Credit Assessment & Credit Risk Ratios
Ratio’s
A purchased company report can give you a different, usually better view of the financial standing of the company than raw statistics.
One way of analyzing accounts is to calculate ‘ratio’s’. Ratios give you a set of figures to match against industry and company standards. For instance:
|
CURRENT RATIO = |
||
| Current Assets |
(say) £900,000 |
|
| divided by | Current Liabilities (say) £600,000 | |
|
= a Current Ratio of 1.5 |
||
A ‘current ratio’ between 1.0 and 1.5 is average: less than 1.0 is a risk: over 1.5 is not a risk. However, this is only one ratio: there are many ratio’s, some important, most are beyond the requirement of small company credit sales.
If you want/need to use ratio’s in your assessment of your customers, you need to fully understand what the relevance of each individual ratio means to you. I suggest you buy a simple book on understanding company accounts. There are many books available that have been written for the ‘non-financial manager’. However, not all published accounts are simple to read: which could mislead you to provide credit to a struggling company.
The following is a rough guide to acceptable ratio’s (remember, you must not rely on any one piece of information).
Current Ratio
| Low Risk | Average Risk | High Risk |
|
Over 1.5 |
1.0 – 1.5 |
Under 1.0 |
Current Assets divided by Current Liabilities: to assess ability to meet current/ short term liabilities.
Acid Test
| Low | Average | High |
|
Over 1.25 |
0.75 – 1.25 |
Under 0.75 |
Current Assets (less stock) divided by Current Liabilities: as above, plus, the test of the company’s true liquidity (actual cash, debtors -v- creditors, loans).
R.O.C.E.
This % figure should be higher than the borrowing rate of the company (e.g. bank base 7% + 2-5% = 9% to 12%).
‘Return on Capital Employed’. Profit before Tax divided by Capital Employed x 100: to assess the profit that the company’s assets are making, as a %.
Debt/Equity
| Low | Average | High |
|
Under 50% |
50 – 90% |
Over 90% |
Debt (loans, overdraft, etc.) divided by Equity (shareholders funds, less intangible assets etc.) x 100 =? %:to assess whether company is using external funding to supp ort business, or using their own money.
Profit/Sales
| Low | Average | High |
|
Over 10% |
3 – 10% |
Under 3% |
Profit before Tax divided by annual Turnover x 100: to assess profit margin of sales after costs.
Debtor Days Sales Outstanding (DSO)
| Low | Average | High |
|
Under 55 Days |
55 – 85 Days |
Over 85 Days |
Total of Debtors x 365, divided by annual Sales =? DSO the company’s ability to recover sales revenue.
Creditors Days Sales
| Low | Average | High |
|
Under 45 Days |
45 – 60 Days |
Over 60 Days |
Total of Creditors divided by annual Sales, x 365 Days: to assess the number of days to pay suppliers etc.
Visit Customer Premise
This is very much like walking into someone’s home. Within a short period you can evaluate standards, characteristics, preferences etc. If this option is available (especially an unannounced visit) take it.
Remember no one piece of information should be relied upon. If it looks good, but feels bad, start on a low credit limit (as low as you feel is necessary). If the customer has cash problems you will know soon enough. If you are not the cheapest supplier locally and the customer is new to you, you may be a short-term answer to the customer’s inability to pay their largest supplier. Without being paranoid, look for the reason behind the reason! You will find that if you ask a direct question ‘face to face’ with another person, you usually get near the truth.
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