection agency might be hired to work the higher dollar claims. The efficiencies provided by a collection agency are real because collection agencies employ only professional debt collectors. These debt collectors are trained to know the most effective and efficient ways to work claims and their success rates are typically much higher than in-house collectors. Agencies usually work on a contingency basis, so they only are paid when a debt is collected.

Cash Flow of a Potential Customer

Debt Collections can be avoided by analyzing financial data.
Analyzing a potential customer’s cash flow can help businesses make better credit decisions to avoid the need for debt collections.

For a large potential new customer, financial statement analysis is especially important. When extending a large amount of credit to a customer, the credit department must assure that the customer is credit worthy. This careful examination will also help minimize debt collections in the future. This section will discuss how to evaluate the potential new customer’s cash flow situation.

The cash flow statement of a company shows the inflow and outflow of cash as it relates to the company’s operations, investments and financing for a specified time period. The company’s operations include all activities which generate revenues. The cash flow relating to operations usually come from transactions which create income. The company’s investments include extending credit to customers and collecting payments from the debtors, as well as the purchase and sale of securities that are not classified as cash equivalents. The company’s financing includes taking out a loan from a bank or other creditor and making timely payments on the amount borrowed as well as obtaining investments from owners and providing them with a return on their investment.

There are two allowable ways to report cash flows as stated by the Financial Accounting Standards Board (FASB): The direct approach and the indirect approach. The direct approach is recommended by the FASB; however, the indirect approach is more typically employed by companies as the way to report cash flow.

The most significant cash inflow from operations for most companies comes from the sales of their primary products. Cash outflows from operations include supplier payments, employee payments, interest payments and taxes.

Cash flow generated from the investments of a company include buying and selling assets that will generate long-term profits, buying and selling securities that are not classified as cash equivalents, and making loans and collecting interest payments on those loans.

Cash flow relating to a company’s financing includes taking loans from creditors and paying back the borrowed amount and receiving investments from owners and paying the owners a return on their investment.

For each of the three categories of cash: operations, investments and financing, the credit department should calculate the net change in cash for the specified time period. The net change in cash represents the net increase or decrease in cash for the specified time period. Once the three categories have been calculated, the credit department should take the sum of the three categories. Next, the total net change in cash should be added to the beginning cash balance for the specified time period. This sum will equal the ending cash balance for the specified time period.

Careful evaluation of the cash flow statement will help the credit department get a feel for the future cash flow potential of the new customer. It will also provide the credit department with insight about how able the customer is to pay its debts. Finally, the cash flow statement will enable the credit department to identify and understand how the customer generates income as well the cash inflows and outflows. These data taken together with the other credit and financial statement analyses should give the credit department plenty of information from which to make the ultimate credit decision.

The cash flow of a company can have a big impact on debt collections. If a company has plenty of cash, it typically will not go delinquent on its accounts payable. Therefore, when a credit department takes the time to examine a customer’s cash flow statements, especially over the past several years, a pretty good assessment can be made about the company’s future potential as a good paying customer. When a customer becomes a problem, and accounts receivable collections are necessary, the credit department may decide to hire a collection agency. Collection agencies are particularly successful if the debt is not too old. When turning over an account to a collection agency, the credit department should include in the file all the credit and financial statement analysis data along with the contact information, invoices and any contractual paperwork. The debt collector will take all of this information and carefully research the customer and the claim before making the first phone contact. Professional debt collectors have a very high collection success rate because they know the best ways to motivate debtors to pay.

Operating Cycle of a Potential Customer

Calculating information about a potential customer's operating cycle can help make good credit decisions to avoid debt collections
Debt collections can be avoided by making smart credit decisions before extending credit to a new potential customer. Calculating information about a company’s operating cycle can help assist a credit department in making good credit decisions.

When the credit department makes credit decisions, it must evaluate a potential new customer’s ability to generate cash which can be used to pay its creditors. Determining that the customer operates with an adequate level of working capital relative to the industry will lead to a positive credit decision and fewer debt collections in the future. This section will focus on understanding the potential new customer’s operating cycle.

A company’s operating cycle is the number of days from inventory purchase to receiving payment for the inventory that was sold. The average number of days across all customers is considered the length of the company’s operating cycle. The length of this cycle will affect the company’s need for working capital to operate effectively. A company with a very short operating cycle will require less working capital to operate than a company with a very long cycle.

Days of Inventory on Hand measures the number of days it takes to sell the inventory of a company. To calculate the Days of Inventory on Hand, the credit department must first calculate Inventory Turnover. Inventory Turnover measures the cost of goods sold during the specified time period, and can be taken directly from the customer’s income statement. If the cost of good sold is divided by the average inventory during the same period, this will equal the number of times the inventory was depleted and had to be replaced, also known as Inventory Turnover.

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
For example, $100,000/$20,000 = 5.0 inventory turns

Next, the credit department should calculate the number of days it took to deplete (turn) the inventory. This is called Days Inventory on Hand.

Days Inventory on Hand = 365 Days ÷ Inventory Turnover.
For example, 365/5 = 73 days

The Average Collection period is another operating cycle ratio which measuring the number of days it takes to turn accounts receivable into cash. To calculate this ratio, the credit department must first calculate Accounts Receivable Turnover. In most cases, a rough estimate of Accounts Receivable Turnover is represented by the Total sales for the specified period divided by the average accounts receivable for the period.

Accounts Receivable Turnover = Total Sales ÷ Average Accounts Receivable.
For example, $200,000/$50,000 = 4.0

In this example, accounts receivable is turned into cash 4 times in the time period.

The next thing the credit department should calculate is the average number of days it takes to turn the accounts receivable into cash.

Average Collection Period = 365 Days ÷ Accounts Receivable Turnover.
For example, 365/4 = 91 days

The credit department now has all the data needed to calculate the customer’s operating cycle:

Operating Cycle = Days Inventory on Hand + Average Collection Period
For example, 73 + 91 = 164 days to go from inventory purchase to cash from sale of inventory.

The reason why the length of a customer’s operating cycle matters is because it represents how efficiently the customer manages its current assets. By comparing its cycle to the industry and to other companies within the industry the credit department can see any discrepancies and look for answers if necessary. In addition, the operating cycle can help the credit department identify an inadequate level of working capital. Working Capital is pumped up when accounts receivable are turned into cash. Working capital is depleted when accounts payable are paid with cash. If accounts receivable are not increasing enough to keep up with accounts payable, then working capital is not adequate and a potential creditor must ask how the customer’s payment obligations will be met.

Days Payable Outstanding is another ratio which will help the credit department understand the customer’s working capital picture. It measures the number of days it takes the customer to pay its vendors for purchases. The credit department must first calculate the Accounts Payable Turnover for the specified time period.

Accounts Payable Turnover = Total Purchases ÷ Accounts Payable
For example, $50,000/$5,000 = 10 turns

Where Total Purchases = Ending Inventory – Beginning Inventory + Cost of Goods Sold
Accounts Payable is the Accounts Payable figure from the Balance Sheet

Days Payable Outstanding = 365 Days ÷ Accounts Payable Turnover
For example 365/10 = 36.5 days

In the example, the customer pays its vendors on average in 36.5 days. Comparing this number to the industry and other companies within the industry will tell the credit department if further investigation is warranted.

When making credit decisions, the credit department takes many factors into consideration. Financial statement analysis is particularly important when a new customer plans to buy large quantities of product and requires extensive credit. Taking the time for due diligence will enable the credit department to make the credit decision with confidence and will likely prevent future debt collections. Thorough credit analyses are particularly important during tough economic times. Many companies experience a squeezing of working capital when the economy goes south. Having less working capital makes it difficult for a customer to keep up with its debts. Hiring collection agencies to help with accounts receivable collections can be a very effective way of managing debt problems. Collection agencies are experts in debt collections. Often times, when working with a large delinquent customer, negotiation skills become paramount. If a dispute is involved, professional debt collectors have extensive experience and can overcome many obstacles that the debtor might try to put up in order to drag out or avoid the paying debt. Since most commercial collection agencies work on a contingency basis, payment is only required when the debt is collected. When times are tough and staffing is tight, collection agencies might be a positive choice.

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