Business risk indicators
Category: Corporate Banking
The operations of a company can be understood as a cycle: every company invests cash to buy raw materials. It adds value in the manufacturing process to convert raw materials into finished goods. The finished goods are sold, often on credit terms. In order to generate new cash, the company must ensure that its customers finally pay their bills.
Each stage of the business cycle is mirrored by one or more balance sheet items. So the business cycle gives you a better understanding of the related current assets in the balance sheet and of the particular risks that are connected with them.
| Stages of the business cycle | Related balance sheet items |
|
Cash Supply Production Demand Collection Cash |
Cash, short-term bank deposits Raw materials Work in progress Finished goods, inventory Receivables Cash, short-term bank deposits |
a. Supply risks
The company must be able to obtain all the raw material it needs to produce its goods
— in sufficient quantity and quality
— at an acceptable price and
— at the right time.
A credit analyst has to consider the following issues:
Can the raw materials be easily obtained, or are they a scarce commodity? Where do they come from? There may be restrictions on their availability by acts of government, individuals or nature. Are the means of transport fast and efficient or are they subject to delays?
Companies that rely on commodity goods provided by a number of local or regional suppliers, have relatively little supply risk. A firm is highly vulnerable, however, if it is exposed to only one highly specialized supplier who is located overseas. Can a company easily change the source of its raw materials? How is the long term supply of the necessary materials secured, e.g. by long-term contracts?
Many factors can affect the price of the raw materials. Is the price expected to change? What has the company done to protect itself against adverse price changes? Often a company can negotiate a better price by agreeing to pay immediately on delivery or in a very short period of time.
b. Production risks
A company must convert the raw materials into finished goods in a manner that is
— cost effective,
— timely,
— efficient and that
— ensures sufficient quality.
The process by which the company adds value to the raw materials should always focus on the customer and his needs. The production process must ensure that the customer gets at least the quality he wants. All steps in the process that do not add value should be eliminated. In most companies, such unnecessary work accounts for a considerable proportion of total costs. On average, experts estimate, such a waste of resources makes up 35 % to 50 % of total sales (!) in the manufacturing industries as a whole, 30 % to 40 % in the construction industry, and 30 % to 50 % of all administrative expenses in the service industries. The efficiency of business processes, however, is very difficult to assess from the banker’s point of view. An account manager should, nevertheless, draw his clients attention to this problem.
More obvious is the plant and equipment of a company. Its machinery should be well maintained and up-to-date. Are obsolete machines regularly replaced by investment in improvements or by new equipment? Does the cash flow allow for these investments? Is the company dependent on one or on only a few machines for a major part of production? What happens if these machines fail? And last, but not least:- does the plants and stock rooms appear to be clean and orderly?
Is energy always available and at what costs? Could the company become subject to government regulations forcing it to spend a lot of money to control pollution at its factories? Are their any environmentally dangerous by-products?
Labour costs will always be a major cost in adding value to raw materials. But even more important than wages and salaries is the fact that workers must be highly motivated to produce quality products that generate long-term customer satisfaction. Are the staff members well trained? What does management do to keep the staff’s expertise up-to-date? What does the company do to keep skilled labour? How many days are workers absent due to illness?
c. Demand risks
Demand risk concerns the question whether the produced goods can be sold or not. A company with a wide range of buyers that are spread across different industries is less exposed to demand risk than one that has to rely on a single major buyer. So, the bank should know about the customer base of its corporate clients. What factors influence their buying decision — quality, brand name, price, availability, timely delivery etc. Which distribution system does the firm use to ensure that the finished products reach the buyer? Is it reliable in cost and time?
Demand risk is greatly influenced by the company’s competitors in the market place. So, the bank should gather information about the market in which its corporate client operates in. What are the forces determining this market? Who are the key competitors? What are their strategies for selling competing products in the market? What does the management do to counteract this threat?
d. Collection risks
Finally, the business has to be completed by collecting cash for the sold goods. The company has to collect its account receivables. On the balance sheet, receivables appear as an asset. They are, however, worthless if the company’s customers do not pay cash for them in the end. Thus, a firm that sells for cash has no collection risk. Most firms, however, sell on credit terms. The credit analyst must, therefore, consider who the customers of the company are. What credit terms has the company offered? Which factors might prevent the customers from paying? Are the receivables insured against losses? Do the sales and accounts departments efficiently control the account receivables, and at what cost? By means of factoring, receivables can be sold at a discount and be converted into cash immediately. This might be cheaper than keeping a bloated accounting bureaucracy.
e. Ratios measuring business risk
These considerations can be distilled into some ratios that help to quantify business risk. The chances that an event is occurring to interrupt the business cycle are the more likely, the longer or the more complex the business cycle is. Thus, companies with a long production process and high value added, generally, have a greater level of business risk than companies with a short cycle that can quickly convert assets into cash. So, the length of the business cycle can serve as an approximate measure for business risk.
The company should try to minimize the time needed to complete the business cycle, because the production and selling processes tie up money. This ratio should be monitored over time. If the time between the arrival of the raw materials and the sale of the finished goods lengthens, it may suggest that the process is becoming less efficient. If the company needs more time collect its trade receivables, this may indicate that the collection process has become inefficient or that some receivables should be recognized as bad.
A well-managed company will take care that only the minimal level of assets is tied up in the business cycle, because business risk may be defined as the uncertainty that assets will not be converted into cash.