By Dean Kaplan+
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 is the fifth article in a nine part series of articles about financial statement analysis. This article 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
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.
Click here to go on to the next series in this nine part series Financial Statement Analysis And Debt Collections 6 of 9.
And be sure to check out the rest of the articles in this series:
- Credit Analysis
- Financial Statement Analysis
- Financial Statement Reliability
- Credit Investigation Levels
- Net Income Analysis
- Financial Strength of a Potential Customer
- Liquidity Position of a Potential Customer
- Cash Flow of a Potential Customer
- Operating Cycle of a Potential Customer
The Kaplan Group is a boutique collection agency specializing in large (over $10,000) debt collections due from businesses. Founded in 1991, the company has a stellar reputation (A+ rating with the Better Business Bureau) and is recognized as one of the leading collection agencies for results on large and complex matters.