Credit risk ratio - credit managers reviewing financial documents

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A bank would never lend money without reviewing a potential customer’s finances — they want multiple years (and possibly a pint of your blood) to assess your credit risk ratios before they consider lending you any of their money. Why is it considered bad form or intrusive when I — a credit manager for a material supplier — ask a contractor for their financials? 

I am not sending hundreds of thousands of dollars’ worth of lumber or roofing materials out the door on a handshake. I am a nice woman,  but don’t get confused: This is business. 

Contractors may be reluctant to share financials

To a sales rep, the most feared word in the English language is “No.” To a contractor who is looking for credit, the most irritating words appear to be “Can I get a copy of your latest financial statement?” 

I am not sure why this request chaps so many people’s backsides.  

A contractor’s classic response to a request for financial statements is often, in no particular order: 

  • “We don’t give those out.”
  • “We don’t share financial information.” 
  • “Why?”
  • “We gave it out once years ago, and that company did not keep it confidential.”
  • “We don’t trust any of you anymore.” 
  • “No one else ever asks for them. Your competitors don’t.”
  • “It is none of your business — do I ask to see yours?” (One particularly surly character asked me what assurances he had that my company wouldn’t go out of business. That logic would be acceptable if we owed him money, but I digress.)

When a contractor refuses to share their financials, it isn’t necessarily a red flag, but it is at least a yellow one.

It might mean that they’ve been burnt before, and are feeling gunshy. It might mean that they are trying to hide something. Or it may mean that they simply don’t know their numbers well enough to share them with a “stranger.” 

Trust and confidentiality are important

One solution credit professionals often use is to offer to sign a confidentiality agreement. This gives your customer the comfort of knowing if you do choose to act foolishly, they have repercussions. 

I also offer to come up and review them in their offices. Just let me review them at your place, and they won’t leave the premises. Everyone gets what they need. 

One contractor took a totally unique take: Rather than send me his financial statements, he invited me up to his place of business to review them. Sitting across a desk from me, he pulled his financials up on his computer and said, “Ask me what you want to know.”

I stumbled for a minute, and then started asking him the usual questions that I would look for. He read me the numbers that I asked for. Hedged on a few things. That was what I went home with.

But it was a start. I was building trust and it takes time. He put me through that exercise for several years. He eventually had no trouble emailing me his financials, but it took time and relationship-building between us.  

Requesting and reviewing financial statements 

While you can request any number of financial statements from a contractor, the two financial statements I want to see in a credit review are a contractor’s balance sheet and income statement

It is not that I don’t appreciate getting a balance sheet alone, but it really doesn’t tell me a whole lot. A contractor’s balance sheet is a snapshot of that particular moment in time of that company. What that company has (assets), what it owes (liabilities) and what is worth (equity) — all for that moment in time. The view could be much different tomorrow or next week. 

The income statement is the second piece of that puzzle. An income statement summarizes the company’s operating performance during a specific period of time. It gives perspective on the health of the business. Getting one without the other usually proves frustrating and leads to more questions than answers. 

What about the cash flow statement?

In my alternate credit-granting universe, I am able to get the balance sheet, income statement, and the ever-elusive cash flow statement. The cash flow statement with the other two documents represents the credit version of the Triple Crown. They are hard to get, and I’m still not quite sure why. Getting a balance sheet and income statement together can be a challenge. Getting a company to throw in the cash flow statement makes me giddy. 

Cash flow statements are exactly what the name implies. They show the movement of cash in and out of the company for a period of time. 

Creditors asking for financial statements year after year are looking for a story about what is going on with the business. It is the best way to get an accurate financial picture. With a multi-year history, oftentimes a story or pattern emerges. If a company makes 5 million one year, is that good or bad? Well, I don’t know — did you lose 10 million the year before? Well, then 5 million would be good. If you made 10 million the year before, not so good: What happened there? 

So, having the history and really seeing what is going on is incredibly insightful. I have had people tell me “Thea, I don’t want to send them to you. They don’t look great this year and I am afraid you will cut my credit line.

The end of that sentence usually has nervous laughter attached to it. I understand the anxiety. But if I am looking year over year and looking at other factors, it is not always about the bottom line. 

The nice thing about financials is: Math does not change. Numbers are numbers. 

I have to admit, financials are not my first love. But since the first resource in business is money, it was important to grow to love them. Hey, I love my job, but there are plenty of hobbies to keep me entertained if my job didn’t get in the way. I have learned to appreciate the financial statement whenever I can get them. 

Reviewing contractor financials for credit risk

When requesting a financial statement, I am usually looking for the fiscal year-end. The fiscal year-end is an accounting period covering 12 consecutive months, 52 consecutive weeks, 13 four-week periods, or 365— okay, you get the idea. 

If those aren’t available, I ask for a copy of the interim financials — basically, a financial report covering a portion of a fiscal year. This can be quarterly or mid-year — I have even had some companies present them monthly, which I must admit is really tough to weed through month after month. 

You now have asked for and received the coveted financials you requested. What are you looking for, exactly? Not being mathematically gifted, I have had the good fortune over the years to work with a lot of great accountants and other analytical types who have been, and continue to be, very generous with their knowledge and patience. It also helped that I married an accountant. All were extremely generous with their knowledge. 

Credit risk ratios: 3 numbers to review

When I have a contractor’s financial statements in front of me, I am typically looking for three things to determine their ability to pay our invoices: current ratio, working capital, and profitability.

1. Current ratio

A contractor’s current ratio is the company’s ability to pay its current obligations from its current assets. This information is available on the contractor’s balance sheet: To calculate this ratio, divide assets by liabilities. A current ratio below 1 can be an indication that the contractor may run into trouble repaying debts if they are unable to turn it around. 

2. Working capital

Basically, working capital is the money a business has on hand to cover day-to-day operations. It can also be called the “current” position. A contractor’s working capital is the difference between their current assets and current liabilities. Think of it like basic checkbook math: How much you brought in, minus what you spent. Whatever is leftover is your working capital. 

3. Profitability ratios

When I look at profitability, I want to see the contractor’s gross margin, operating margin, and net margin. These numbers should all be found on the company’s income statement. 

Gross margin shows total sales revenue minus the direct cost of those sales, including the cost of goods sold. A contractor’s operating margin is their gross margin minus indirect costs, like overhead and administrative expenses. Comparing gross and operating margins will give you an idea of how much overhead the company is carrying — if these fixed costs are too high, the contractor may have reduced flexibility to navigate cash flow swings. 

Net profit margin shows the contractor’s profit after taxes and interest. 

Other financial questions to ask

Take a few extra minutes to review other aspects.

What are the cost of goods and long term debt? What are sales and costs doing year to year? What about the expenses? Has the company taken on any additional debt? 

Some other questions center on their banking relationship: Do they have a line of credit? When does it mature? What is the size of the credit line? Is there room on it, or is the line completely or largely used up? Does the company have loans? How many? What is the amount of each loan and when do those loans mature? 

These are all questions that can affect the ability of a company to pay its bills on time or even continue in business. 

8 financial red flags for contractors

Here are eight red flags credit managers look for when reviewing a contractor’s financials.

  1. The owner does not understand or is not familiar with items on their financial statement
  2. Balance sheet does not balance
  3. Operating losses
  4. Negative working capital 
  5. Out of compliance or violation of loan covenants 
  6. Maxed out Line of Credit 
  7. High debt to equity ratio 
  8. Overdraft on accounts 

If you catch any of those red flags, or something on the financial statement does not make sense or “add up” (ha, yes, my attempt at an accounting pun), treat it like you would a clause in a contract that doesn’t make sense, or you don’t understand. Ask questions and get answers. There may be a logical explanation — or they are what they are.

Offering credit solutions without a contractor’s financials

If all your solutions are met with a complete and utterly total “No!” then you have a business decision to make.

I would love to say if someone doesn’t give me their financials, it’s game over, but that would be a lie. You will have to look at all the factors and make the best business decision with the information you have at that time. I usually pull a few people in at that point for input.

How valuable is this customer to us? What history or other information do we have? Assess the risk and reward and make the decision. 

Thea Dudley teaches credit & collections

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