How To Evaluate Creditworthiness Of Your Customers - Man With Empty Pockets

How To Evaluate Creditworthiness Of Your Customers

Evaluating The Creditworthiness Of Your Customers Is Crucial For Success

Evaluating the creditworthiness of your customers is one of the most important things you can do to reduce risk and ensure the success of your business. This article will guide you through the critical processes and financial ratios to examine when performing credit analysis.

Why Credit Analysis Matters

Before extending credit, terms or financing, it's critical to determine if a customer has the means and intent to pay you back. Otherwise, you risk taking losses from delinquencies and defaults. Credit analysis gives you an objective way to evaluate creditworthiness.

Performing credit checks and analysis should be standard procedure, especially for high-value customers. Don't rely on intuition or take people at their word. Take the time to thoroughly vet your customers regularly.

Evaluating whether a company is creditworthy can be a daunting task. Here is a step-by-step guide to help:

Where to focus:

Focus on your biggest customers first, the larger the value you lend to them, the bigger your risk.

Key Information to Collect

To begin your credit analysis, you'll need to collect relevant documents and data on the customer:

  • General business information
  • Bank references
  • Trade credit references
  • Financial statements - at minimum the most recent audited income statement, balance sheet and statement of cash flows

Check References Thoroughly

Conduct comprehensive reference checks, contacting other customers they have traded with on credit in the past. Pick up the phone and directly contact the customer's references to verify details.

Ask about:

  • How long they've extended credit
  • The credit limit extended
  • Payment history - late payments? defaults?
  • Overall opinion on working with the customer.

Document everything for your records.

Review their audited financial statements:

Review the company's financial statements, which include the balance sheet, income statement and cash flow statement. The balance sheet shows the company's assets, liabilities and equity. The income statement shows the company's revenue, expenses and net income. The cash flow statement shows the company's cash inflows and outflows.

First we will look at the Income statement, calculating their profitability ratios, leverage ratios and liquidity ratios. Before we dive in, here is a quick explanation of the terms we use and what they mean:

What is Gross profit?:

Gross profit is a financial metric that measures the profit a company earns from the sale of its goods or services before the deduction of selling and administrative expenses.

How To Calculate Gross Profit:

Gross profit is calculated by subtracting the cost of goods sold (COGS) from the company's total sales revenue.

Here are some key points to understand about gross profit:

  • Gross profit is the income a business has left over after paying all direct expenses related to the manufacturing and distributing of its products or services.
  • Gross profit only includes variable costs that increase or decrease with the level of production output, such as direct materials, direct labour and factory overhead.
  • Fixed costs that are not directly tied to output, such as insurance and rent, are not factored into gross profit.
  • Selling expenses (which are indirect costs) such as sales people, sales commissions, advertising and marketing expenses are not included in the calculation of Gross profit.
  • Gross profit can typically be found partway down the income statement, prior to a listing of selling, general and administrative expenses.
  • Gross profit is more useful when tracked as a percentage of sales on a trend line to determine how effectively a company is leveraging its resources.

In summary, Gross Profit is the profit a company earns after deducting the costs associated with making and distributing its products or services. It's a useful metric for assessing a company's efficiency at using its labour and supplies in producing goods or services.

Operating Profit (Earnings Before Interest, Depreciation and Taxation):

Operating profit is the profit a company makes from its core business functions for a given period, excluding the deduction of interest, depreciation and taxes.

How to Calculate Operating Profit:

Operating Profit is calculated by taking revenue and then subtracting the cost of goods sold (COGS) and all other operating expenses.

In summary, Operating Profit is essential because it measures the profitability of a company’s core business operations. It is a useful and accurate indicator of a business's health because it reflects the residual income that remains after accounting for all the costs of doing business (except for interest costs, depreciation and taxation).

Net Profit:

Net profit reveals the profits of the organization after taking into account interest, depreciation and taxation. It reflects the success or failure of the business entity’s operations over a specific period, usually one year. 

How to Calculate Net Profit:

Net Profit is calculated as Operating Profit minus Interest Costs, Depreciation and Taxation)..

In summary, Net Profit shows the real profits after taking all expenses (including interest costs, depreciation and taxation) into account for that time period.

High Level Review of Financial Statements for Credit Worthiness

Carefully examine the customer's financial statements using these guidelines:

Income Statement

  • Is revenue growing sustainably?
  • Are expenses reasonable or outpacing revenue?
  • Is net profit consistently positive/increasing?

Balance Sheet

  • Are assets increasing or decreasing in value?
  • Is debt at reasonable levels compared to assets?
  • Is shareholder equity positive/growing?

Cash Flow Statement

  • Is operating cash flow consistently positive?
  • Are cash inflows/outflows reasonable?

Ratio Analysis To Determine Financial Health

Let’s begin with the more detailed ratio analysis to check whether our prospective customer is credit worthy:

Profitability Ratio Analysis:

We use 2 ratios to check profitability: Gross Profit Margin and Operating Profit Margin

Gross Profit Margin:

Gross Profit Margin is the ratio that calculates the company’s profitability after deducting the direct Cost of Goods Sold from Revenue. It is expressed as a percentage of sales. Gross Profit margin shows whether a company is running an efficient operation and how profitably it can sell its products or services.

How to Calculate Gross Profit Margin:

Gross Profit Margin is calculated by dividing Gross Profit by Revenue and multiplying your answer by 100 to get a percentage.

A higher ratio is better. Expect 40-60% for retail, 30-50% for wholesale/manufacturing.

 Example: Revenue of 200 with a Gross Profit of 50 gives a Gross Profit Margin of 50/200x100=25%

Operating Profit Margin:

Operating profit Margin is the ratio that measures the profitability of a company’s core operations after accounting for Operating Expenses and Cost of Goods Sold (COGS). It is expressed as a percentage of sales.

Operating profit margin is a valuable tool for comparing the profitability of various businesses within the same industry and tracking profitability trends over time because it is expressed as a percentage of sales rather than an absolute amount.

Aim for 10-20% or more. Higher is better.

How to Calculate Operating Profit Margin:

Operating profit margin is calculated by dividing operating profit by revenue and multiplying your answer by 100 to get a percentage: 

Example: Revenue of 200 with an Operating Profit of 24 gives a Gross Profit Margin of 24/200x100=12%

Net Profit Margin:

Net Profit Margin reveals the amount of profit that a business can extract from its total sales. It is the percentage of revenue left after all expenses have been deducted from sales.

A high net profit margin indicates that a business is pricing its products correctly and is exercising good cost control. Generally, a net profit margin in excess of 10% is considered excellent, although it depends on the industry and the structure of the business. Net profit margin is perhaps the most important measure of a company's overall profitability.

How to Calculate Net Profit Margin:

Calculate the net profit margin: Net profit margin is calculated by dividing Net Profit by Revenue and multiplying your answer by 100 to get a percentage.

 Example: Revenue of 200 with an Net Profit of 18 gives a Net Profit Margin of 18/200x100=9%

Liquidity Ratio Analysis:

Next we will look at some important ratios to understand how well the company is able to meet its debt obligations. This is a crucial area to investigate as it can highlight looming risks, even when a company is profitable.

How To Calculate The Debt-To-Equity Ratio:

Debt-to-equity ratio is calculated by dividing total liabilities by total equity. Below 1 is ideal, up to 2 is ok depending on industry. Higher ratios indicate more debt burden.

How To Calculate The Debt-To-Assets Ratio:

Debt-to-asset ratio is calculated by dividing total liabilities by total assets. This measures the percentage of assets financed by debt. Below 50% is good. Too high means increased bankruptcy risk.

How To Calculate The Interest Coverage Ratio:

Calculate the interest coverage ratio: Interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by interest expense. It evaluates the ability to pay interest expenses. Minimum of 3x is recommended. Higher ratios are better.

How To Calculate The Current Ratio:

The current ratio is calculated by dividing current assets by current liabilities. It tests short-term liquidity. 1.5-3x is ideal. Below 1 indicates potential cash flow issues.

How To Calculate The Quick Ratio:

Quick ratio is calculated by dividing current assets minus inventory by current liabilities. 1-1.5x is good. Much below 1 is a warning sign.

How To Calculate The Cash Ratio:

Cash ratio is calculated by dividing cash and cash equivalents by current liabilities. It measures cash cushion for paying near term liabilities. 0.5x minimum, 1x is better.

Compare ratios to industry benchmarks. Monitor changes in ratios over time.

Check the Customer's Business Credit Score

Business credit reports including scores from Experian or D&B provide an objective snapshot of the customer's creditworthiness based on payment history, collections, bankruptcies and other public records.

Document Everything

Keep detailed records on all aspects of your credit analysis for each customer. This provides support if you need to defend your credit decisions later.

Ongoing Monitoring

Creditworthiness changes over time, so conduct periodic reviews of higher risk customers. Watch for red flags like late payments.

Performing thorough credit analysis upfront allows you to extend credit confidently to trustworthy customers and avoid costly defaults down the road.

Want to learn cash flow management strategies used by elite cfo's to increase cash and grow profits? VIEW THE CASH MANAGEMENT SOLUTIONS

 

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