Pause Before Extending Credit: Check the Debt to Asset Ratio
by Aaron Nelson on December 16, 2014
Extending credit to another business will always involve a certain amount of risk. However, some companies’ entire business model depends heavily on being able to extend credit. Before extending credit, businesses need to gather, analyze, integrate, and apply information to inform their decisions about which opportunities present a healthy amount of risk and which they should avoid. They should also use data such as the debt to asset ratio to determine how much funding they can safely give to the business and what interest rate is needed to make the risk worthwhile.
Businesses seeking credit are required to provide accurate financial statements to show possible creditors exactly what the current state of financial health is for the business. A creditor can conduct an audit of a business’s financial statement in order to determine how big of a credit risk that business is.
A company’s financial state should include information on things like the debt to asset ratio, which is also known as the financial leverage ratio. These ratios demonstrate how much debt the business currently has, stated in terms of a ratio with their current total financial assets. This, in turn, can be used to determine how capable the company is of meeting its existing financial obligations.
A business with a high debt to asset ratio would be considered highly leveraged, and would therefore be a very poor candidate to receive more credit. A business like this is already operating with a large amount of risk. This is because even a slight change in financial circumstances could leave the company unable to meet its existing obligations, let alone any new obligations the company were to take on in the future.
On the other hand, if a company has a very low debt to asset ratio, this would indicate that the business’ leaders have been conservative about taking on debt in the past. These businesses could conceivably take on more debt with very little additional risk, as they already have a level of assets that exceeds their current financial obligations. As a result, a creditor might determine that it could safely offer more credit to such a business, with a lower interest rate to reflect the lower level of risk that the borrower represents.
Of course, not everything in credit analysis is so black and white. You must look at each individual situation carefully, comparing the debt to asset ratio and other indicators of financial strength with the industry averages for similar companies, and then attempt to make an educated decision on each case. Often times, doing a financial statement analysis should be considered a useful method of determining which companies you should definitely not extend credit to. By the same token, a positive financial statement analysis should merely be looked at as a “yellow light”, clearing you to proceed with caution, rather than a clear go-ahead to extend credit to a company.
As is the case with all matters related to credit analysis, it’s important that you take the time to consider all of the data that’s available to you. At D&S Global Solutions, we provide a variety of account receivable recovery service solutions, including preventative measures. With our advanced technology, data analytics, and the evaluation of our experts, we have the tools to yield the best results for our clients. Reach out to us with questions about how we can help support and augment the efforts of your business and improve your relationship with your clients.
You can learn more about steps your business should take prior to extending credit in one of our earlier blog posts.