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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:

1. Sales growth,
2. Gross margin,
3. Operating expenditure percentage,
4. Accounts receivable days,
5. Inventory days,
6. Accounts payable days, and
7. 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

So you’ve been thinking about growing your business and you’re full of ideas. But then you start to think about financing that growth and the glow of enthusiasm dulls as the questions form in your mind. How much financing do you need? How do you get it? From where?

Financing always seems to come with mountains of paperwork, which doesn’t appeal to many business owners. But there is an easier way, which involves getting Creative CFO to help. We have the team, skills and affordable products to help your business grow, with a straightforward approach that will not overburden you or your company.

A business poised for growth or a strategic shift is faced with the following questions:

• What to finance?
• Where to look for funding?
• What is the company’s optimal debt capacity?

Creative CFO can help you answer these questions.

Adding debt to the balance sheet

Even if a company has cash resources, these are usually needed for the day-to-day running of the business and working capital needs. If cash resources are used to fund a project or to pay for an asset this will place a huge strain on operating cash requirements.

An alternative to depleting your available cash resources is applying for a loan which will introduce new debt to your balance sheet. Adding debt to the balance sheet may be scary, but if it is responsibly taken on, it will not overburden the company. Rather, it will support growth and create a new generation of cash flow. For a completely new project or a new source of revenue, debt funding combined with an equity injection could be the best way to source cash.

What is the invested cash used for?

Not all the cash invested or lent to the business is necessarily used to pay for new assets. It could be to support the initial increase in operating costs, such as new staff members, or to pay rental for increased office space. These are just a few of the daunting decisions that a business owner needs to make. That’s why Creative CFO offers a range of expertise and investment products developed to take a business to the next level. We have the experience and knowledge necessary to shoulder some of the burden as we offer solutions that are tailored to your company’s needs.

Applying for funding

A survey conducted in 2018/19 revealed that access to finance is the biggest barrier to success for an SME. This is because SME’s face several challenges when they apply for new funding. Banks and financial institutions remain cautious of lending to SMEs, largely due to the perception that the risk of recovering the loan will be too high. Historically, the lender has much more negotiating power than the SME. Creative CFO believes in helping SMEs succeed, which is why we strive to make the credit market more accessible and return some of that power to the SME.

We want to partner with our clients to build sustainable businesses with a stable balance sheet, and to maximise the SME’s ability to exploit growth opportunities without exorbitant costs or an onerous borrowing structure. We know that each SME is different and has the potential to tap into unique possibilities. Together we will explore the options available to develop a bespoke balance sheet structure that will maximise your potential and help to build a successful and sustainable business.

Creative CFO’s approach

Creative CFO has a flexible approach to assessing a business and its associated risk profile. Our assessment is not based on the conservative principles applied by first-tier lenders which are better suited to large corporations. We will assess your risk profile on a stand-alone basis, with no preconceptions, coupled with an understanding of the business’s financial and operational structure and performance, the industry that it operates in and the competitive advantages that make it unique.

The Independent Business Review

An example of a product offering that could support effective strategic growth is the Independent Business Review. A business review is an objective assessment of the commercial and financial position of a company to determine its future viability. The review is made available for both internal and external stakeholders. The review includes a stress test of management’s business strategy and plans for real challenges and opportunities. It also evaluates the risk of meeting performance forecasts, and identifies potential upsides that could be exploited.

In performing this review, we focus on market prospects; customer and product profitability; working capital; funding structures; and management processes. After an initial assessment, we would meet with you or the necessary representative team to discuss what you would like to achieve and what your concerns are. Then we do a deep-dive into the business and prepare a succinct report.

How does the business review help?

The report can assist management in addressing the areas of the business that are identified to refine current processes and policies, and introduce cost savings, optimise operating efficiencies and generally streamline and refine the business model to strengthen net cash inflows and the operating performance.

A business review can expose those areas of the business that will benefit from a cash investment, and explicitly indicate how the cash can be applied to introduce new or increased cash flows. One example of this would be to highlight the need for a vacant role to be filled so that vital financial functions are performed that can strengthen the working capital cycle and increase the cash inflows.

An independent business review will also indicate pressure points such as direct costs that impact margins, whether optimal pricing decisions are in place (including whether customers are price sensitive), and what economies of scale would be introduced by certain volumes of product. A trajectory that shows a negative correlation between increased production versus fixed costs will appeal to a funder, and provide reassurance that new cash inflows can support debt repayments. In short, the review will communicate vital data about your business to the lenders.

Applying for funding is a big step for an SME. It can be tricky to convince lenders that your business is the right one to invest in, but this is where a business review and the advice of Creative CFO will stand you in good stead. When you are ready to take the plunge and accelerate the growth of your company, contact your Creative CFO financial manager, or email our Investment Team to find out more.