By Dean Kaplan+
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 is the seventh article in a nine part series about financial statement analysis. This article 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
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
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
Return on Assets = Net Income
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.
Click here if you are ready to go on to the next article in this series Financial Statement Analysis And Debt Collections 8 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.