Every investor is familiar with the legal caveat, "Past performance is not a guarantee of future results." But the warning is apt for business owners and credit officers evaluating potential trade partners' creditworthiness, too. Just because a potential customer paid bills promptly in the past, it doesn't guarantee that they have sufficient resources to pay them in the future.
If you are evaluating a private company's financial risk or creditworthiness, you won't get the complete picture unless you request and analyze their current financial data. Many credit reports are historically focused, using payment histories or even community scores. And while that type of analysis is better than nothing, it's best if you can supplement those reports with something that measures future risk. What will happen six or 12 months down the road is more important to your business relationship with that company than what happened in the past.
"A firm may have never missed a payment before until it blows apart," notes Rebel Cole, PhD, professor of finance at DePaul University.
It may not be feasible to request and review the financials of every business with which you interact. Yet, for companies that are big players in your supply chain or customers that make up a significant portion of your revenue, assessing their financial position is a critical step towards managed risk and sustainable business relationships. Here are three reasons that a company's financial statements can be a good place to start a risk analysis:
1. They reveal what other debts are on their balance sheet. If this is a customer of yours, for example, it can be alarming to see that they have a significant amount of liabilities; if they run into problems with cash down the road, you will have to compete with all those other liabilities to claim the payments due to you.
2. They reveal how a company is using its cash. Similarly, if this is a supplier and you see that their inventory levels are climbing or that their sales are declining, that may be a sign to you that this company will soon face cash constraints, meaning you might be able to ask for cash discounts for paying upfront or that you might need to start looking for a replacement supplier should this one go under.
3. They can help you be proactive in managing the relationship. Current financial data is helpful because it can uncover cash problems that may be looming in the company's future but which haven't yet impacted payment histories or past relationships. If, when reviewing a company's financial data, you see that they have been unprofitable for a while or that their accounts payable are climbing, you can ask questions of the business owner now to see when and how that might affect your contract with them. The financial data and the resulting analysis allow you to take steps to avoid problems that could hurt you in the long run.
Clearly, a recent set of audited, annual financial statements from a company you are evaluating would provide the most comprehensive analysis. But if that data isn't available, or if you don't have time to evaluate a company's financials line by line, a good place to start is the company's profitability and cash levels. Net Income to Sales and Cash to Assets won't tell the full story, but if a company is profitable and has some cash in the bank, then they are less of an immediate financial risk. Given how quickly the economic environment can change, the more recent the data, the better.
When financial data for a company is available, it makes sense that a risk analysis incorporates that objective financial data. In some cases, though, that data just isn't available. In those situations, a risk analysis may focus on the company's payment histories, publicly available lien information, and references from past business relationships. Used in isolation, these techniques may not be sufficient to yield a complete analysis, but if they can be combined, or even if they can't, they are better than performing no risk analysis or than assuming this company is in perfect financial standing.
After all, as legendary baseball manager Yogi Berra said, "The future ain't what it used to be."