Introduction
Assessing a customer’s ability to repay its debts as they come due is a critical step for commercial lenders and trade creditors in deciding whether to extend credit. The capacity evaluation ensures that extensions of credit are grounded in a realistic assessment of the customer’s financial viability.
At its core, capacity scrutinizes a customer’s financial health from various angles—technical, operational, and financial. It’s a process that goes beyond surface-level metrics to uncover the true capability of businesses to meet their debt obligations.
Understanding Capacity
Where the first C, Character, considers the customer’s willingness to pay creditors, Capacity looks to the customer’s ability to repay amounts owed. Ability is not just about having enough money in the bank. Capacity depends upon technical, financial, and operational aspects of the customer’s situation. In the commercial lending context, this means thoroughly examining the borrower’s financial statements and cash flow projections to evaluate their potential to make consistent debt service payments on the loan. In keeping with the theme of this series – Think Like a Lender – trade creditors should do exactly the same before extending unsecured, interest-free trade credit.
The process of evaluating capacity begins with a thorough review of the customer’s liquidity, cash flow , and leverage:
- Liquidity: Cash, cash equivalents, and short-term borrowing capacity available to pay debts as they come due
- Cash Flow: The ability to generate or raise cash to maintain liquidity
- Leverage: The extent to which the customer’s business is financed with debt (as compared to equity)
Strong liquidity, positive operating cash flow, and prudent use of leverage are the cornerstones of financial health. An assessment of these three metrics provides a clear picture of a customer’s ability to manage its debt obligations without compromising operational integrity.
The Role of Ratio Analysis
Ratio analysis is a key tool in the trade creditor’s arsenal for assessing capacity. Financial ratios are based on measurable, objective metrics and offer a quantitative basis for assessing a customer’s financial health and capacity and comparing customers to one another. Every ratio answers a specific business question.
Two critical ratios often used by commerical lenders are the debt service coverage ratio (DSCR) and the total leverage ratio.The DSCR measuresavailable cash flow to pay current debt obligations, answering the question of whether a borrower generates enough income to cover its loan payments. The typical formulation of the DSCR is net income divided by debt service payments over a particular measurement period (typically a year or a quarter). A higher ratio signifies a greater ability to service debt, making it a valuable metric for lenders. A DSCR less than one indicates that the business cannot even make debt service payments on its funded debt – much less pay its trade vendors on a timely basis – and is indicative of immediate or impending financial distress. A downward trend in DSCR over a series of quarters suggests a declining ability to pay debts as they become due and the potential for eventual financial distress.
The total leverage ratio provides insight into the proportion of debt used by a company to finance its assets. This ratio answers the question of how much of the company’s capital structure is financed through debt, reflecting the company’s reliance on borrowed funds. How much leverage is too much varies by industry and with macroeconomic conditions such as prevailing interest rates, growth expectations, and the state of the credit cycle. Excessive leverage deprives a business of financial flexibility, which can lead to a loss of liquidity in the event of economic downturns or shocks.
These two ratios provide a longer-term assessment of the financial capacity of a business, which is why they are staples of commercial lending. In that respect, they are useful for trade creditors assessing a customer’s long-term prospects. However, because trade creditors typically extend credit on a short-term basis, ratios looking at the customer’s ability to pay on a shorter timeline are of equal importance.
Two key ratios relevant to trade creditors are the current ratio and the quick ratio (or acid-test ratio).
The current ratio divides a company’s current assets (assets reasonably expected to be converted into cash within one year) by its current liabilities (liabilities due within one year). The current ratio answers the question of whether the customer will be able to pay all of its short-term debts as they become due. A current ratio of 1 or above indicates that the company should be able to pay all of its short-term debts as they become due, absent any accounting errors or fraud (such as understatement of bad debt reserves or overstatement of inventory value) – but the higher, the better. A current ratio below 1 is a potential red flag of near-term liquidity concerns.
The quick ratio answers the same question, but on a shorter timeline. The quick ratio divides a company’s most current assets – cash, cash equivalents, and net accounts receivable – by its current liabilities, to assess the extent to which the company has enough near-cash assets on hand to pay all of its current liabilities immediately. Because the numerator of the quick ratio is only a subset of current assets, the quick ratio will always be less than or equal to the current ratio. As with the current ratio, higher is better, particularly from the standpoint of a trade creditor.
Importance in Trade Credit
The evaluation of capacity is not exclusive to commercial lending. Capacity is equally vital In the trade credit context. Trade creditors, who sell goods and services to businesses on credit terms and typically on an unsecured, interest-free basis, should conduct a careful assessment of their customers’ ability to pay within the agreed terms. The same metrics used in commercial lending, such as liquidity, cash flow, and leverage, are valuable indicators of a creditworthiness in trade transactions.
A Closer Look at Financial Statements
Financial statements are central to the capacity analysis. Income statements, balance sheets, and cash flow statements offer a wealth of information about a customer’s financial health and its current and future ability to pay. A rigorous financial statement analysis, including an assessment of long-term and recent trends in liquidity, leverage, and cash flow, should consider the ratios discussed above, and also identify trends in revenue, expenses, profit margins, and overall financial behavior. These insights are instrumental in making informed credit decisions.
Financial Projections: Forecasting Future Capacity
Beyond historical data, lenders also consider their borrowers’ future financial projections. Projections can be useful for trade creditors as well. These forward-looking statements provide a glimpse into the customer’s expected financial performance, including anticipated revenues, expenses, debt service needs, and cash flows. Accurate projections are critical, as they help assess whether the customer can sustain debt service payments in the future, considering potential changes in their business environment or industry trends.
Mitigating Risks through Comprehensive Assessment
The ultimate goal of assessing financial capacity is to mitigate risks. Lenders and trade creditors face significant exposure when extending credit. A fulsome analysis of the customer’s capacity is a critical step in managing default risk. By understanding the customer’s financial strengths and weaknesses, creditors can make informed decisions, structure credit terms to reflect the level of risk, and, when necessary, require additional safeguards such as collateral, letters of credit, or guarantees.
Conclusion
Financial capacity is a cornerstone in the foundation of commercial credit. This in-depth look at capacity has underscored the importance of a thorough financial analysis—focusing on liquidity, cash flow, and leverage—to ensure customers can responsibly manage and repay their debts. Such assessments are key for mitigating risks and fostering relationships based on financial health and reliability.
The next post in our discussion of the 5 Cs of Trade Credit will discuss the third C: Capital. Understanding a company’s capital structure is essential for assessing its financial resilience and long-term viability. In our upcoming discussion, we’ll address the nuances of capital, examining how it influences a company’s ability to secure financing, invest in growth opportunities, and maintain the financial flexibility needed to weather economic fluctuations.
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