Should you ask your customer for a financial statement?
The need for a financial statement will be determined by the extent of the risk exposure and the information already obtained from your credit investigation. From both the credit application form and subsequent credit investigation, a quantified decision should be able to be made as to the credit limit and what the perceived level of risk may be. Keep in mind, there is an important policy tradeoff between credit investigation costs, bad debt expense and carrying costs. Bad debt and carrying costs can be reduced by credit investigation. However, at some point the costs for additional credit investigation will outweigh its benefit of reduced bad debt and carrying costs.
Therefore, a policy of full investigation for every customer is not generally advantageous. The depth of the credit investigation should depend upon the order value and the extent of the risk exposure.
If the anticipated credit limit (risk exposure) is high and the information obtained in you credit investigation does not justify that credit limit (risk exposure); a current audited financial statement should be requested. While it is common to ask for financial statements, private companies often resist furnishing them.
As the credit grantor, you will most often be presented with two financial statements — the income statement and the balance sheet. Financial statements prepared by a CPA should include an opinion, income statement, balance sheet, statement of retained earnings, statement of cash flows, and the accompanying notes to the financial statements.
There are four basic types of financial statements: audited, compiled, reviewed, and management prepared. Audited statements are prepared by a CPA and offer the most reliability. The financial statements are the responsibility of management; however, the CPA is legally liable for what is said in the opinion.
Many of the financial statements that you receive may not be audited. These statements are usually prepared by an accountant who does not express an opinion. Those financial statements are referred to as compilation and review. Compilation refers to financial statements prepared from the books and records of the client. It does not include any review or verification and the accountant does not assume responsibility or liability for the financial information. Review refers to financial statements prepared from the books of the client and includes limited inquiry and analytical procedures.
Management prepared statements are used most often for interim period analysis. When dealing with a small or privately held business, management prepared statements may be the only ones available. When reviewing management prepared statements it becomes important to use previously obtained information from your credit investigation to help determine if the management of the company is trustworthy.
Financial statements can provide a good picture of the health of a company. However, a balance sheet is only a snapshot of a company at the moment of time that it was prepared. Therefore, it is out of date before they are issued. That being said, financial ratios mathematically test accounts on a company’s financial statements to help determine financial strength. Ratios include a test for liquidity to help determine a company’s ability to pay back regular creditors; leverage to help determine if a company has taken on too much debt; profitability to test a company’s ability to make sales and earn profit; and efficiency to help analyze a company’s operations.
While financial statements can be helpful in determining the credit limits for customers, it is also necessary to review the notes of the financial statements because sometimes companies will hide critical obligations or liabilities in these notes. Your company should have a Credit and Collection Policy and Procedure that includes guidelines for setting credit limits and when a financial statement should be required. If you have any questions or need assistance in establishing a Credit and Collection Policy and Procedure please contact our office.
