"Trust but Verify" Creditworthiness

By Mary Ellen Biery, Research Specialist, Sageworks, Inc.

More than four years after the peak of the US financial crisis, financial professionals, businesses, and borrowers still remain cautious about their exposure to risk. 
 
In a recent survey, only about 6 percent of senior loan officers at US banks said that credit standards for commercial and industrial loans or credit lines had eased over the past three months. Instead, most respondents said that standards were basically unchanged. And among financial institutions that had eased credit standards or loan terms, it was more often due to aggressive competition from other lenders – not a more favorable economic outlook.
 
Credit managers outside of banking, too, are exercising caution in their own extensions of credit. The Credit Management Association found that 30 percent of respondents expected to tighten credit policies in the upcoming quarter. At the same time, corporate credit managers are under more pressure to evaluate credit because demand, as measured by the number of received applications, had picked up. 
 
How can a business keep a pulse on the companies with which it interacts? As a CPA, you can advise your business clients on how to evaluate potential business partners, further instilling your role as a trusted business advisor. 
 
All too often, companies trust that a potential business partner is creditworthy with very little evidence to support the assumption. Ronald Reagan made popular the catchphrase "trust but verify" regarding the former Soviet Union, but the maxim is a good one for businesses considering new business relationships too. 
 
"Most [business-to-business] credit risk is really of a thirty-, sixty- or ninety-day nature, so it's very short term," says Hugh W. Connelly, CFA, president of Univest Capital Inc., a small-ticket corporate finance business. 
 
"As long as the customer pays their bills within thirty days, I don't think people even look at the creditworthiness of the customer. They just assume that because they paid their bill on time last month, they're going to pay their bill on time this month."
 
But that's dangerous. Many businesses examining a company's trade-credit history are evaluating data that's ninety days or older – ancient by business terms, according to Connelly. 
 
Connelly says payment histories can be valuable, but he recommends that credit managers shouldn't rely too much on them either. Depending on the situation, it makes sense to perform a more thorough financial analysis.
 
Sageworks analyst Libby Bierman says that if a company's risk appears to be above a given threshold or even if payment history is spotty, deeper analysis, such as a review of financial statements or cash flow, may be warranted. Additionally, requesting and analyzing financials might be a necessary step in the review process for suppliers that are particularly crucial to the supply chain or for customers requesting credit lines over a certain amount. 
 
Conducting due diligence on a supplier could also help credit managers trust but verify the integrity of a supply chain, a significant operational exposure. "Checking a supplier's likelihood of default based on current finances could save you money and trouble," notes Bierman. "If they go out of business, you could be out of a key line of credit and a key supplier, or if they don't make their payments on time to their suppliers, that could affect your whole supply chain," she notes. 
 

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Michael Mazzarino, founding partner of strategic advisory firm SCA Group LLC, says that in addition to quantitative verification, credit managers should consider qualitative checks. "It's extremely useful to get in a car or airplane to visit the supplier, partner, or customer," he says. "You see a lot that you don't often see in the analysis of financial statements or projections."

 
For example, walking through a customer's warehouse may reveal boxes of very old inventory. "You may or may not have a problem with cash being tied up, but at least you have the genesis of a question," Mazzarino adds.
 

About the author:
Mary Ellen Biery is a research specialist at Sageworks, a financial information company and provider of the Business Credit Report by Sageworks. She is a veteran financial reporter whose works have appeared in The Wall Street Journal and on Dow Jones Newswires, CNN.com, MarketWatch.com, CNBC.com, and other sites.

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