By Larry Grogan, CCE

Fresh out of college I began working for D&B as an Inside Reporter in the Credit Services Division. One of my tasks was to write new BIR’s (Business Information Reports) on businesses. There were always two big challenges:

  1. convince the business owner over the phone that I was in fact a representative of D&B and not some competitor spying on his/her business (this was before email and caller ID!)
  2. Sell the owner on how the report would benefit the business by enabling suppliers to make informed judgments about the solvency of the business and its ability pay its bills on a timely basis.

These challenges are similar to what many of us face today working within a business when we request financial statements from our privately held Customers. The purpose of this article is to share some ideas on how to request and receive some level of financial disclosure, perhaps where you were never able to before.

For your consideration:

  1. Credit is based on confidence. Yet many of our privately held customers direct us to outsiders to obtain indirect support for our credit decisions via credit reports and trade / bank references. Although useful, nothing tells the story of a business like their financial statements and related footnotes. Nothing opens the door to win/win conversations with the customer who is willing to share when asked about poor financial results and what is being done to turn it around. Not too long ago I realized that movie critics don’t make movies. They just stand in judgment of them. People like me and you who analyse financial statements, in most cases have never run a business. That is why I find conversations with business owners so interesting. They take great pride in their business and having their financials when their results are good…or bad can lead to a better understanding of risk and in turn, a confident extension of credit.
  2. Trade credit is not in the same league as bank credit but there is no reason not to imitate bankers in how they view risk assessment and their expectation of financial disclosure from their customers. When we ship goods on open account credit, it is like a series of short term, unsecured, interest free loans to customers. Although the selling terms are definite, they are often stretched and we have to expend collection effort to pull the cash in. And often this is all done on the basis of a credit report showing payment performance rather than a Balance Sheet and Income Statement showing financial performance. Although financial statements may not be forthcoming from most private companies, form the habit of always asking. Consider noting it as a requirement or at least a ‘please attach…’ in your credit application.
  3. Since 2009, the Prime Rate seemed to be stuck at 3.25%. It just increased to 3.5% and further increases are expected in 2016. It behoves us to ‘think like a banker’ and raise our expectations of improved financial disclosure. In general, as rates increase, borrowing costs go up and profitability goes down. And customers increase their dependence on their creditors to fund their working capital shortfalls. All the more reason to know as much as we can about our customer’s capacity to manage the credit we are extending to them. Financial statements are often a better early warning tool than payment data alone.
  4. If your team’s approach is based on the idea that private companies never share their financials, challenge this ‘all or none’ thinking and consider seeing it like a baseball player’s batting average. A batter with a .300 average (3 hits for 10 at bats) is considered to be a good batter. The key is to decide in advance at what level of credit limit is financial data essential to your credit decision and routinely request this data from every customer falling into this ‘material’ category. You won’t always get the financial data you are requesting but if you track your ‘batting average’ over time, you might be surprised to find by asking and expecting to receive, many times you will get more than you ever thought possible. Test this.
  5. View requesting financial data from your private customers as an improvable process. Develop a step-by-step approach. Ask your team what objections they hear from customers and brainstorm effective ways to overcome them (why wing it?). Script the responses for consistency. Come up with a list of benefits customers will realize by providing good financial disclosure (higher credit limits, fewer orders on hold etc.). Like a batter who works on improving his swing, your team’s Financial Statement Request batting average will improve as you identify and share best practices and success stories.
  • Sell yourself first: How does having financial data from your private customers help your overall credit function?
    • if you can get your customers’ Shareholders Equity and subtract Goodwill and Intangibles, you can arrive at their Tangible Net Worth (TNW). For decades, many credit teams have used the following formula: extend a credit limit based on 10% of customer’s Tangible Net Worth. For a customer you deem to be lower risk, extend more. If higher risk, extend less. If very high risk, consider requesting some form of security (Letter of Credit, Cash Deposit, Corporate Guaranty, Credit Insurance or Personal Guaranty). It’s hard to ‘right-size’ a credit limit or to know when to request security if all you have is a credit report. Financial data enables you to calculate ratios, ask your customer questions based on those ratios, and to assign a risk rating and calculate an appropriate credit limit – one not based solely on their need but one that takes into account their financial capacity.
    • a more informed and well- rounded credit decision based on financials can lead to reduced past-dues (reduces over-extension of credit) and less bad debt.
    • The dialogue that often occurs when you and your customer discuss their financial results (particularly if they are negative) can enable you to help them – especially if they explain why the results are bad and share what steps they are taking to turn them around.
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      1. In the life of a typical customer, at least 4 opportunities to request financials may present themselves: a) when the customer is new and is completing your credit application b) when they are growing with your company and need a higher credit limit c) when they become higher risk due to slowing payments or negative news items and you plan to lower their credit limit. d) one year after your prior request. At some point, their original ‘no’ may turn to a ‘yes’ if they have come to value your company as a supplier and want to grow with you. Don’t give up.

     

      1. When requesting financials or related data, ensure you are talking to the person with the knowledge and authority to address your request: Owner, Controller, CFO, CPA, VP of Finance, accountant etc. A good approach would be to ask for the controller’s name and email address and request what you need in writing. This gives them time to prepare a response and they will likely respond by email as well. A written response can be viewed as carrying more weight than a verbal one.

     

    1. Did you know a customer can tell you a lot about the financial health of their business without sharing a single number? Simply ask them if they, in lieu of providing specific financial data, would be willing to answer a few yes/no questions? For example:
      • Is the company generating a positive Operating Profit year to date? How about as of the last year end?
      • Is the firm generating positive Net Profit (bottom line) year to date? How about as of the last year end?
      • Is the firm generating positive Cash Flow from Operations year to date?
      • Is the firm in compliance with its bank covenants?

      Here’s what you can glean from this: all businesses should generate an Operating Profit. If not, something is wrong with how they are purchasing and/or pricing their good & services – or they are not selling sufficient volume to cover costs. If a firm has positive Operating Income but has a Net Loss, that suggests they may have a lot of interest-bearing debt since one of the largest items between Operating income and bottom line Net Income is Interest Expense. Negative CFO might suggest poor management of A/R and/or Inventory as these are often the largest ‘users’ of cash. Often companies will slow payment to suppliers and/or borrow more to raise cash to pay their bills. If they depend on a bank line of credit to fund their working capital, and due to an Operating Loss have a minimal or negative Interest Coverage ratio, they might break a bank covenant which could put their line of credit in jeopardy or at minimum lead to a higher interest rate and a penalty to waive the covenant violation. A few yes/no type questions can yield a lot of information while allowing the Customer to remain in their comfort zone.

       

        1. If some of these answers come up negative or the customer seems evasive, show empathy and say something like this: ‘All businesses have challenges. As a credit person, if I know a business has problems, and they know it and demonstrate they are proactively working to resolve them, that goes a long way in inspiring confidence. Please tell me more about your plan to turn the business around’ (or ‘Help me understand what you are facing so I can see what we can do…’)

       

      1. As the diagram below suggests, there are many levels of financial disclosure. When requesting financials from a private company, view it as a negotiation and start by asking for the highest level of disclosure and depending on their response, work down from there. Many small businesses find audited financials to be too costly and opt for ‘Reviewed’ or ‘Compiled’ financials which are more affordable. Some customers might send you their internally prepared financials which can be very detailed but can be easily summarized in an Excel spreadsheet. Near the bottom of the diagram, you can observe the strategy of getting partial data-usually to enable the credit person to calculate a few key ratios including Current Ratio, Interest Coverage Ratio and Total Liabilities to Tangible Net Worth (a leverage ratio). So if a customer refuses at the start of your call to provide a Balance Sheet and Income Statement, your goal by the end of the call is to request partial data over the phone to enable you to do some routine ratios. If the answer is still ‘no’, document the call and make another request next year. If the customer raised an objection you were not prepared to address, go to work on coming up with a response that could potentially lead to a more positive outcome…next time.
      Audited Financial Statements
      Reviewed Financial Statement
      Compiled Financial Statements
      Management Prepared Financial Statements
      Tax Return
      Partial financials – viewed on-site per Customer requirement
      Partial financials – gathered via email
      Partial financials – gathered verbally
      Financial Statement yes/no type questions (non-numeric)

      Additional tips:

        1. For a new customer, always ask for 3 years of financial data so trends can be observed. Two years of data are also very useful and if all you can get is one year, even that can bring additional insight to your credit decision.

       

        1. Ask when their year-end is and what month of the year their financials generally become available and note it so you can better time your request and eventually automate it. Upon receipt of financials, note the auditor sign-off date as it is a good predictor of when they might become available next year.

       

        1. If customer has a strong reluctance to share financials, offer to sign a confidentiality agreement (their form or yours). Be sure to sign it using your job title and have a legal- minded person review it before sending it back to Customer.

       

        1. Once a customer begins sharing financials, especially if they only provide partial data, encourage them to upgrade their level of disclosure when you contact them the following year. Maybe they omitted the Statement of Cash Flows or Footnotes. Note it and ask. Maybe it was unintentional? Or maybe they don’t pay their accountant to prepare these documents? Always ask for more and be grateful for what you get, ending the call / email on a positive note.

       

        1. Keep good notes. Who you spoke to, their title and the reason they gave for not providing data, if applicable. Things change fast in business and the person who declined to provide data this year may leave the company or assume a different role and their replacement may understand the benefits of sharing data more than their predecessor. Conversely, your role may change and whoever takes your place would be far better off building on your documented experience with a Customer vs. starting from scratch.

       

        1. Be sure to identify which of your customers are public companies since audited financial information on them is free and easy to obtain via sec.gov or tools like Credit Risk Monitor. Moody’s, S&P and Fitch ratings are generally free when accessed via each providers respective web sites. Stock prices and their 52 week range are also readily available (via yahoo finance) and take into account a lot of financial and market data and can therefore provide insight as to how well a company is doing and is expected to do in the future.

       

        1. Consider how your analytical skill set will grow by having more financial statements to analyse. How you can use Excel to calculate ratios and score them and create additional value for your company and credit team. NACM has several class offerings to help you develop these skills and also offers the Certified Credit and Risk Analyst (CCRA) certification. See nacm.org for more information.

       

      In conclusion, when selling to a public company, we don’t worry about a Financial Statement Request batting average since there is always more than enough financial data available to support our credit decisions. But it does come in handy with private companies since in many cases, they have other suppliers to choose from and can display a ‘take it or leave it’ attitude. Or they have found they get plenty of trade credit without Providing any financial data because many companies don’t ask for it.

      If you keep in mind that they continue to buy from your company for a reason, probably because you are better than the competition, you will eventually find an opening to request and receive financials data where they may have been unwilling to share before. Be persistent, systematic, creative and persuasive. Take the high level view that by having their financials data, you can use the credit function as a way of serving your customers even better by giving them the Credit Limit and Risk Rating they truly deserve while at the same time protecting your company’s investment in its Account Receivable asset.

      This article was originally published in the January/February 2016 issue of “The InterConnection.”