Utilizing a potential or existing customer’s annual financial report is a good way to gauge their potential risk before agreeing to sell on credit. There are many variables included in annual reports, some more significant than others. Being able to identify potential red flags is crucial in avoiding accumulating bad debt. Here are some key metrics that should be understood to help determine the financial state of your customer.
The Latest Financial Numbers Should be Evaluated in Context
A company who at first glance seems to be doing well due to last year’s performance may mislead you to believe that they are worthy of buying on credit. Although their latest revenue earnings may seem high (along with other numbers) and sway you to believe they are in tip-top financial shape, without evaluating the overall trend of these numbers, they can be misleading. Even if numbers appear good. If they are trending downwards this could spell trouble in the future.
The Significance of The Cash Flow Statement
Understand that cash flow from operations is an incredibly good indicator of recent company performance. A positive cash flow is one of the most reliable ways to identify a trustworthy customer from a risky customer. With that being said, a negative cash flow is not the end of the world. Sometimes these numbers come as a result of important investments and paying off debt which still shows a positive trend in company performance.
Assess the Current State of Assets and Liabilities
Breaking down the components that go into the current ratio will help discover the true financial state of a customer. Identify important assets: cash, accounts receivable, and inventory. An increase in cash is a great sign. Additionally, a high figure in inventory is typically positive, but sometimes this can result from slow-moving inventory and decreased sales. Liabilities draw a red flag as they show what financial obligations your customer still has to pay off.
Debt to Worth Ratio and What it Means
The debt to worth ratio gives an idea of the overall leverage of the company. A company with high levels of debt and low levels of equity is a high-risk customer. Also, make sure to distinguish between short and long term debt. Debt that can be paid off quickly can change the overall picture of a company’s financial state.
Having a better understanding of what an annual report provides will help you minimize customer risk. The most important thing to keep in mind is that financial metrics can be misleading and should always be evaluated in context to related figures, oftentimes prior years’ numbers.