Can Credit Analysis Save Me Millions?

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Millions are lost by companies who aren’t properly managing credit or onboarding customers the right way. If you have a lax process or no process at all, you’re exposing your business to potential financial risk and loss. What are you taking action on today to make a difference or are you ok with that?

Let’s discuss how things should look for your business and why Comprehensive Credit Analysis can be a life saver for your business if done right. I put this in a format this week so you can literally copy/paste a bunch of this to help your business.

Credit analysis is crucial for financial management, helping businesses mitigate financial risk and support growth all while being comfortable with the customers they are working with. By understanding the creditworthiness of clients and potential customers, businesses can make informed decisions, reduce the likelihood of bad debt, and foster sustainable growth.

This week’s edition of The Bottom Line explores key financial ratios and metrics used in credit analysis, best practices for conducting thorough credit checks, developing and implementing effective credit policies, and leveraging data analytics to monitor and assess credit risk continuously. ———> Credit analysis is ongoing. It’s not a 1-time pass/fail test and then ignored…..right?

Best Practices for Conducting Thorough Credit Checks on New Clients

Conducting thorough credit checks on new clients minimizes risk and ensures your business engages with creditworthy partners. Here are some best practices that I have put together for you over my 15 years in corporate finance:

• Gather Comprehensive Information:

  • Collect detailed financial statements from all customers if possible and especially any receiving potential credit north of $50k. I’d make this your starting point for it being required.

  • Obtain credit reports from reputable credit bureaus to assess credit history and payment behavior. I’ve had luck with Dun & Bradstreet over the years being cost affordable and if utilized correctly, it’ll provide tons of valuable insights for you/your team.

• Verify References:

  • Contact trade references provided by the client to gain insights into their payment history and business practices. Phone and email.

  • Speak with financial institutions and other suppliers to verify the client's creditworthiness. Banks will be tougher to provide detail most likely, but can confirm if in Good Standing so keep that in mind.

• Evaluate Financial Health:

  • Analyze key financial ratios and metrics to assess liquidity, leverage, profitability, and activity levels. See more below.

  • Look for trends in financial performance over the past several years to identify potential red flags.

• Assess Industry Risk:

  • Consider economic conditions and industry-specific risks that may impact the client's business. Think seasonality cash flow issues…

  • Compare the client's financial ratios with industry benchmarks to gauge their relative performance. Performing well or performing poorly?

• Set Credit Limits and Terms:

  • Based on the credit analysis, establish appropriate credit limits and payment terms. Who is approving this for your business?

  • Consider implementing tiered credit limits, where new clients start with lower limits that can be increased over time based on payment behavior and level of business.

I can’t stress enough how my 15 years in corporate finance always comes back to credit analysis many times when issues arise. If you aren’t in the line of finance, that’s ok and why I started Guernsey Consulting. Can’t hire an accountant full-time? I have you covered and can take care of this process for you at a significant discounted cost to your business.

Want to discuss? ———>Review and call me this week. It’s going to save you TONS over the life of your business.

Developing and Implementing a Credit Policy that Balances Risk and Sales

A well-defined credit policy balances the need to drive sales with managing credit risk. Here’s how to develop and implement an effective credit policy and how to keep your Sales team happy at the same time:

• Define Credit Objectives:

  • Establish clear objectives for your credit policy, such as minimizing bad debt, maintaining strong customer relationships, and supporting sales growth all while reducing financial risk.

• Set Credit Criteria:

  • Outline the criteria for extending credit, including the minimum financial health standards, required documentation, and acceptable credit scores that must be met.

  • Define the process for evaluating and approving credit applications. This needs to be detailed, but easily followed by internal team members. Want a free template? 

• Establish Credit Limits and Payment Terms:

  • Determine the credit limit and payment terms based on the client’s creditworthiness and your risk tolerance.

  • Consider offering early payment discounts to incentivize timely payments if this makes sense for your business model.

• Implement Monitoring and Review Processes:

  • Regularly review clients’ creditworthiness and adjust credit limits and terms as needed. High risk, frequent review. Low risk, semi or annual review. Adjust as needed.

  • Monitor payment behavior and take prompt action on overdue accounts to mitigate risk. ADP monthly and AR reporting monthly. This is an absolute MUST.

An effective credit policy not only mitigates risk but also supports business growth by enabling sales teams to engage with confidence, knowing that credit risks are well managed. In past roles, I have relayed to our sales groups that we want to onboard “financially healthy” customers….Train your sales team to know what this means.

Using Data Analytics to Continuously Monitor and Assess Credit Risk

Data analytics plays a transformative role in modern credit analysis, enabling businesses to monitor and assess credit risk with greater precision. Here’s how to harness the power of data analytics for your business:

• Leverage Real-Time Data:

  • Utilize real-time financial data and credit scores to stay updated on clients’ creditworthiness.

  • Integrate data from various sources, including financial statements, credit reports, and payment history, for a comprehensive view of how the customer is performing.

• Predictive Analytics:

  • Employ predictive analytics to forecast future payment behaviors and identify potential risks before they materialize. ADP/DSO…

  • Use machine learning algorithms to analyze historical data and predict default probabilities. ERP systems can be huge help here if this is something you can afford, if not we can show you how to build this out through Excel/Google Sheets.

• Segment and Profile Customers:

  • Segment customers based on risk profiles, payment behaviors, and financial health. Think in terms of A, B, or C players.

  • Develop tailored credit strategies for different segments to optimize risk management. Contact frequency, team member assignment, sales assignment, etc. all play a vital role in this.

• Monitor Trends and Patterns:

  • Analyze trends and patterns in clients’ financial performance and payment behaviors. Use DNB or something similar? You can pull this live through the platform.

  • Identify early warning signs of potential credit issues and take proactive measures to mitigate risk. “Pay you when paid” is a common cash flow issue and many miss this…There’s your freebie to take action if you hear this from a customer.

By leveraging data analytics, businesses can enhance their credit analysis processes, make more informed decisions, and manage credit risk more effectively. Who doesn’t want to save money, collect on time, and lower financial risk???

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Key Financial Ratios and Metrics Used in Credit Analysis

Financial ratios and metrics are essential in credit analysis, providing insights into a company's financial health and its ability to meet obligations. Here are some critical ratios and metrics that I use to help:

• Liquidity Ratios:

  • Current Ratio: Measures a company's ability to pay short-term obligations with current assets. A higher ratio indicates better liquidity.

  • Quick Ratio: Similar to the current ratio but excludes inventory, providing a more stringent measure of liquidity.

• Leverage Ratios:

  • Debt-to-Equity Ratio: Indicates the proportion of debt financing relative to equity financing. A lower ratio suggests less risk.

  • Interest Coverage Ratio: Measures a company's ability to meet its interest obligations from earnings.

• Profitability Ratios:

  • Net Profit Margin: Shows the percentage of revenue that translates into profit. Higher margins indicate better profitability.

  • Return on Equity (ROE): Measures the return generated on shareholders' equity. A higher ROE indicates efficient use of equity.

• Activity Ratios:

  • Receivables Turnover Ratio: Assesses how efficiently a company collects its receivables.

  • Inventory Turnover Ratio: Measures how quickly inventory is sold and replaced.

Understanding and analyzing these ratios provide a comprehensive picture of a company's financial stability and risk profile, forming the foundation for sound credit decisions. These are just skimming the surface of what you can measure, but will help you.

Pro Tip - build all of these out within Excel/Sheets and as you analyze financials/reports you can easily input details to obtain results to the above. Allowing you to either save in the customer file or use for the approval process.

TL;DR - That’s ok, I have you covered!

• Key Financial Ratios: Understand liquidity, leverage, profitability, and activity ratios to assess a company's financial health and creditworthiness.

• Thorough Credit Checks: Gather comprehensive information, verify references, evaluate financial health, assess industry risk, and set appropriate credit limits and terms.

• Effective Credit Policy: Define credit objectives, set criteria, establish limits and terms, monitor and review regularly, communicate clearly, and use technology for efficiency.

• Data Analytics: Leverage real-time data and predictive analytics, segment customers, and monitor trends to enhance credit risk management.

• Call Me.