By Dean Kaplan+
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 is the eighth article in a nine part series about financial statement analysis. This article 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.
Click here if you are ready to go on to the final article in this series Financial Statement Analysis And Debt Collections 9 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.