Let’s say your business finds itself in a position where an investor has shown an interest in injecting cash into your company. Whether this investment comes in the form of equity or as a loan to be repaid, the investor will usually want to see specific information about your business.
At this point, the investor will start using technical terms and sometimes they might seem to be speaking a different language. Essentially, the investor wants to assess your business’s financial risk profile . This is a combination of business and financial data about your company that helps the investor decide whether or not to invest. In this article, which is part 1 of this series, we are going to help you understand the process of determining your company’s risk profile.
The seven key indicators of financial risk
There are seven key indicators of financial risk that provide insight into management’s ability to lead the business through economic, market, and competitive challenges. They are not the only relevant indicators of risk, but they are what the analyst uses to launch an assessment.
These seven core cash drivers are:
- Sales growth,
- Gross margin,
- Operating expenditure percentage,
- Accounts receivable days,
- Inventory days,
- Accounts payable days, and
- Net capital spending.
A complete financial risk assessment consists of a thorough analysis of financial statement data and notes, financial ratios, cash flow and projections. This is key in determining the overall credit risk profile of a business and is more than just whether you can borrow or how much you can borrow. It is a temperature check of the overall health of your business, although the numbers are just one tool in the analytical process.
🔸 What can sales growth tell you?
Sales growth is a measurement of the rate of change in sales from one comparable accounting period to the next. Understandably, it is one of the most important drivers of profit in risk and cash flow assessments. It impacts many income statement and balance sheet accounts. Well-managed sales that are less volatile allow management to chase growth using the cash generated by the company rather than using borrowed (and therefore more expensive) money. This lower debt decreases your financial risk and supports more sustainable growth.
Rapid sales growth, for instance, tells the analyst that a higher level of operating assets and cash will be needed to support this growth, and the question is then whether the company is fully prepared to scale up its operations and sustain this growth trajectory. A large increase in sales is likely to increase trade debtors and inventory, which puts a strain on cash, perhaps even creating the need to initiate or increase debt. The interest now due will offset the increase in revenue. Management should have a clear strategy and detailed cash flow forecasts to proactively monitor and control this growth phase.
The reason for the sales growth is also a key factor to be considered, whether it be, for example, reduced prices to improve sales, a competitor leaving the industry, or a new product or technology that boosts sales. Alternatively, increased competition, the resignation of a key sales representative or a recession could adversely affect sales. The impact on cash and profitability needs to be accurately recorded, and the duration of the deviance is also a factor that impacts the overall financial risk profile.
🔸 Why the emphasis on gross margin?
With the exception of the services industry, production costs are typically the largest costs of doing business, and the gross margin is therefore a major influence on the profitability of a business, and the first indicator of a business’s ability to be profitable. Gross margins vary greatly for different industries and business types. The analytical value derived from this driver includes a comparison to industry benchmarks. The margin is affected by management decisions, industry influences, and global economic conditions. In general, the higher the margin, the lower the financial risk and the stronger the cash flows of the company.
There are a number of potential scenarios that may influence the gross margin of a company. For instance, a material supply shortage in an industry could drive up production costs and lead to lower profits, or the global economy could be beset by inflation or a recession, although the former could be offset by a price increase. Automation of the production process would impact the costs that affect the gross margin. Similarly, a decision by management to cut selling prices could also influence the margin. Overtime incurred to meet an increased demand would have a positive effect on the margin if the increased production is scaled to exceed the increased production costs. These are all examples of scenarios that influence the gross margin which could be used by analysts to determine the financial health of a company and its prospects with respect to profitability and cash flow.
🔸 How important are operating expenses (“opex”) as a percentage of net sales?
Opex as a percentage of net sales gives us a ratio that represents the portion of gross margin consumed by expenses related to selling, general and administrative costs. The ratio is a keen measure of management’s ability to manage expenses consistently throughout various phases of the business cycle. Absolute levels and trends in this ratio are highly informative about the operating efficiency of a business, with an inverse relationship. The lower the costs, the higher the suggested operating efficiency. As with most indicators, the level of opex varies greatly from one industry and business type to another. The most useful comparison is that of a company’s opex to the industry benchmarks. The lower and better controlled a company’s opex is, the better its financial risk profile.
In the scenario of a recession, which would imply a drop in sales, some variable operating costs would decline because they are directly linked to the sales volumes, but fixed costs would be fairly rigid. If the company has a lean opex structure, it will be more resilient to the recessionary effect, and the opex percentage would remain fairly stable. Management would thus be maintaining a stable financial risk profile.
The historic trend of the opex ratio would also be an indication of the stability of the business and of its ability to withstand external pressures, such as competitive forces (higher rental at better premises) or industry changes (such as wages). A consistent ratio that is fairly low if benchmarked to industry norms will be reflective of consistent management policies and strong controls governing expenses.
🔸 What do accounts receivable days, inventory days, and accounts payable days indicate?
Accounts receivable days, inventory days and accounts payable days are activity ratios that help the analyst to gauge the financial risk profile of a company. This is because all three components impact heavily on the cash flow position. As for all other indicators, these measures vary from industry to industry and benchmarks are the most useful comparison to determine the health of the ratios. Factors such as seasonality and the location of the debtor, creditor or business (terms) and source of inventory will play a role in determining the risk profile too. A comparison of historical measures and trends will indicate the stability of the cycle for debtors, creditors and inventory.
Accounts receivable days refers to the average time it takes to collect cash from customers for the sale of products or services. This is an indicator of the efficiency of the collections process and management of the debtors. A more efficient process will result in fewer accounts receivable days. The better the receivables are collected, the better the cash flows and the stronger the financial risk profile of the business. It is important to know what influences the time taken to collect the debt, as this understanding will support the perception of the reliability of cash flows. If a customer has longer terms either to boost their support or to accommodate specific trading circumstances, cash flow may need to be substituted to compensate for this, thus weakening the financial risk profile.
Accounts payable days refers to the average time it takes a business to repay its suppliers, and it is similar to accounts receivable days but in a converse relationship. Taking longer to pay a supplier may slow the outflow of cash but it can penalise the business if a discount is available or the company’s credit rating and/or reputation is adversely affected. The effect of discounts available for payments made should be compared to the equivalent cost of borrowed funding that may be required to pay creditors early. The financial risk profile is determined on the back of a thorough understanding of the components of the ratio.
Inventory days refers to the average time it takes a business to sell its stock. The more efficiently inventory is controlled, the lower the inventory days will be and the stronger the financial risk profile of the company. Peer comparisons are a good benchmark of the effectiveness of the inventory policies and procedures. The faster inventory is turned into sales, the better the cash flow into the company. Trends in this ratio are important as they could indicate slow-moving or obsolete stock, fast-moving stock that is in high demand, and various other scenarios that would require proactive management. Detailed inventory information will assist management in making sure that inventory is relevant and sought after, and that excess cash is not absorbed by the inventory cycle.
🔸 What is the relevance of capital expenditure (“capex”) or net capital spending?
Capital expenditure (“capex”) is often grouped with gearing, liquidity and debt service coverage measures to provide insight into financial risk evaluated by an investor or lender.
Although capex falls outside of the trading framework of a company, it has a direct impact on the cash resources of a company and the impact on the operational ability of the company should also be considered. Net capital spending is the difference between the amount of cash spent on fixed assets and the amount of cash received from the sale of any assets in any one year. An investment in a capital asset is usually funded partly by internal cash resources and partly by external funding, particularly in relation to expansionary capex. This investment in an asset is expected to lead to an increase in the generation of revenue and future cash flows. The lag between the actual expenditure and the ability of the asset to generate revenue should be taken into account when determining the cost of borrowing money and the ability to repay that money.
A lack of spending on capital items is also a focus area for an analyst in a business where revenue is derived from the sweating of fixed assets. For example, a manufacturing firm that has assets that constantly need repairs and that have been written down to a nil net book value in an industry that is exposed to technological advancements will indicate a high risk. In conjunction with this perception, future expected capex must be planned for as it is critical both in terms of cash flow projections and operational efficiencies.
🔸 Are these the only relevant contributors to a financial risk assessment of my business?
These seven factors form the initial phase of a financial risk assessment. They are not the only relevant contributors but they are what the analyst uses as a springboard to launch an assessment. Once you understand these seven basic factors the elements that follow on from this will make sense. After the initial assessment, your business’s risk profile will then be layered with a further analysis of more complex financial elements to determine a holistic picture of the financial, business and blended risk profile of your company.
Reference: Moody’s Analytics