Essentials of Customer Credit, Part I: Understanding Financial Statements

Building a framework to evaluate customer credit is essential to protecting your business from financial risks. This blog series covers the different methods of assessing customer credit, key metrics to track, and invoice behaviors that may indicate financial distress — so you can begin to build a customer credit framework that highlights and even predicts future risks to your business.

Why it’s Important to Monitor Customer Credit

When times are good, many business owners neglect customer credit, instead focusing on maximizing revenue. But with the U.S. economy well into extra innings—following years of accommodative monetary policy and low interest rates—now is the time to start assessing the credit quality of your customers so you can grow and protect your business in any financial climate.

Begin by asking yourself these questions:

1. Do you actually know whether your customers are stable financially?
2. Will your customers be able to continue operating through a financial downturn?
3. Do you offer your customers payment terms, and if so, will they be able to pay?

If you’re unsure, you’re not alone.

In fact, in a recent online survey we conducted we found that the majority of participants did not proactively establish the financial health of their customers. It’s easy to understand why when many businesses are focused on growth (in which case sales will trump risk) or simply lack the expertise or resources to commit to an analysis.

But monitoring customer credit risk is very important. It can help you forecast churn, mitigate late payments, and weed out prospective clients who may struggle to pay you. Delayed or unpaid payments can result in problems that can affect your company’s performance, operations, cash flow, and your ability to plan ahead.

So where do you start? We understand evaluating the financial health of your customers may seem daunting if you don’t know what to look for. At LSQ, our goal is to make it easy to grow and protect your business. That’s why we’re writing this blog series. It covers the different methods of assessing customer credit, key metrics to track, and invoice behaviors that may indicate financial distress — so you can begin to build a customer credit framework that highlights and even predicts future risks to your business.

What you can learn from Financial Statements

So let’s start with the first and most common approach for assessing customer credit: reviewing customer financial statements.

Start by collecting the three main financial statement documents: balance sheet, income statement, and cash flow statement. The balance sheet shows what a company owns and what it owes at a particular point in time, like year-end or quarter end. The income statement shows how much money a company earned, and spent over a period of time, like 12 months. The cash flow statement shows the company’s cash inflows and outflows over a period of time and sometimes highlights items not reflected in the income statement, such as a major cash investment or cash distribution to owners.

Having a consistent process for obtaining financials from a customer will keep you current on how they are performing: we recommend collecting income statements and balance sheets every quarter. Financial statement data is most useful when you can observe trends over time, so compare current statements with past ones. Your focus should be to observe and analyze changes in these key credit metrics:

Revenue (same as sales)—the first line item on the income statement—tells you how much product or service your customer sold during the period reported in the income statement. To turn a profit, a business’s revenue must exceed its expenses. And if your customer reports a decline in revenue, this could spell bad news for you when the time comes to get paid.

Margins reflect how effective a company is at managing its expenses, expressed as a percentage of sales. Gross profit (after subtracting manufacturing and other expenses directly associated with producing the product), operating profit (after all expenses other than taxes), and net profit (after taxes) margins can give you a good idea of how much cash is left on over after accounting for costs. The higher a company’s profit margins, the better chance you’ll get paid in full, on time.

Financial leverage lives on the balance sheet and refers to the use of borrowed funds (debt) to expand or invest in business operations. A company will choose to leverage their existing assets if they anticipate an increase in profits and returns outweighing their current cost of debt. While leveraging assets is excellent for generating working capital, the risk of bankruptcy increases when leverage climbs higher.

Cash conversion cycles measure the length of time it takes for a company to convert its investments in inventory and other resources into cash flow from sales. Cash conversion is calculated by taking into account Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO). This metric allows you to measure how long a firm manufactures and stores inventory, pays suppliers, and ultimately receives cash.

While collecting and understanding financial statements is a good way to start, it alone paints only a partial picture of your customer’s financial health. In Part II of our Essentials of Customer Credit blog series we’ll explore how to leverage third-party credit providers to help build a financial mosaic that clearly highlights and even predicts future risks to your business.

Looking for even more info on avoiding financial distress with your customers? Download LSQ’s free Guide to Navigating Customer Credit.