Credit Risk for Business

by | Jul 20, 2022

There’s an old accounting adage “Turnover is vanity, profit is sanity and cashflow is king.”

What does it really mean? And how does it affect the banks appetite to lend?

Let’s start by understanding what each of the following means:

Turnover: this is the total amount of revenue generated or earned by your business over a specific period (example, one year).

Profit: this refers to the financial gain, specifically, the difference between the amount your business has sold versus the amount your business has spent (cost of sales and operating expenses).

Cash flow: this is the movement of money into and out of your business, especially as how it affects liquidity. Essentially, cash flow is how much money your business holds.

Broadly speaking, the Investopedia website describes cash flow as: the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow. Free cash flow is the cash generated by a company from its normal business operations after subtracting any money spent on capital expenditures (CapEx) — Cash Flow Definition (investopedia.com)

When the bank evaluates the strength of your business, these are just three of the key factors they look at when assessing your credit risk. It is therefore crucial that your company’s financial records are up to date. This is done by having updated financial statements, by submitting annual tax returns and by preparing reconciled monthly management accounts.

From a banks perspective, credit risk mostly stems from lending to their clients. Other forms of credit risk do exist, but based on the volume of lending banks do, this is a fundamental part of their business and therefore it is where a large part of their risk lies. The risk that the bank faces is the possibility of those lenders defaulting on their loans.

The bank tries to mitigate this risk through understanding the strength of the business they are evaluating; this is based on the company’s financial history. History that can only be recorded through valid, accurate and timely reconciled financial data. When evaluating the business, the bank will require detailed financial information, as stated above, but it will also require an in depth understanding of the industry the business operates within. Different industries carry different risks, mining, agricultural, hospitality or retail industries all hold various risks that are unique to them, and the bank understands this and applies various risk ratings accordingly. A business’ history and longevity will also play a pivotal role in the credit risk assessment applied to the business. A company that has been operating for twenty years, has a long track record of profit and performance will carry a lower risk to the bank in relation to one that has only been in operation for two years.

When the history of a company is factored in, then security for the loan becomes crucial to the loan being approved. The history of the business will determine what security is required when you lend. Security can be in the form of personal surety, which is a guarantee provided by the borrower, or it can be in the form of a company’s accounts receivable (debtors book), an asset like property or company’s equipment. How much collateral you require depends on various factors ranging from your credit history, the loan amount required or the purpose of the loan. Further to this, the importance of the business owner and its shareholders cannot be underestimated, as the conduct of any individual reflects positively, or negatively on the business’ that they are linked to. The banks’ view is that often, a business and its values is an extension of the business owner and its shareholders. Therefore, if the business owner is one who’s personal finances are in arrears, or the individual has a poor credit rating then the lender can, and will, reasonably assume that the conduct could extend to their business. It is therefore imperative that not only does the business prove it has a healthy financial standing, but also the individual behind it.

At waufm, our experienced financial management team will ensure that your business’ accounts are processed daily, reconciled weekly, reviewed monthly and that you receive a tailored financial report that will not only assist in making better business decisions, but will ensure that you have timeous financial data ready for any credit application.

Contact Dale Petersen on 021 819 7802 to find out more.

1 Comment

  1. LUKAS SNETLER

    The absolute truth!!! Well said indeed!!

    Reply

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