By Dean Kaplan+
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 is the sixth article in a series of nine articles about financial statement analysis. This article 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
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
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.
Click here if you are ready to go on to the next article in this nine part series Financial Statement Analysis And Debt Collections 7 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.