When understanding the cash conversion cycle, it is helpful to remember that any dollars in inventory and accounts receivable are investments in working capital that have not yet been converted into cash.
Conversely any amount in accounts payable is working capital being financed by trade creditors and is allowing the company to delay spending their cash. Any investments in inventory or receivables are essentially cash that a company has not collected yet and will decrease the overall cash available to the company to finance operations. From the calculation above, ABC Corp. We could see that XYZ Corp. This explains why they took longer to pay their vendors.
Note: This measurement is not as effective for service companies such as consulting businesses, technology companies, and insurance companies that have little to no inventory and might even have very quick accounts receivable turnover. In this next section we will discuss profitability ratios. Profitability is also sometimes analyzed through earnings performance ratios.
No matter what you refer to them as, they always have to do with the return on something i. In this section we will explore three primary profitability ratios:. These ratios by themselves may yield some insight and will definitely be helpful in analyzing whether to extend credit to a customer or to determine their long term viability.
The Securities and Exchange Commission SEC requires all publicly traded companies to file quarterly and yearly financials i. These reports will be based on the approved GAAP requirements.
For those publicly traded companies that you are doing business with, this can really help in your validation and trending models because there will be multiple months and years on file. For private companies, you will want to ask for three years, three quarter-ends, or three month-ends of data to determine a trend. The best comparison is when you can compare year-over-year to see how they are doing and compare with other like companies in the same industry.
This should give each credit professional the ability to analyze the current statement in a meaning full way by reviewing a trend to determine what you think will happen in the future. All of the information you need for this section can be found on the income statement. One of the most common profitability ratios is the net profit margin. This is also sometimes referred to as the bottom line margin. Here the number is expressed as a percentage and should be above zero.
This is kind of a no brainer as a company should be profitable to stay in business. This is one of the most frequently used ratios. Historical net profit margins provide the analyst with the ability to determine if the customer is trending up or down. Are they making as much money as their competitors? Did the profit margin increase from the prior periods or did it decrease? Net Income after Tax. Assuming that both companies are from the same industry, we could make an assumption that ABC Corp.
One other thing to be considered is the type of industry of the company you are evaluating. You should have a good understanding of what the margins should be in the industry you are evaluating. If either company, ABC Corp. Gross profit margin can be a great asset to any credit professional.
In the second chart below, we expressed the same numbers as a percentage to give you a better perspective to how these companies manage their cost of goods sold. In this second example below we can see where XYZ Corp. Now you will need to determine if this is good or bad. Here you would want to do more analysis and ask some follow up questions for XYZ Corp. For example, expenses outpaced sales as a percentage, why?
You may be able to figure this out if you have a detailed page breaking out cost of goods sold. The last ratio on profitably will be operating profit margins. Operating Profit Margin: Operating income divided by net sales. Operating Income. The higher the operating profit margin, the better cost controls a company has.
When a company is well established and been in business for a number of years, fixed cost should go down and thereby the operating profit margin go up. Here you want to see a trend where the operating profit margin is increasing every quarter and year. A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds. If a company you are selling to is no longer in good standing with their bank due to the inability to meet covenants or the inability to pay their loans, then the company will either have to seek funding from their vendors by stretching their bills, or file for bankruptcy.
A profitable business does not necessarily mean that there is enough income or cash flow to support its debt payments.
If you are analyzing a company that is profitable, how can you determine the strength of their profits? To fully analyze this relationship of income and cash flow compared to debt service, 3 basic ratios have been outlined below:. These three ratios are further defined in detail below.
Times Interest Earned Ratio: The times interest earned ratio is expressed as the operating income of the company divided by the interest expense of that company:.
Interest expense can be found as a line item on the income statement. This is the amount of interest that was due and payable in the particular period that the income statement covers. These amounts for ABC Corp. An average company will have a cushion, perhaps a ratio of 1.
As shown above with ABC Corp. When subtracting interest expense from operating income, XYZ Corp. Covering required interest payments should be maintained at a minimum. In addition to this, many companies have liabilities that require principal payments to reduce the balance on the debt over a set period of time. For instance, equipment depreciates and loses value over time, so a business will need to make principal payments on this debt to avoid having its loan value exceed the value of its asset.
The next two ratios help to analyze the full ability of a company to service its required debt payments. The reason why taxes have not been added back to the ratio calculation above is because taxes are equally, if not more important as paying back bank loans. Federal and state tax liens can prevent a company from obtaining funding and negatively impact their cash flow.
Depreciation and amortization expenses are added back to net income since these are non-cash expenses and can be used to help service debt. These expenses can be found as a line item on the income statement or on the statement of cash flows. Since interest expense is one of the primary debt payments as shown in the previous ratio, we would also add back interest expense to the numerator. The current portions of both long-term debt and capital leases can be found under current liabilities on the balance sheet.
These represent the amount of principal payments that are due within the next year. The figures needed for this ratio calculation for ABC Corp. Just like the last ratio, if this ratio is over 1, than this means that the company has the ability to make their required debt payments.
An average company will have a cushion of 1. Operating profit and EBIDA in most cases is based on the accrual method of accounting, meaning that revenues and expenses are entered when invoices are issued, not when they are paid. Just because a sale was made does not mean that the company has collected the receivable and has the cash on hand in order to pay the interest [and principal] that is due. The cash flow from operations can be found as a subtotal on the statement of cash flows.
This is slightly different than the operating profit and EBIDA of a company that shows the inflows and outflows of receipts, but does not tell you if they were paid or not. The cash flow from operations needed to calculate this ratio for both ABC Corp. Again, if the ratio is over 1, then the company generated enough cash to afford its required debt payments; however, a cushion of at least 1.
When this occurs, it is important to go back and analyze the efficiency ratios that were discussed previously. As shown previously with the debt service coverage ratio, ABC Corp. This paper has also broadly discussed the various types of audit opinions coupled with some beginning financial statement analysis.
In fact, most of what we learn, and need to know, is based on just plain work experience and the school of hard knocks. Are there any credit designations I could earn to further my knowledge in this field?
What other resources are available out there that are commonly used for benchmarking and learning other tools in credit management?
NACM affiliated associations offer valuable credit services in formal credit training in the form of: classroom credit classes, online credit classes, webinars, monthly publications, seminars, and annual credit conferences, just to name a few. At your local NACM affiliate, you should be able to get your formal credit training no matter what your background and also meet other fellow credit professionals working toward similar goals and objectives.
At most NACM affiliates, they have the resources courses that will allow you to complete the more commonly held credit designations of:. For credit professionals aiming to expand their knowledge in the international credit management arena, the following designations are also available:.
The first three designations require the completion of 10 to week classes in: Credit Principles, Financial Statement Analysis, and Accounting.
The international designations are completed mostly on the internet, but are just as rigorous and comprehensive in their material and test taking as the ones just discussed. This is a paid member service, but they do offer a lot of complementary benchmarking reports on many different companies and industries. We already mentioned NACM www. This popular website allows one to get the latest news developments on large companies along with investor opinions, financial statement data, and related competition information on companies.
Google Finance and other search engines offer similar information as well. But this is a start. Finally, the authors of this paper wish you the best of luck in your new credit career and we hope you have enjoyed this paper and got as much out of it as we enjoyed writing it. We strongly encourage you to get involved in this very dynamic and honorable profession called commercial credit.
We are confident that you will find it challenging, personally and professionally fulfilling, and hopefully very rewarding. Glossary of Financial Terms and Ratios.
Current Ratio CR : Total current assets divided by the total current liabilities: should be greater than 1. Quick Ratio QR : Total current assets minus the inventory amount, all divided by the total current liabilities also known as the acid test ratio : generally lower than the CR, but should still be above 1 depending on the industry.
Times Interest Earned Ratio: Operating income divided by interest expense: should be over 1 to pay interest expense on debt, and usually has a cushion of 1. Cash Flow from Operations Debt Service Coverage Ratio: Cash Flow from Operations add back interest expense if using the indirect method divided by the sum of current portion of long-term debt CPLTD , current portion of capital leases, and interest expense: should be over 1 to cover required debt payments with healthy companies reporting 1.
As the advocate for business credit and financial management professionals NACM and its network of Partners take great pride in being the primary learning, knowledge, networking and information resource for commercial creditors nationwide. Join our network today! We are located close to Baltimore and not far from DC. My Account. Online Courses. Live Webinars. Visit our Knowledge Center. Business Credit Magazine. Knowledge Center. Overview of Financial Statement Types Before even beginning the process of analyzing a financial statement, it is important to understand the different types of financial statements, how they are prepared, and how reliable the information contained in them may be.
In an unqualified opinion , the firm conducting the audit represents that the information is presented fairly, in all material respects, and correctly represents the financial position of the business being audited. This is the language you want to see in the cover letter of your audited financial statements. A qualified opinion will have identified a specific area in which the firm conducting the audit was not able to confirm that the information expressed was in compliance with either company policies and controls, or the accounting policies governing the audit.
This may not mean the information is inaccurate or cannot be relied upon, but you should seek to understand the circumstances and details of a qualified opinion to determine if the qualification would significantly alter the assessment of the financial information and your credit analysis. An adverse opinion would mean that information was not able to be verified and may indicate fraud or other issues.
This could also represent that the accountant or firm conducting the audit was not able to verify that the subject of the audit has the financial wherewithal to be considered a going concern and continue to operate its business. An adverse opinion is rare, and any reliance on financial information carrying an adverse opinion may not be advisable. While cash flow is typically considered a primary source of loan repayment, it may not be sufficient to cover operating expenses and additional debt repayment.
Estimating cash flow can also be difficult for start-up businesses or business expansion. Creditors utilize financial statements to determine secondary sources of loan repayment, also referred to as collateral, such as business-owned real estate, equipment, receivables or inventory. In the event a business is unable to repay its debt, the creditor may be able to liquidate these items to satisfy the debt. Jeff O'Kelley is a professional photographer and writer, currently based in the Tampa, Florida area.
O'Kelley holds associate degrees in telecommunications and website design from St. Petersburg College.
You start with a set destination in mind and then plan your route there. Expanding on our previous point, the depth of data and predictive capabilities that the financial BI dashboard software offer can mitigate financial risk, significantly. Working with the right mix of metrics, you will begin to see any potential dips in performance or negative patterns unfold intuitively, which means you can take critical actions that prevent potentially devastating monetary calamities.
Armed with dynamic, visual, and interactive KPIs, not only can you mitigate financial risk and protect your company from glaring inefficiencies, but you will be able to make smarter investments and decisions. Here are some of the KPIs that you should focus on for financial protection, and growth:. In addition to reducing financial risk across the board, a data analytics dashboard can also protect your business from fraudulent financial activity. Through frequent benchmarking and analysis, you will increase your chances of identifying any abnormalities and investigate the matter immediately.
This quick response approach will empower you to get to the root of the problem, tackling the issue while reducing further financial damage. This is also one way you can gain insight into whether a company is potentially under- or overpriced in the stock market.
Since one of the main reasons a company exists is to make profits for itself and its shareholders, this is crucial information — no compromises. Some companies, like Apple , like to sit on colossal amounts of cash. Their strategy is to have this money built up so that they can remain financially solvent even if some pretty catastrophic things happen to the economy.
However, other companies prefer to invest their money if they can do so while remaining financially healthy. For example, computer chipset manufacturers like Intel upgrade their factories and equipment on a regular basis. These upgrades are extremely expensive, and while they are a good long-term investment, the company in question must make sure they have the short-term cash flow to support these kinds of moves.
If your supplier or vendor relationships are strained, inefficient, or fraught with issues, you will stunt organizational productivity, damage your brand reputation, and ultimately, lose money frequently. Typically, your vendors or suppliers will have individual payment processes and credit rules. Streamlined financial analytics ensures payments and transactions remain fluent at all times, especially if used with a modern client dashboard.
Plus, by working with metrics such as Vendor Payment Error Rate, it's possible to keep track of vendor payments while identifying any under or overpayments during a set timeframe.
Accessing this level of insight will optimize your vendor or supplier processes, saving time and money in the process. This particular report tells you how much money a company made or lost in a given time period typically a fiscal year.
This piece of financial reporting software offers a snapshot of your assets and liabilities aka debts at a given moment in time. This report shows how much money flowed into and out of your business during a period of time.
The cash flow statement is crucial for things like making sure you have enough money to make payroll.
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