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Credit Notation < Assess your customers

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Credit Notation
The business creditworthiness assessement tool presented here is used and improved in Credit Management services of many companies. Simple and easy to use (a few minutes needed to perform an analysis), it is including all the main criteria to perform this analysis while producing useful advises in credit risk decisions you have to make with your customers. This tool will give you for each client recommendations to avoid bad debts.

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Credit Notation method


The credit notation is based on behavioral information, legal and financial informations: Payment behavior, Age of the company, Legal form of the company, Age of the business relationship and evolution of orders, Evolution of the turnover, EBIT and net income, Financial structure with the level of equity in relation to total assets, Indebtedness, working capital and cash ... etc. A total of 15 criteria are used to build up this "credit score", each criteria has a defined weight in the final calculation. Four notes are possible: A: Company solid, B: Company stable, C: Company fragile, D: Company close to failure. It is a clear and useful help in the customer risk analysis and the result has to be integrated into your business approach to request, if needed, down payments or payment guarantees. The result of the credit notation is one of the elements used to calculate the credit limit granted to your customer.

Use the simplified credit rating with clients who refuse to disclose their balance sheet and income statement, which is common in several countries. In some countries (notably the Middle East) commercial culture is that these documents are confidential and are only internal management tools for managers. In this case, the solvency assessment will be based on others criteria like compliance and payment behavior, which is of course reflected in the tool.

Next: secure your receivables

Tools download:
Credit notation Credit risk Kit Easy credit notation

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1/18/2014 9:36 PM

Understand and analyze the balance sheet < Assess your customers

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Understand and analyze the balance sheet


The balance sheet is a snapshot of a company's financial condition. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. The balance sheet shows if company's activity is mainly financed by: owners equity: capital stock, retained earnings, reserve, liabilities: accounts payable, loans payable, tax payable. The higher the part of owners equity is high in comparison with debts, the more the company is financially autonomous, therefore solvent. In the opposite way, more debts part is high more the company depends on them to finance her activity, which can continue only if suppliers and banks credit lines are maintained and raised proportionately with company growth.

What is the balance sheet?

Assets are divided into two parts : current assets: accounts receivables, inventory, work in process, cash, etc., that are constantly flowing in and out of a firm in the normal course of its business, as cash is converted into goods and then back into cash, fixed assets: land, buildings, equipment, machinery, vehicles, leasehold improvements, and other such items. Fixed assets are not consumed or sold during the normal course of a business but their owner uses them to carry on its operations. If we look to the company's financial resources (owners equity + liabilities) and the assets, we can determine the part of the owners equity which finances the current assets; in other words the business activity of the business. This is the working capital. Conversely, more working capital is weak, and the working capital requirements financed by the liabilities (negative treasury), more the company is financialy weak and depends on its creditors (banking, suppliers) to maintain and develop its activity.

Dynamic view of the balance sheet: the working capital and the working capital requirements

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1/18/2014 9:34 PM

Understand and analyze the balance sheet < Assess your customers

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How to calculate the working capital requirement?


Working capital: equity- fixed assets. The WC must be positive and large enough to cover the WCR. If the WC is negative, that means that equity is not sufficient to finance fixed assets and the company has recourse to the short-term bank loan (whose renewal is not guaranteed) to finance it. The default risk is maximal! Working capital requirement: Operating assets (inventories + accounts receivables) - operating liabilities(payables). The WCR represents the need to finance the operation. It depends strongly on the sector of activity. For example, industrial companies generally have a higher WCR while the major retailers have a negative working capital (they are paid by their customers before they pay their suppliers). Net cash: WC - WCR. The Net cash is the remaining of WC after absorption of WCR. If the WC covers WCR, the net cash is positive. This amount is reflected in cash (excess cash on a bank account). If the WC does not cover the WCR, net cash is negative. Stable financial resources are insufficient to finance the activity and the company has recourse to the short-term bank loan or credit suppliers to finance the operating cycle. This situation is problematic because the company is dependent on credit given by suppliers or / and short term loans which renewal is not assured. The risk of failure is high even if many businesses are in this case!
Be careful with the companies having an unbalanced capitalization with an even negative weak WC and a high WCR. Resultants of a bad management or a too light financing, these situations make these companies very risky whatever is the good will of the leaders to respect their commitments. Tensions of treasury are almost systematic and the risk of delays of payment or unpaid invoices is very high. A turnover decrease, an unpaid invoice or a disengagement from a creditor (banks, supplier) can be fatal and lead the company to the bankruptcy. Analyze the financial structure as a whole and in a dynamic way. Each case is particular and the evaluation of the assessment depends intrinsically on the company business sector and of the financial need which results from this. Thus, a simple trade has to finance mainly its stock when an iron and steel company must finance very heavy fixed assets (equipment, grounds. .etc), stock and credits allowed to customers.

Next: The Tangible Net Worth

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1/18/2014 9:34 PM

The balance sheet key ratios < Assess your customers

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The balance sheet key ratios


The balance sheet analysis and of the herebelow ratios inform us about the company financial balance. Will your customer be able to pay you at the due dates of your invoices? Is he solvent ? Does he have sufficient liquidity to honor its short-term and medium / long term debts ? This analysis will enable you to determine it.

Solvency Ratios
Total liabilities / total equity : Its showing the proportion between equities (internal financing) and debts (external financing). The more important the internal financing is, the lower is the risk of bankruptcy. Who really owns the company ? Shareholders Bank Equity / (equity + liabilities) = % Bank loans / (equity + liabilities) = %

Creditors (including suppliers) short term liabilities / (equity + liabilities) = % The total makes 100%. The higher % are in the high part, lower is the risk. Loan ratio: Loans payable > 1 year / Equities. Shows the banking debt level. The lower it is, the less the company is financially dependent on its banks. Should not exceed "1" in which case the banking dependence level is too high.

Liquidity ratios (ability to honor its short term debt)


Cash ratio: Accounts receivable + cash and cash equivalent - short term debts. This ratio is an excellent indicator about the capacity to refund the short term debts (thus to pay its suppliers). >1 solvency is good. <1 The company must sell its inventories to ensure the payment of its creditors. Tensions of treasury and delays of payment can appear. Daily Sales Outstanding (DSO): Accounts receivable / Gross revenues x 360. This indicator is showing if the accounts receivable is well or badly managed and if the company is able to be pay by its customers. 60 days if the accounts receivable are well managed (LME law in France restricts payment term up to 60 days maximum). Above 90 days is worrying especially if its customers are French (payment terms can be longer with foreigners customers). Daily Payable Outstanding (DPO): Accounts payable / cost of goods x 360. DPO is showing the payment behaviour with suppliers. Be careful with companies having a high DPO, you may be paid with delay. This indicator should remain below 90 days. Inventory tunrover days: average inventory / cost of goods sold x 360 days. A ratio showing the days it takes to sell the inventory on hand. More the result is low (< 20 days) more the company is controlling successfuly its purchasing processes and its WCR. If it is high (> 30 days), the WCR is increasing that may generate tensions of treasury. High inventory levels are unhealthy because they represent an investment with a rate of return of zero.

The financial statements falsifications


Some companies balk to publish financial statements representative of their real situation and falsify their balance sheet to post a situation in conformity with their wishes. By this way they try to: hide financial problems which could worry their partners (customers, bankers, suppliers, shareholders etc). diminish the net income in order to pay less taxes or to not reveal their business margin.
In order to perform a relevant solvency analysis it is needed to detect this falsifications which can skew the assessment and the analysis which results from this.

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1/18/2014 9:35 PM

The balance sheet key ratios < Assess your customers

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Real example of balance sheet falsification

Accounts receivable falsification: here is an assessment which shows seemingly a correct financial situation. Equity Liabilities Equity Liabilities &

P&L Gross revenues EBIT Net income

K 12 625 516 265

Assets

Fixed assets Current assets*


*including accounts

413 5652
4983

895 5170

receivable

If we look in details to the balance sheet we can see that the DSO is 144 days, which is very high. Why ? because this company underwent 2 unpaid for a total amount of 2 millions euros without reflecting it in their balance sheet and income statement which are in fact completely wrong. Normally, the unpaid invoice should have been written off, which impact the EBIT and the Net income which become largely negative. The loss comes in reduction from equities to -1.1 million euros. The "fair" financial statements are completely modified like below: P&L Gross revenues EBIT Net income K 12 625 -1484 -1735 Assets K Equity liabilities Equity Liabilities and K

Fixed assets Current assets*


*including accounts

413 3652
2983

-1105 5170

receivable

Current assets are largely lower than the debts short terms. The company is unable to refund its debts and goes for bankruptcy (what happened a few months after the publication of the false financial statements).

Be attentive with the figures leaving the standards. A daily sales outstanding of 144 is sufficiently high to doubt on the accuracy of the accounts and to ask explanations to your customer. A similar falsification is very common on the inventories valorisation: when a company overestimate inventories values the net income is higher than it should be as it should be impacted by the devaluation of obsolete inventories.

Next: the credit notation

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1/18/2014 9:35 PM

Analyze the Profit and Loss account < Assess your customers

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Analyze the Profit and Loss account

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The financial analysis is the cornerstone of the valuation of the solvency of your clients. Don't panic! It is simple. The most important is: the understanding of the balance sheet and of the profit and loss account, their analysis with key indicators. We are not going to get lost in interminable calculations but we will analyse simply what is the most important. By chance, it is in front of our eyes on first pages of the financial statements of your customers.

Understand the profit and loss account


The profit and loss account highlights the turnover accomplished over period given (usuually 1 year) from which it subtracts expenses supported by the business during the same period. The result of this subtraction shows the benefit or the loss made by the company at the end of the financial year.

Compare the evolution of the turnover and the profitability on last 3 financial years (5 so possible) to determine the medium-term viability of your client.

Turnover and profitability are two key indicators for any business, second one even more than the first one. As long as a business is profitable the risk of insolvency is low. A turnover increase without profitability or strengthening of shareholders equity weakens the business. Why? Simply because the need in cash rises with the increase of the turnover while financial resources do not increase. Consequently, problems of financing of growth and cash difficulties can appear, which can be controlled only with thirds contributions (banks, factoring, credit given by suppliers etc). This will reduceh the financial autonomy of the company.

Go further with income statement intermediate balances


These indicators help to determine if the company is profitable and to understand what are the main factors contributing to the net result (positive or negative). Is the company's business is profitable or not ? Is she burdened by financial costs or is her net income improved temporarily by an exceptional profit ?

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1/18/2014 9:32 PM

Analyze the Profit and Loss account < Assess your customers

http://www.creditmanagement-tools.com/analyze-the-profit-and-loss-acco...

This analysis will help you not to get fooled by an "artificial" positive result or to not stop your analysis to a net loss but based on an intrinsically profitable and viable business.

Intermediate balance

Calculation Sales of goods - purchases

Interpretation

Trade margin

of goods + Goods inventory change Trade maring + Production

Relevant indicator to determine the gross margin of an activity of reselling such distribution or trading. Represents the creation of value that the company provides to goods and services purchased from third parties. The value added must be sufficiently high to absorb all other expenses of the company. Remaining amount after deduction of operating

Value added

- purchases of raw material other purchases and external charges

operating profit before depreciation and amortization (EBITDA)

Value added - tax - wages and salaries - payroll taxes

expenses to value added. It is a key indicator of profitability and business performance as it is independent of the financial policy of the company. EBITDA should maintain and develop the means of production and pay the capital invested.

Operating profit

EBITDA - depreciations and provisions

Operating profit includes the amortization of fixed assets and provisions for risk (eg accrual of bad debts). This purely financial result is often negative because firms are generally consumers of financial products

Financial result

Financial income - financial charges

(lines of bank overdrafts, bank loans, factoring etc ...). A significant negative financial result often reflects a weak financial structure and an excessive recourse to banks. Warning!

Result before tax

Operating profit + financial result

Final result calculated from operating income and expenses. It is independent of taxation and exceptional income and expenses. This result relates to unusual activity. For example, a capital structure transaction can create an exceptional result. Be careful because it can distort the true profitability of the business and distort an analysis that would be based solely on net income. The net income represents the profit or loss at the end

Exceptional result

Exceptional income Exceptional expenses

Net income(profit or loss)

Result before tax + exceptional result - income tax

of the year (the difference between total revenue and total expenditure). It is increasing (if positive) or decreasing (if negative) the equity. If positive, it can remain invested in the company or be partially distributed to shareholders as dividends.

The most important is to determine what are the main part in the P&L contributing to the net income (positive or negative) and to understand what is the size of the company, what are its strengths and weakness, the evolution in its turnover and profitability...etc. These indicators allow you to refine your understanding of the business by zooming into some key points generating income or losses. A detailed analysis will also help you to check if there are some manipulations in the financial statements.

The cash flow


The cash flow represents the excess cash generated by the activity of the company during the year. It allows: to repay loans, to pay shareholders, to invest, to strengthen the financial structure of the company. The cash flow is a key indicator in many aspects. It is very important for shareholders because it is strongly linked to their earnings. It gives confidence to creditors about the company's ability to repay the debts and allows managers to invest in the development of their business. How calculate the Cash flow: Net income + depreciation Next: understand and analyse the balance sheet

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1/18/2014 9:32 PM

The Tangible Net Worth < Assess your customers

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The Tangible Net Worth


The Tangible Net Worth (TNW) is a relevant indicator to assess the real value of a company based on the balance sheet. It can be used for credit analysis to validate the outstanding level that is granted to customers. For example, it may be stipulated in the rules of the company that the credit limit granted to customers shall not exceed xx% of tangible net worth. Indeed, the TNW meets the obvious need, but not so easy to get, to know the intrinsic value of a company based on what is material, ie that can be converted into cash in case termination of the activity and to liquidation (sale of fixed assets, inventory and payment of receivable) and the payment of debts with third parties (banks, suppliers, taxes ... etc..).

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TNW is a concept very down to earth. All intangible valuations, ie intangible assets: patents, expenses, goodwill, licenses and all other intellectual property that the company may have are excluded in the calculation.

Tangible Net Worth calculation


Essential prerequisite to any assessment of TNW, it is necessary to ensure that the balance sheet is representative of the financial reality of the business. If this is not the case, the TNW will be biased and lead to a false estimate of the value of the company. For example, if the value of the stock is overvalued (valuation in the balance sheet of dead stock), tangible net worth will also be false (see the pitfalls of balance). This principle is true for any difference in value of balance sheet assets (fixed assets, receivables ... etc..) compared to reality.

Why exclude intangibles from credit analysis


Intangible assets are immaterial and unquantifiable (cash is intangible but perfectly quantifiable), they are subject to subjectivity in large proportions. Indeed, how to define rationally the value of goodwill or a patent? It is extremely difficult because their actual value depends on external context which may rapidly evoluate. For example, a patent may have some value for a few months and become obsolete overnight. The value of goodwill may vary depending on many criteria: competitive environment, market growth, positioning. Consequence of this subjectivity, the valuation of intangible assets varies with the business strategy. They will swell if the executive wants to sell his company, they will decrease if it wants to reduce its net income. Moreover, the principle of credit analysis is to determine the capacity of a company to pay its bills in a few months. However, intangible assets are hardly marketable and therefore does not strengthen the solvency of a company in the short term.
The principle of tangible net worth is not to deny the intangible assets of a company which are, in most cases, a reality, but to put them aside because they do not help the company meet its debts .

TNW calculation method


Total assets - intangible assets - total of debts to third parties

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1/18/2014 9:35 PM

The Tangible Net Worth < Assess your customers

http://www.creditmanagement-tools.com/the-tangible-net-worth-c1-r770.php

Credit analysis and Tangible Net Worth


What to do once TNW is calculated? First, the TNW is not enough to achieve a solid financial analysis. Many other factors must be taken into account when looking to the income statement and balance sheet. However, TNW provides information about the financial base of the client. As a lender (a deferred payment granted to the client equals a credit given), we must ask ourselves the following question: how much can I loan to this company? TNW plays a pivotal role in the answer to this question: it does not make sense to give to the customer a credit limit greater than 100% of his TNW. 80% is far too high. Tip: Never set a credit limit exceeding 50% of the TNW, which is already very high. Every company has to define a rule that will serve as a benchmark in determining the credit limit. The calculator of credit limits developed by Credit tools weighted the "authorized %" of TNW to define credit limits based on several additional criteria. This percentage varies depending on cases. For example, if the customer analyzed has serious cash flow problems, it is very risky to grant him an outstanding equal to 50% of its TNW because you may become his main creditor. You won't be able to disengage and you will face an agonizing dilemma: Cancel or reduce the credit line, which can push the customer to bankruptcy, which will result in bad debts for the supplier, Continue to accompany him by accepting late payments with the risk that despite this assistance he fills for bankruptcy and thus generates very large outstanding for those who have given support. However, it may be possible to grant a credit limit of 50% of the TNW to a small company with an excellent financial structure and a good cash.
The credit analysis inheres subjectivity. The use of the Tangible Net Worth does not change this assumption. Nevertheless, it is a relevant indicator which together with other elements of analysis can give a coherent and realistic business view. It provides a essential point of reference in determining the credit limit granted to his client.

Next: Balance sheet key ratio

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