Beginner's Guide to Bankruptcy
By: Adam Easton | Alejandro Ojeda | Eve Sahnow | Jessica Pierre | Kevin Quinn | Tawnya Marsh
Receiving your first bankruptcy notification can be an anxiety laden experience. Bankruptcy documents can be difficult to understand for those who do not deal with them on a daily basis. This simple guide is your companion to help you spot key issues when a customer files bankruptcy. It is written in an easy to understand style, without “legalese”. It is NOT intended to be an all-encompassing solution for dealing with troubled customers. This is meant to assist the entry level credit professional navigate and define the surface of the bankruptcy process. This will help you spot issues to raise with senior management.
Find out if the information is true and accurate or simply a rumor.
WARNING! Verification is extremely important as there are strict legal consequences for attempting to collect a debt if a bankruptcy has been filed.
WARNING! Verification is extremely important as there are strict legal consequences for attempting to collect a debt if a bankruptcy has been filed.
PACER – PUBLIC ACCESS TO COURT ELECTRONIC RECORDS
(This is the fastest and most reliable way to verify, so why go anywhere else?) Electronic access service that allows you to get case information directly from bankruptcy courts.
https://www.pacer.gov/ (Requires login and password)
Google search – Why not? Google knows all!
True? – Move to “Get your Ducks in a Row”
False? – See if you can determine where the basis of the rumor came from. (Talk to other vendors / trade groups)
Hmmm...Pay close attention to the filing date! This will dictate other rights such as potential preference issues (having to send money back) and reclamation (trying to get your stuff back).
Do we have orders pending or in transit?
Yes? – If you were paid up front, good for you! If not, you should consider cancelling or rerouting those shipments back to your warehouse. If already delivered, you may have a chance to reclaim your material. Reclamation will be discussed later.
No? – mark the account for non-shipment.
If you have a contract in place, you need to explore what your options are before you cancel. More about contracts in a bit, but you may want to seek legal counsel. Just sayin...
What does the account look like? People are going to ask a lot of questions so you need to be ready. Gather the proper documentation, to include two years of account records on:
- Delivery tickets (bills of lading, proof of delivery), credit application, guaranty and current statement. (This is the start of it but you will need all the info below retained for later consideration).
- Payment information - Check remittance copies, ACH/Wire receipts etc.
- Invoices (paid and unpaid) and a statement of account.
- P.O.'s which could be emails, voicemail, fax etc.
- How much do they owe you?
The Big Dogs! – This will include notification to salespeople, managers, CFO and others in your credit department (including other branches).
Your Peers! – Luckily NACM can help with this process. Visit NACM’s portal, they will verify (good thing somebody’s got your back) then send out notification to others in your industry group.
YOU WILL NOT BE AUTOMATICALLY NOTIFIED!
What is it? The automatic stay or “stay” bars you from ALL collection efforts. The automatic stay is put in place immediately after filing and there is no notification sent to anyone. The "automatic stay" protects the debtor and its property, stopping actions by creditors to collect on pre-petition debts (any amounts owed prior to the filing) or litigation. Think of it as a shield that is put into place between you and the debtor as soon as the bankruptcy petition is filed. The automatic stay applies to all chapters of bankruptcy
What does it mean to me? Collection Efforts HALT!!! The following can be considered collection efforts: demand letters, statements, phone calls, or invoices sent by emails or fax. As soon as you know about the bankruptcy, stop all efforts to collect any pre-petition amounts owed by the debtor or you will be in violation of the automatic stay (technically notice of the bankruptcy is not required for these efforts to constitute a stay violation).
Can the "STAY" be removed? - In some situations a creditor can ask the court to lift the “stay". Common reasons to do this would be: debtor is behind on home mortgage payments, automobile payments, failed to maintain insurance on home or vehicle or has a non-dischargeable debt such as alimony, child support, or other debt the debtor has agreed to reaffirm (you can't get rid of this one bucko!). If the stay is lifted, the creditor can proceed with certain actions that would otherwise be prohibited by the automatic stay.
Am I someone that can request a "lift" – Under certain circumstances, a creditor can ask the court to lift the stay. For example, if you have a lien on the debtor’s property and the debtor owes you more than the value of the property, you can ask the court to lift the stay. Otherwise, get in line. (meaning no).
How do I "Lift"? A motion is required to be filed with the court. Your next step is to pick up the phone and call your favorite attorney to file a motion (with the presiding court) explaining (in detail) why you are requesting the lift.
Exceptions to the Automatic Stay - If a debtor is filing the second bankruptcy within a year, the automatic stay applies only for 30 days unless extended by the court. If a debtor is filing a third time within a year, the automatic stay goes into effect only by the request of the debtor (if the third filing was in good faith).
Hmmm.. Courts take the automatic stay very seriously. There are consequences for failure to abide by these rules. So keeping your nose clean will keep you out of trouble. Violation of the automatic stay can lead to contempt of court.
Expiration of the stay
With respect to acts against property of the estate – the stay expires when property no longer belongs to the estate.
With respect to the debtor – the stay expires the earlier of when the case is closed or when the case is dismissed.
There are many exceptions and caveats to the automatic stay. If you have further questions regarding this you should seek legal counsel.
Exceptions to the Automatic Stay
What is it? Think of reclamation as a way to “reclaim” the goods that you sold on credit. Once the goods have been delivered or paid for, title has transferred. But, the Uniform Commercial Code (UCC) defines a process to get your goods back in the event of insolvency. The caveat is that successful reclamation requires cooperation with the debtor, who is already in bankruptcy and most likely unwilling to help.
What does it mean to me? Both the UCC and the Bankruptcy Code provide very clear direction on the reclamation process. What you can and cannot do is spelled out for you. Under the UCC, it is the seller’s right to demand that an insolvent (defined as easily as liabilities > assets) buyer return goods purchased on credit. A seller can reclaim goods delivered to a buyer if the seller satisfies the following conditions:
- The goods were shipped on credit
- The buyer was insolvent at the time it received the goods
- The seller demands return of the goods within 10 days of the buyer’s receipt of the goods
- The buyer is in possession of the goods when the seller made the reclamation demand.
Reclamation in bankruptcy: It is important to understand that reclamation rights continue under Section 546(c) of the Bankruptcy Code. Section 546(c) requires a written reclamation demand and expands the reclamation reach-back period to 45 days from the above mentioned 10 days. Note that reclamation rights are subject to any lien on the property sought to be reclaimed.
What do I do? Determine if you have sold them anything on credit in the last 45 days!!
If your answer is NO - get to the back of the line.
If your answer is Yes - Get out your favorite pen again, your "Reclamation Letter" should follow the guidelines below:
- State that it is a demand for reclamation
- Identify the goods subject to the reclamation and include copies of invoices and purchase orders.
- Demand an inventory of the goods on hand and make sure they segregate them until return transportation is arranged.
- Send letter through email, fax and certified carrier to include a signed return receipt.
- For a sample demand letter see the Manual of Credit and Commercial Laws from NACM.
What has to be on the other side for this to work?
- The buyer has to have your goods
- Goods have to be identifiable as yours
- Goods cannot be altered or processed (Must look as shipped)
- Goods are not subject to a lien
WARNING! Once a customer files bankruptcy, a reclamation demand must be sent within 20 days or reclamation rights are lost! Best practice is to send the demand as soon as possible because reclamation rights are only valid if the debtor still has the goods.
Demand Deadlines:The 45-day reach-back period is based on the physical receipt of good, for instance when the goods are delivered and signed for.
Hmmm...Computing 45 day reach-back: Begin counting backward starting the day before filing date. If your goods were received (title transferred) during this time, then they fall within your reclamation rights.
Early Case Considerations
“How do i put myself higher on the Totem Pole!”
First, answer this question:
ARE YOU A SUPPLIER OF GOODS OR SERVICES?
If the answer is “goods,” keep reading here.
If the answer is “services,” sorry! You will not have a priority administrative claim.
What is it – 503(b)(9) elevates all or a portion of the goods supplied to the debtor 20 days prior to the bankruptcy filing from a low priority general unsecured claim to a higher priority administrative claim. The goods must be sold in the ordinary course of business.
What does it mean for me – The 20-day portion of your claim has a much better chance of being paid in full. While secured creditors still retain priority over your 503(b)(9) claim, it’s still much better than being a general unsecured creditor. Unlike a reclamation claim, a 503(b)(9) claim is still available even if a secured creditor has a lien on the goods you shipped and if the debtor has already sold the goods.
What do I do – you must file a motion for allowance and payments of your 503(b)(9) claim. Always consult counsel for assistance with these filings.
Hmmm.. Check the local rules and any orders in the bankruptcy case that permit or require the filing of 503(b)(9) claims by proof of claim form rather than by motion
“The court may not know about you”
What is it? A debtor must provide a list of all known creditors when filing a petition for bankruptcy. You may or may not be a known creditor. It is important to verify that you have been listed as a creditor, your company is listed accurately and the amount owed is correct. If you are not listed as a creditor and do not have notice of the bankruptcy filing, it may preserve your right to continue collection action. (Talk to your legal counsel)
What do I do? You should obtain a schedule of creditors in the bankruptcy case. You can find the court filings through Pacer, or your attorney can get them.
“Proving they owe you money”
What is it? A proof of claim (aka POC) is your way of notifying the court that you’re owed pre-petition debt. The actual POC form is a written statement that notifies the bankruptcy court, the debtor, the trustee, and other interested parties that a creditor wishes to assert its right to receive a distribution (pay out) from the bankruptcy estate.
What does it mean to me? You need to decide if you’re going to file a POC. There will be a notice sent telling you to "file a proof of claim" and list a deadline (Bar Date) to get your claim filed or not to file a proof of claim. In most Chapter 7 and Chapter 13 bankruptcy cases where there are assets to distribute, creditors must file a proof of claim in order to get paid.
What do I do? File a claim because failure to do so will result in no distributions (if there are any).
What to attach - All supporting documentation to support the basis and amount of the claim, including any applicable contracts, invoices, purchase orders, account statements, and security interest (if secured), etc. DO NOT send originals! Take copies of the documents and keep a copy for yourself as well.
WARNING! Be aware of the deadline because late-filed claims may not be allowed.
If your claim is an Unsecured Debt - To see a sample proof of claim go to: http://www.uscourts.gov/forms/bankruptcy-forms/proof-claim-0
A creditor may file a proof of claim on its own, but some may wish to consult with legal counsel.
** Do I qualify as a critical vendor? – Ask yourself, will the debtor survive without you (or at least your goods and services)? If yes, Skip ahead to critical vendor discussion.
If your claim is a Secured Debt - If your debt is secured or you think you deserve "Priority" status, the proof of claim may be more complex and you might wish to consult legal counsel.
Understanding how to prepare and file a proof of claim is critically important for any creditor
WHERE DO I SEND THE CLAIM? – Typically you will send this to the clerk of the bankruptcy court where the filing is held, or in some cases, to a claims agent that may be appointed (which can be determined by looking at the case docket).
HOW DO I SEND CLAIM? – It is recommended that you submit your claim via reputable carrier (UPS/FEDEX) with tracking to ensure timely delivery.
WARNING! A claim is only considered timely if it is actually received by the claims bar date.
Don't file a claim- If you receive notice not to file a proof of claim, it has been determined that no assets have been discovered yet to make a distribution to creditors. If assets are discovered, you will receive a notice setting a deadline to file a proof of claim.
New Rule-Supporting documents must be attached. Exception: If supporting documents have been lost or destroyed (but must attach explanation of circumstances)
“Is is worth it for us to fight this?”
What does this mean to me? You need to weigh the amount of your claim with the anticipated legal fees if represented by counsel. Administrative and legal expenses can be costly, especially in complex chapter 11 cases.
What does it mean to me? You need to identify which chapter of bankruptcy you’re dealing with. The chapter will help determine the likelihood of any recovery (7, 11 or 13):
- Liquidation (chapter 7) - Filed by individuals or companies. Creditors must file a proof of claim in order to be eligible for a distribution.
- Reorganization (chapter 11) - Most common type of business filing. Intended as a reorganization. Can result in a plan or a sale of assets, among other results. The company remains in control of its assets and has all rights of a trustee. If the creditor is listed on debtor’s schedules in a chapter 11 bankruptcy and creditor agrees with amount listed by debtor as being owed, creditor does not need to file a proof of claim (unless the creditor’s claim (i) is listed on the schedules as disputed, unliquidated or contingent or (ii) is not listed on the schedules, in which case the creditor must file a proof of claim in order to be eligible for a distribution).
- Repayment (chapter 13) - Filed by individuals who retain assets and pay creditors over time under a structured plan
Hmmm.. Main difference between 7 & 13 - 7 = property of the estate is whatever debtor had at the time of the bankruptcy filing. 13 = property of the estate includes any property obtained by the debtor after bankruptcy filing until the time plan is confirmed.
What do I do? You need to determine if the debt is Secured or Unsecured. In other words, how is the debt classified by the court? Once you’ve classified your debt, make a final decision on how to proceed with filing your claim with the court.
Secured - Has the benefit of a security interest over some or all of the assets of the debtor. Was the security interest perfected over 90 days prior to Bankruptcy? You get paid first (even before the lawyers). File a claim.
Unsecured - Does not have the benefit of any security interest. Typically, but not always, is paid less than full value and pro rata with other unsecured creditors. See prior section on 503(b)(9) claims how your unsecured claim can be elevated to a priority administrative unsecured claim. Elevating all or a portion of a supplier’s claim from a low priority general unsecured claim to a higher priority administrative expense claim.
Can the debtor's business survive without you?
What is it? - Critical vendors are those that are essential to the bankrupt business’s survival in chapter 11. In other words, you’re supplying a product or service so important to the debtor’s business operation that without it, the debtor would fail to reorganize.
What does it mean to me? - If you supply a product or service that is so critical to the debtor’s operations that finding a replacement vendor would be overly burdensome on the debtor, the bankruptcy court may grant you critical vendor status. If you supply a product that is easily obtained from any other vendor, it is unlikely that the court will grant your critical vendor status. The benefit to becoming a critical vendor is that you can obtain payment in full of your prepetition claim. It also is a likely indicator that your relationship will survive a sale of the debtor’s assets and that your contract (if you have one) potentially will be assumed by the buyer. Often, however, as a quid pro quo for payment of your prepetition claim, you will be asked to extend the same credit terms as they had prior to the bankruptcy. This frequently is done through execution of a critical vendor contract which often provides that your critical vendor payment will be subject to clawback if you “misbehave” (i.e., revoke credit terms without justification). In addition, critical vendors rarely are given a preference waiver, so any payments you received in the 90 days prior to the debtor’s bankruptcy filing may still be subject to recovery by the debtor (subject to any preference defenses you may have – see discussion below on preference defenses).
How to get selected as a Critical Vendor:
To be considered a critical vendor, the debtor must file a motion with the bankruptcy court and prove to the judge that a creditor’s products are necessary to the survival of the business and difficult or impossible to get from other vendors. If the debtor is able to carry this burden then it will be authorized to pay its critical vendors in full.
In order to grant a supplier critical vendor status, courts look at several factors:
- Debtor needs particular products for the company to survive
- Vendor likely would stop selling the debtor absent payment of its prepetition claim.
- Whether payment to critical vendors (and therefore continued supply from those vendors) would increase the likelihood of a successful reorganization.
WARNING! Tread lightly when discussing critical vendor status because if you approach the debtor it can be deemed a violation of the automatic stay.
Are you as big of a deal as you think you are?
What is it? Are you one of the largest unsecured creditors? If so, you might consider becoming a member of the creditors committee. The unsecured creditors' committee is appointed by the U.S. trustee, in a chapter 11 case, and is made up of the largest unsecured creditors (usually 7 but sometimes fewer) of the debtors who are willing to serve. Committee members have a more active role than other creditors and have greater access to information and to the debtor’s representatives. The committee represents the interests of all unsecured creditors in a fiduciary capacity.
What do I do? A creditors committee must first be formed. The US trustee owns the process of forming the committee.
- The U.S. Trustee may appoint a committee as soon as possible after the bankruptcy case is filed if there is significant interest among unsecured creditors.
- The process begins with the US trustee sending a questionnaire to the largest unsecured creditors. Creditors interested in becoming a member of the committee complete and return the questionnaire to the U.S. trustee. From that point the U.S. trustee convenes an in person meeting of those creditors that are interested in serving. The trustee will select members of the committee from among those who submitted questionnaires and are present at the meeting (although sometimes this is done based on the questionnaires alone without an in person meeting).
What does it mean to me? The committee has official duties and responsibilities. There is a time commitment involved with being a committee member.
- Review the progress and status of the case and discuss the same with the debtor. Also, the debtor is required to file periodic financial reports with the Court and the Office of the United States Trustee. These reports should provide valuable information for the committee.
- Investigate the financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of the business.
- Participate in the formulation of a plan.
- Ask the Court to appoint an examiner in the case. An examiner is a professional (often a CPA) with the expertise to investigate the business and file a report drawing conclusions regarding the viability of the same, the competence of past or current management, possible fraud, etc.
- Request the appointment of a trustee. A trustee is an independent third party charged with the responsibility of controlling estate assets.
- Ask the Court to either dismiss the case or to convert it to one under Chapter 7 (liquidation). One cause for dismissal or conversion is unreasonable delay which is prejudicial to creditors.
The Bankruptcy Code provides further that the debtor must meet with the creditor's committee to transact such business as may be necessary and proper, and that the debtor shall furnish to the committee, upon request, information concerning the debtor's business and its administration. If in the performance of its duties, the committee would be aided by the services of an attorney,
Accountant or other professional, the Code provides a means for the appointment of such individuals as may be selected by the committee. The compensation of such individuals will be paid from assets of the debtor's estate, and will not be chargeable directly to individual committee members.
Think About It! - Considerations Throughout the Entire Case....
"You mean they are still in business?"
What is it? Some creditors may decide to sell to a debtor after they’ve filed chapter 11 bankruptcy. The debtor in bankruptcy, known as a Debtor in Possession (DIP), is now essentially creating new debt that is not part of the bankruptcy case.
Vendors need to manage their post-petition credit risk very closely. Due to the possibility that a debtor may have limited cash flow through the bankruptcy process, vendors may want to consider whether to continue doing business, and if so, under what terms. Steps in determining a debtor’s post-petition liquidity include searching PACER to determine whether the debtor has authority to use its lenders cash collateral or has obtained DIP financing. This information might help you as the creditor feel more comfortable with the debtors’ ability to pay you for post-petition shipments. In addition, if the debtor fails to pay you for any post-petition shipment you are entitled to a higher priority administrative claim for those shipments (although there is no guarantee administrative claims are paid in full). If you are not comfortable extending credit post-petition, you can impose COD or cash in advance terms or elect not to ship at all.
"What? I might have to pay money back to the bankruptcy estate?"
The answer to this is “yes” - Keep reading.
What is it? Preference and fraudulent transfer actions are some of the most common bankruptcy-related claims that creditors face. It may not seem fair, but it’s a reality of bankruptcy. The US Trustee will review all payments made to creditors going back 90 days from the date of filing. Any transfer (payment) made by the debtor to the creditor will be analyzed by the trustee. The intent of preference & fraudulent transfers analysis is to prevent a debtor from “preferentially” paying one creditor over another or “fraudulently” transferring assets to another party. The concept is rooted in fairness.
What does it mean to me? No creditor wants to receive a preference action. Nonetheless, you have to deal with it. You may receive a “demand letter” from the US trustee. The demand letter lists the payments that the trustee or debtor-in-possession identifies as having been made to you within the 90-day period. The demand is for immediate payment, usually less some small discount. When a creditor receives a preference demand letter, the creditor should always have experienced bankruptcy counsel review the case to determine whether the creditor has valid defenses (explained more below).
What do I do? You have to defend the preference action. The trustee or debtor-in-possession has the initial burden of proving that the elements of a preference exist. For starters, a prepayment is not a preference (even if the prepayment was received within the 90 days before bankruptcy). The Bankruptcy Code provides defenses to preference actions. The three most common are all “affirmative defenses,” meaning that the creditor has the ultimate burden of proof on these issues. The most common defenses used by creditors are explained below:
Creditors often are concerned about taking payments from their customers when the customer is known to be headed into bankruptcy. The reason is that the payment might be subject to clawback as a preference. Consider, however, that it often is better to have the money in-hand for several reasons:
- You have use of the money,
- The burden is then on the trustee to come after you to try to recover it as a preference, and
- You might have defenses to a later preference claim.
As it is often said, “possession is 9/10ths of the battle!” So, take the payment.
Ordinary Course of Business Defense – This defense is highly subjective, but the most common methodology is to look at the debtor’s payment history to evaluate its average time to pay your invoices for some period of time prior to the 90-day preference period. Did the timing stay consistent before and during the 90-day preference period? You may also use the average time for payment in the relevant industry to prove the ordinary course of business defense. What is the typical payment timing for other companies in the same industry? (Depending upon the court, the relevant industry might be the creditor’s or the debtor’s industry, if they are different.)
Contemporaneous exchange for new goods or services Defense - The creditor proves the “contemporaneous exchange” defense by showing that the creditor provided new goods or services contemporaneously with (i.e. at or near the same time) a payment that was of equal value to the goods or services provided and that the parties intended the transaction to be a “contemporaneous exchange.” For example, if the creditor delivers goods worth $100 on June 1 and is paid $100 for those goods on June 2, so long as the parties intended the $100 payment to be for the $100 in new goods and intended that the payment would occur “substantially contemporaneously” with delivery of the goods, then the contemporaneous exchange defense applies.
New Value Defense – This defense gives you credit for goods that you ship during the 90-day period after you have received an otherwise preferential payment. The value of any “new” goods or services shipped during the 90-day period after an otherwise preferential payment can be offset dollar-for-dollar against any prior preferential payments made by the debtor. In order to use this defense, most courts require that the later shipment remain unpaid, although some courts will count the later shipment as new value even if you have been paid for that shipment. Mechanically, using a simple example, this defense works as follows: you receive a $10,000 payment on Day 80 prior to the bankruptcy filing and ship $7,500 of new goods (for which you were not paid) on Day 70 prior to the bankruptcy filing. Under this scenario, assuming that the $10,000 payment meets all of the elements of a preference and would otherwise be avoidable by the trustee, you are entitled to offset the $7,500 shipment such that your net exposure is $2,500. This defense is much more objective than the ordinary course of business defense.
Don’t get comfortable! They have 2 years from the date of filing to file a preference lawsuit.
"Wait! We have a contract! What do I do now?"
AKA - Executory Contracts
This can be a complicated issue in any chapter 11 bankruptcy case, but don’t let the fancy words intimidate you. This area of bankruptcy is understood by only a small number of people with a specialized knowledge or interest. If you’re confused, that’s okay. We’ll walk through the basics, but it’s always wise to consult bankruptcy counsel if you are aware of any existing contracts that require performance by either you or the debtor.
What is it? - An executory contract is a contract that has not yet been fully performed, that is to say, fully executed. Put another way, it's a contract under which both sides still have important performance remaining, even if your customer is in bankruptcy.
What does it mean to me? If you are a party to a pre-petition contract (aka executory contract), debtors and bankruptcy trustees are authorized to “assume or reject” these contracts in bankruptcy.
Are you serious? Yes, property interests of the debtor filing for bankruptcy become property of the estate. An executory contract is property of the bankruptcy estate.
Why? The Bankruptcy Code allows debtors to shed (i.e., reject) burdensome contracts (e.g., those where the debtor is paying more than current fair market value) and to retain (i.e., assume) beneficial contracts.
How? Only with bankruptcy court approval can the debtor “assume or reject” an executory contract. As a party to an executory contract, the debtor is required to send you notice of a motion seeking authority to assume or reject your contract and you are given an opportunity to object, if appropriate. Bankruptcy courts defer to the debtor’s business judgment when deciding whether to permit assumption or rejection of an executory contract.
What does Assumption mean for me? A debtor may assume an executory contract by:
Obtaining an order from the bankruptcy court permitting assumption of such contract after notice and an opportunity for the non-debtor counterparty to be heard in the bankruptcy court
Confirming a plan of reorganization, which provides for assumption of the contract.
If your contract is assumed, you are entitled to a cure of all defaults (with limited exceptions). This means that if you are owed money under a contract for prepetition sales, if your contract is assumed, you will receive payment in full of your prepetition claim (as opposed to payment of some cents on the dollar).
What does Rejection mean for me? Rejection of an executory contract is essentially the debtor’s declaration that it will not perform its remaining obligations. Upon rejection, the debtor no longer can be compelled to perform.
What do I do?
If you receive a notice that the debtor is seeking to assume your contract, it should include what the debtor believes is the amount needed to cure any defaults. You should review this carefully to be sure that you agree with the amount. If you do not, you will want to retain bankruptcy counsel who can file an objection for you to assert the correct cure amount.
If you receive a notice that the debtor is seeking to reject your contract, first consider whether it is a leverage play by the debtor to try to get you to renegotiate the terms of your contract in exchange for continued business. If the contract is one you would prefer not to lose, you might wish to contact the debtor to see whether negotiations are possible. But know that it is ultimately the debtor’s right to reject your contract. If your contract is rejected, you are entitled to file a “rejection claim.” The order authorizing the rejection or a subsequent notice should tell you the deadline to file your rejection claim. A rejection claim is a claim based upon the debtor’s breach of your contract, which is what is deemed to have happened upon rejection. It is as though you are filing a lawsuit in state court against the debtor seeking damages for the debtor’s breach, but instead you are asserting those damages in the form of a rejection claim in the debtor’s bankruptcy case. The rejection claim is treated as a general unsecured claim.
WARNING! Beware the $0 cure. Often, in the context of a sale of the debtor’s assets, a notice will be sent to many contract counterparties at once stating that the contracts identified on an attached exhibit will be assumed and assigned to the buyer as part of the sale. In many cases, the exhibit is lengthy and the notice requires that any objections must be filed within a very short period of time. Be on the lookout for a $0 cure amount! If your contract is listed and the cure is erroneously listed as $0 but you do not object timely, you will not be entitled to any cure and will lose one of the greatest benefits of having your contract assumed.
Be cautious and monitor all filings and due dates. Deadlines are simply that... DEADLINES! Late or misfiled paperwork can cost you the ENTIRE amount of your claim.
Most proceedings take months and sometimes years to unwind. Use this time to read up on bankruptcy proceedings so next time, you will be ready.
Hmmm.. There are so many things here that should be considered. Too many to get into in this “highlights only” document. 90-day lookback, prepayment, practical considerations, key defenses, ordinary course of business, new value, contemporaneous exchange etc. etc.
NACM has many resources available; start with the latest edition of "Manual of Credit and Commercial Laws" by National Association of Credit Management(NACM). The information is fantastic and sample forms are even provided. A no brainer for sure. As sure as you are that you have all your ducks in a row, you are not an expert. The trickier the case and higher dollar amount at stake, the greater the likelihood you should obtain legal counsel.
Mark Dunham – Lieutenant Colonel Retired - US Navy & Air National Guard
The Meridian Group | 223 Fourth Ave, Suite 1700 Pittsburgh, Pennsylvania 15222-1713 | (412) 232-0113
The United States Department of Justice | “Information For Prospective Creditor Committee Members On Chapter 11 Cases”
Manual of Credit and Commercial Laws - 2014 Edition
Principles of Business Credit 7th Edition
3 A.M. Flashbacks
UCC Article 9 for Dummies
Graduate School of Credit and Financial Management
By: Christen Borman, Douglas Jacobson, Jovan Rosa, Rocky Thomas, Susan Thomas, and Melvin Ucelo
“Risk comes from not knowing what you’re doing”
As a credit manager in the world of business to business (B2B) commerce, it is your job to facilitate sales while managing the risk associated with the extension of credit and protecting your company’s investment in accounts receivable. Trade credit is essential to the accommodation of sales growth and, as we know, there is always some risk associated with the extension of credit. Unfortunately, as B2B creditors, we often don’t have the luxury of requiring collateral to extend credit. The prudent and risk free approach would be to require payment at the time of the transaction. However, the last we checked, our companies have sales growth, increased market share and profitability as their core goals. In a competitive environment, it is essential that we find ways to efficiently leverage the extension of credit to accommodate these goals.
The good news is that there are laws and regulations that provide protection for B2B creditors and give us legal remedies to help mitigate the risk that comes with the extension of trade credit. It is called the Uniform Commercial Code (UCC). The bad news is that most of us are not legal experts and it can be a daunting task to research and understand the UCC. We are hopeful that “UCC Article 9 for Dummies” will provide a quick guide to help the commercial creditor take advantage of the tools available to successfully secure their accounts receivable.
Legal codes and laws are not an easy subject to understand. The Uniform Commercial Code contains the legal framework that governs commercial business transactions. The articles of the UCC are a set of laws governing the sale of goods, leases, negotiable instruments, bank deposits, funds transfers, letter of credit, bulk transfers, bulk sales, warehouse receipts, bills of lading, investment securities and secured transactions. Within the code one of the most important articles is Article 9, Secured Transactions, which provides the governing rules for any transaction that combines a debt with a creditor’s interest in a debtor’s personal property. In 1998 revisions to Article 9 were completed and were approved by all fifty states by 2001. Article 9 provides a detailed instruction manual on steps to take to legally protect a debt by staking a claim in the debtor’s property.
The understanding and use of the basic elements of a secured transaction in Article 9 can be a daunting task. It requires a thorough understanding of the code and any new amendments. A creditor must be able to follow the process, comprehend the scheme and implement a solution that best fits the purpose of mitigating the risk. In most scenarios, the creditor can gain superior bargaining power by requiring the debtor to provide a security interest to the creditor as part of the transaction. This is done before granting a loan or providing something of value in order to maximize the likelihood of payment in the event that the debtor does not comply with the terms of the agreement. The creditor can exercise its rights created under Article 9. For this to be successful it is important to create an enforceable security interest “Attachment”, protect the security interest from claims of other parties to the collateral “Perfection”, and have the highest “Priority”.
As part of the process, it is always important that the choice of law and the parties’ jurisdiction is well defined in order to enforce rights with no delay. This usually is where the debtor is. Complications arise from the need to understand the common legal definitions used throughout article’s many sections, the fact that its rules have exceptions that a credit manager needs to understand, and that timing of actions and the specificity of documentation, if not followed, will endanger the legal protection the creditor seeks.
UCC Article 9 for Dummies is here to decode and help explain from a credit manager’s perspective, the more relevant aspects of the article and demystify the relevant aspects so we know what to do when it is required to secure a transaction. It’s meant to give a high level view of the code and to highlight the riskier areas. A credit manager should always seek advice from legal counsel regarding specific questions of law, especially if the monetary exposure is large.
The credit manager must ensure that all requirements of Article 9 are properly met and documented to obtain a legal claim in a debtor’s collateral if the debtor does not pay or satisfy its obligations. The credit manager must then take the steps necessary to insure that the legal claim established has priority over other creditors.
The illustration below attempts to capture the main areas of the code that a credit manager must be familiar with to protect his or her company’s financial exposure to a non-paying customer. Definitions of underlined terms are summarized in the glossary.
The main point of Article 9 is to be a secured creditor:
If a creditor is secured it has a claim in something of the buyer’s (the goods exchanged for future payment or other collateral). This gives the creditor:
- Right of repossession of goods extended in exchange for future payment if the payment is never made
- Elevated priority in the potential proceeds? Even if the buyer is filing bankruptcy
- It upholds defense to preference in the potential instance of a bankruptcy filing.
However, a creditor cannot be secured or have the claim in the asset until its interest is perfected.
What is a security interest?
A security interest is an interest in the asset of a buyer. This is important for creditors to leverage their position of being able to fully collect money extended to buyers.
A blanket interest securitization can be made and is often the case with banks that have an interest in all applicable assets of a buyer (except for some real property, aircraft, ships and motor vehicles). A Purchase Money Security Interest (“PMSI”) is applicable when the buyer takes possession of the goods from the creditor and it allows the creditor to seek a super-priority security interest, putting them above all other secured creditors in security ranking. PMSI filings are the only ones that require notification to other secured creditors of the filing since it gives that creditor super-priority interest.
What is collateral and why is it needed in a security interest?
The asset (collateral) in a security interest must be personal property but cannot be real property, aircraft, ships or motor vehicles.
Typical collateral involved in a security interest:
- Accounts receivable
- Stocks, bonds and negotiable instruments
Essentially, the collateral acts as the proceeds to which the security interest attaches. The common types of collateral in a security interest are blanket, consignment, or specifically listing the assets or a Purchase Money Security Interest.
It is imperative that a secured party handles collateral with care. The following case is an example of a creditor’s breach of this duty.
Collateral—Must handle with care!United States v. Baus The secured party neglected to take proper care of collateral consisting of debtor’s plant, machinery, equipment and inventory located in Puerto Rico by leaving it in an unsecured warehouse for two years. Theft and vandalism caused the sale of the remaining inventory to be delayed and led to an 88 percent decline in the value. The $100,000 of the debtor’s inventory netted just $12,131 after the expenses of the sale were taken out. The First Circuit found it “likely” that the government guarantor had breached its duties under Section 9-207
Who is responsible for taking care of the collateral?
Practical expenses incurred in ensuring the proper care of collateral are chargeable to the debtor and secured on the collateral. An example would be the cost of insurance. If the goods are accidentally lost or damaged any shortfall in the insurance rests on the debtor. Payment of taxes and other charges directly related to the preservation, custody, or operation of collateral also fall under this category.
Collateral in Action—Use it don’t lose it!
Collateral Description Errors causing failure to perfect
1st Source Bank vs. Wilson Bank & Trust (Tennessee)
The US Court of Appeals for the Sixth Circuit ruled that a creditor bank did not have a perfected security interest in the debtor’s accounts receivable because “the bank failed to include ‘accounts’ or ‘accounts receivable’ as part of the bank’s collateral in its UCC financing statement” even though those words were used in the security agreement.
Ref: source: Business Credit Magazine, May 2014 – “Mistakes in a UCC Financing Statement’s Collateral Description
Can Be Hazardous to a Perfected Security Interest!”
So now I have an interest in the collateral of my buyer - what do I do next?
File a security agreement!
The security agreement indicates the creditor’s right to file a security interest in the specifically named assets of the buyer, which acts as the collateral to uphold the agreement. In order for a creditor to have a valid security interest the agreement must be signed (authenticated) by both the creditor and the buyer, contain a description of the collateral, and make it clear that the security interest is intended.
Why are people telling me I need to be perfect in this process?
What is perfection in a security interest?
Perfection is when the creditor has filed their security agreement between them and the buyer. It is filed with the secretary of the state that the buyer is registered as a business entity in (or resides in if a sole proprietor). If the buyer is registered in multiple states, multiple security interests can be filed per state. If you don’t file your security agreement, you don’t have your security interest and you don’t have any secured rights in your buyer’s collateral. This would mean…You aren’t perfect!
Importance of Perfection!
Debtor Name Errors causing failure to perfect
1st Source Bank vs. Wilson Bank & Trust (Tennessee)
The creditor, CCF Leasing Company, filed a UCC-1 statement but listed the debtor as “Wing Fine Food”. Because a UCC search using the secretary of state’s search logic would not have produced the financing statement, the court found the filing to be fatally flawed and Wing Foods, Inc. was able to avoid the creditor’s security interest claim.
Ref: NCS Credit blog 11/12/2014
But I don’t have time to go to the Secretary of State!
Due to the detailed requirements of filing (including notification, most creditors prefer to use a qualified service, such as NACM’s MLBS.
Due to the detailed requirements of filing (including notification), most creditors prefer to use a qualified service. However, if you wanted to file a financing statement on your own, you must first make sure you have all the proper documents. You would then submit these documents to the central filing office in the state the debtor resides or its business is registered. This is commonly done electronically. Each state has its own rules for filing so further research must be done in order to ensure full compliance to that state’s requirements.
Required documents to file a financing statement:
UCC1-UCC Financing Statement – this is a Unified Commercial Code form prepared by the company granting credit. When it is filed appropriately it gives public notice that a creditor has a security interest in collateral belonging to the customer documented in the statement. The financing statement must be filed with the office of the appropriate government agency, generally the office of the Secretary of State of the buyer’s location.
Sample of UCC1 Template
How do I know my filing is complete?
Upon request at the filing office, you can obtain notification of acknowledgement when the filing is complete. A specific number is assigned to each UCC filing for identification and will be provided with the requested acknowledgement. This number is referred to as the file number. Furthermore, the date and time of the filing is critical given the hierarchy of security interests by date.
First in line, first in right—except for PMSI filings!
Therefore, the date and time will be recorded with each filing as well.
The filing office where the documents were submitted is the place that maintains the records of the financing statement and any attached documents. At least annually all states must review their filing-office rules to ensure compliance and effectiveness.
A creditor can search for records of financing statements by the debtor name or file number if they know it.
A filing can be refused for several reasons, like when it is not received properly (must be original document), the filing fee isn’t paid, an incomplete or invalid name for debtor or does not have attaching and complete financing statement. However, the filing office must communicate the refusal within two business days from receiving the record. Method of communication depends on the state requirements. Each state also has statutory requirements of holding public record documents that would dictate when they can destruct written records of financing statements.
What are the rules of priority and are there ways to obtain priority over existing creditors?
It is important for the creditor to know the rules of priority and determine the steps necessary to ensure that he is protected. Remember that the UCC -1 must be filed – your security agreement is worthless until the filing is complete. In most cases, if there is bank financing, they will usually have a perfected blanket UCC -1 that takes priority. This why it is important to do a thorough search of all prior filings to determine the effectiveness of your filing.
Rules of Priority:
- Determined by the time of filing or perfection – the first filed has the first right
- It includes both proceeds and the supporting obligations of the collateral
- Perfected interests can be subordinated (see PMSI) with the permission of prior secured parties
Can I secure future shipments that will take priority over existing security interests?
As indicated earlier, many times a bank or other secured lender will have a blanket UCC-1 that gives it priority interest in all inventory and proceeds of the debtor. However, there is way to secure goods and proceeds before they are shipped. This is done through a Purchase Money Security Interest (PMSI). A PMSI grants a security interest to the trade creditor sold on credit terms for the price of the goods sold.
A key advantage gained by a PMSI is that it gives the creditor access to co-mingled funds not specifically identifiable by the creditor or the courts.
Rules and requirements:
- Only covers goods and proceeds sold on credit terms moving forward – does not cover existing debt.
- The debtor must agree and sign off
- Must describe in detail the goods or inventory that is covered
- Always do a UCC search to determine existing secured parties
- The secured party (most often a bank) must be notified and grant a priority for the good s or proceeds of the creditor prior to the debt being incurred. This is called a subordination. It is usually not granted unless the secured party determines that it is in their best interest and provides the potential for additional income and profits.
- Must be filed and recorded once completed and signed.
- The PMSI is perfected once the debtor takes possession of the inventory
- You must send official notification to the holder of the prior security interest prior to debtor taking possession
Sample Purchase Money Security Interest
How do I enforce my security interest once it is in place?
A security interest attaches to collateral and becomes enforceable if:
- value has been given
- the debtor has rights in it and/or the authority to transfer rights to a secured party.
AND if any of a number of conditions are met, one being:
- an authenticated security agreement giving a description of the collateral is completed
What happens if my customer (debtor) defaults?
Secured Creditors in Action!
Assuming that you have filed all of the necessary paperwork and perfected your security interest, there may come a time when a customer defaults on the agreement. At that point there are several options available to you to enforce your lien against the collateral.
Three things you can do:
- Foreclose on the collateral
- Claim a judgment against your customer
- Enforce a claim against your customer in court
As a creditor you may deduct reasonable attorney fees and collection expenses incurred during the repossession of your collateral.
As a creditor you can sell, lease, license, or otherwise dispose of any or all of the collateral covered by the security agreement as long as it is reasonable to both parties. If you are going to dispose of the collateral, you must send notification to the customer and any secondary lien holder unless they waive their right to the disposition of the collateral. In most cases a 10-day notice is sufficient.
All proceeds that are received over and above any debt owed must be returned to the customer or to a subordinate security interest holder. The customer would still be liable for any deficiency amount that is owed after the collateral is seized.
Upon default you may require your customer to assemble the collateral and make it available to you at a place of your choosing and is convenient for both you and your customer.
Notice of disposition should include a description of the collateral to be sold, leased, or licensed, the method of disposition, charges associated with the sale or disposition, and time and place of the disposition.
We will sell (lease or license) the following collateral privately sometime after this date. You are entitled to an accounting of the unpaid indebtedness secured by the property that we intend to sell (lease or license) for the amount of $_______. You may request an accounting by call us at (telephone #).
For a consumer goods transaction:
Name and address of creditor and date
Example: Notice of our plan to sell property
Name and address of debtor
Identification of collateral
We have your collateral and because you broke promises in our agreement we will sell (description of collateral) at a private sale sometime after (date). The money that we get from the sale (after paying our costs) will reduce the amount that you owe. If we get less money than you owe, you will still be responsible for the difference. If we get more money than you owe, you will get the excess unless there is a secondary lien holder. You can get the property back at any time before we sell it by paying us the full amount you owe, including our expenses. For a balance owed please call us at (telephone #). We are also notifying other individuals who may have an interest in this collateral or who owe money under your agreement. (List names of other possible lien holders if any).
Acceptance of collateral in full or partial satisfaction of the obligation can be done only at the debtor’s consent within 20 days of notification. This does not require you as a creditor to dispose of the collateral (Does not apply to consumer transactions)
In consumer transactions collateral must be disposed of within 90 days after taking possession or within a longer period to which the customer and secondary lien holders have agreed to.
The customer or a secondary lien holder has the right to redeem the collateral for full payment of the obligation at any time prior to disposition.
Default—Mistakes can be costly!
Sports Authority Bankruptcy and Implication on UCC Consignment deals:
Sports Authority initially filed Chapter 11 bankruptcy to reorganize its structure and become a much smaller retailer of sports merchandise and clothing. However, in the midst of the initial bankruptcy proceedings the creditors became aware that Sports Authority was listing inventory as an asset when the inventory was in fact part of consignment deals and therefore not assets of Sports Authority but still assets of suppliers (creditors). This critical issue forced Sports Authority into Chapter 7 bankruptcy because it had been overstating its assets and blurring the true financial disarray it was in.
During the bankruptcy the court ordered Sports Authority to start liquidating its assets which caused an argument over the proceeds of the sale of consignment items. Should the proceeds go lenders with secured interests in Sports Authority or go directly back to the suppliers with the consignment agreements that claimed they still owned the items up for sale in the liquidation?
Alas, the crux of the issue acknowledged that had the suppliers protected their consignment agreements by perfecting a security interest and notifying lenders to not use the consignment goods as collateral in their security interests of Sports Authority. This is a critical part of UCC Article 9 and important for all creditors to be aware of in their dealings of consignment issues.
The purpose of Article 9
For creditors to gain a security interest in personal property (assets) of a customer which may elevate their position in collections
Security agreement = security interest
Must have identification of parties, granting clause and collateral (asset) description
No UCC-1 = Not perfected = Not a secured creditor
To become a secured creditor à perfect security interest by filing a UCC-1 with the proper filing clerk
With a perfected interest a secured creditor has:
- Right of repossession of the asset
- Elevated priority in bankruptcy
- Defense to preference in bankruptcy
Mistakes are costly
Always review your work for accuracy. Utilize a third party for additional verification to confirm all steps are complete.
Attachment – when a security agreement is executed and the debtor acquires right in the assets subject to the security interest (collateral). The creditor’s security interest becomes enforceable.
Collateral – property subject to a security interest. Laws vary regarding various types of collateral and the legal jurisdiction. Typical personal property involved in a security interest includes inventory, fixtures, equipment, vehicles, accounts receivable, and stocks/bonds/ negotiable instruments. It cannot be real property.
Control – Control of collateral does not mean the same thing as possession of collateral. See UCC Article 9 parts 1 and 2.
Lien – official claim an asset for payment of a debt or an amount owed by a buyer. It is usually a formal document signed by the credit provider and sometimes by the buyer who agrees to the amount due.
Perfection – a legal process by which a secured creditor can protect itself against claims of other third parties who wish to have their debts satisfied out of the same debtor collateral
Possession – with respect to collateral, possession is the control a person intentionally exercises toward that collateral. To possess collateral, a person must have an intention to possess it. A person may be in possession of an asset but that does not imply ownership.
Priority – where your perfected claim falls with respect to other creditors; what is the legal order of collateral disposition
Security Agreement – the debtor agrees to specific points that govern the lien, e.g. collateral and the nature of the debt obligation
Security Interest – an interest in in a customer’s personal assets to secure the repayment of its debt
Purchase Money Security Interest – a specific type of security interest that enables an entity that provides financing for the acquisition of goods or equipment to obtain priority ranking ahead of other secured creditors.
UCC 1 Financing Statement – a UCC form prepared by company granting credit. When it is filed appropriately it gives public notice that a creditor has a security interest in collateral belonging to the customer documented in the statement.
The Basics of Financial Statement Analysis:
From a Credit Professional’s Perspective
By: Charles Edwards, CCE | Vivian Hoang, CCE | Brendon Misik, CCE | Kenny Wine, CCE | John Zummo, CCE
This is a condensed guide to assist credit professionals that are new to requesting and analyzing financial statements or those that are coming to credit from various other departments (accounts receivable, accounts payable, clerical, sales, etc…) and don't have as much (or any) experience working with financial statements. More experienced credit professionals may also be able to utilize the information contained in this guide to enhance and sharpen their financial statement analysis skills. Many companies do not require financial statements and many more didn't require them prior to 2008; however, the number of companies that have added the collection and analysis of financials to their credit file reviews have grown significantly, especially after the recent economic downturn. Many of these companies have now included the collection of financials into their corporate credit policies. It is now more important than ever to not only collect financials, but also be able to analyze them properly and be able to explain your analysis as part of your credit decision. For that reason, it is very important to have at least a basic working knowledge of financial statement analysis and understanding of the key ratios and ideas that go into a sound credit decision. This is what this guide hopes to achieve for the new entrant into credit management.
This guide will walk through the basic ratios to analyze leverage, liquidity, efficiency, profitability, and debt coverage of a company. There will also be an overview on the four basic financial statements (balance sheet, income statement, statement of shareholders’ equity, and statement of cash flows). In addition, the quality differences in financial statements that a credit professional would receive will also be discussed. These will include internally prepared (using QuickBooks or other software), tax returns, compiled, reviewed, audited with a qualified opinion, and audited with an unqualified opinion. The basic financial ratios will show a comparison of two fictitious companies, ABC Corporation and XYZ Corporation. ABC Corp. will be an example of a financially strong company, while the financial statements of XYZ Corp. will be an example of relatively weak financials. The purpose for this would be to allow you, the reader, to follow along with the authors to show performance, and some compare and contrast narrative on what to look for (financially) between these two types of business entities from a credit perspective. Each section will have some “core” financial statement analysis credit metrics, how the calculations are completed, some caveats to watch out for, and “what they mean” from a credit management perspective.
Additional information will be provided on where the reader could go for more subject information to further fine-tune their financial analysis skill set. There will be a short explanation on NACM's credit class offerings followed by a short description of the various NACM-credit designations as well as some suggested financial websites to check out for additional information. We end this paper with a glossary of financial terms and ratios for easy reference, and an appendix with complete financial statement exhibits on both ABC Corp. and XYZ Corp.
Before even beginning the process of analyzing a financial statement, it is important to understand the different types of financial statements, how they are prepared, and how reliable the information contained in them may be. The cover letter of a financial statement should tell you how the financial statement was prepared; depending on the type, we are able to better understand to what level the information was vetted for our reliance on the information provided. The types of financial statements that you are likely to see, in order of least costly and least reliable, are: internal, compiled, reviewed, and audited financial statements. Below is a more thorough explanation of these types of statements.
Internal financial statements are prepared by members of the business without the support or assurance of any outside sources, such as a CPA firm. These types of statements may also be referred to as management prepared or “in-house” financial statements. Internal financial statements would likely not come with a cover letter or notes. This type of financial information is often generated from in-house accounting software such as Quick-Books or Sage, and is only as reliable as the information being entered by the user. For many smaller companies, this may be the only type of financial statement available. Other types of financials include a cost/fee paid to the preparer and may not be pursued if it has not been specifically requested by a lender or investor. There is no assurance that information generated on internal financial statements is accurate. That is not to say this information cannot be useful, but it would require an assessment of the character and expertise of the source in order to better assess how reliable information delivered in this format may be.
Compiled financial statements will involve the assistance of an accounting professional or CPA, but their services are merely to verify that the data is presented in a format consistent with professionally prepared financial statements. The costs are much less than a review or audit, as there will have been little, if any, attempts to verify the underlying financial information. As such, the reliability of the information would rest heavily on the character and expertise of the individual and business producing the information in much the same way as with an in-house financial statement.
Reviewed financial statements are becoming more and more common with small to mid-sized companies in the U.S. A financial statement review is not as thorough or reliable as an audit, but the cost for a review would be less, and thus a review may be more appealing to the entity covering the cost of preparing the financial statements than would a more costly audit. Reviewed financial statements are prepared by a certified public accountant (CPA) and an effort is made to verify much of the information. The scope of a review will vary by firm or circumstance. A thorough review may include many of the same verification activities that would exist in an audit. A review would likely include ratio analysis, investigations of inconsistencies of major journal entries, a review of records, follow up questions from previous reviews, and a review of accounting & other business practices. A review would not require the accountant to gain any significant assurance of internal controls, assess fraud risk, or other types of audit procedures. A review would also not require a CPA firm to express an opinion on the validity of the financial statements, which removes the firm from any accountability in the event of fraud or miss-represented information.
Audited financial statements are the most reliable form of financial statements. An audited financial statement would require the CPA firm preparing the statement to express an opinion on the reliability of the information contained in the statements. There are three types of opinions that may be expressed: unqualified opinion, qualified opinion, and an adverse opinion.
- In an unqualified opinion, the firm conducting the audit represents that the information is presented fairly, in all material respects, and correctly represents the financial position of the business being audited. This is the language you want to see in the cover letter of your audited financial statements.
- A qualified opinion will have identified a specific area in which the firm conducting the audit was not able to confirm that the information expressed was in compliance with either company policies and controls, or the accounting policies governing the audit. This may not mean the information is inaccurate or cannot be relied upon, but you should seek to understand the circumstances and details of a qualified opinion to determine if the qualification would significantly alter the assessment of the financial information and your credit analysis. The terms “except” or “subject to” used in the cover letter after the auditing firm represents that the information is presented fairly, are generally reference points as to why the opinion is qualified.
- An adverse opinion would mean that information was not able to be verified and may indicate fraud or other issues. This could also represent that the accountant or firm conducting the audit was not able to verify that the subject of the audit has the financial wherewithal to be considered a going concern and continue to operate its business. An adverse opinion is rare, and any reliance on financial information carrying an adverse opinion may not be advisable. A credit professional should discuss this opinion with the auditing firm as well as with the customer in order to gather further information before deciding on the next steps to take in their credit analysis and decision.
Tax returns are another format in which you may see financial information provided from a prospective or active customer. It is important to understand that the rules, laws, and formats governing tax returns are different than those governing an audited financial statement produced for investors and creditors. It is difficult to define the general reliability of a tax return, as they are produced in a variety of ways depending on the return. Tax returns may be prepared by an individual and may pose many of the same reliability concerns that you’d expect from an internal financial statement. There is, however, some additional level of assurance knowing that a tax return is subject to an audit by the IRS, so presenting inaccurate information may come with the risk of perpetrating tax fraud. Tax returns may even be prepared by a licensed CPA and come with much of the same levels of assurance that we’d expect from reviewed financial statements.
Once you know what type of financial statements you are dealing with, you will now have to go through these different statements to begin your analysis. There are four basic financial statements that are commonly prepared by profit-making organizations: balance sheet, income statement, statement of shareholders’ equity, and statement of cash flows. These statements should all be prepared in accordance with GAAP (Generally Accepted Accounting Principles); however, GAAP is not a law and is only required by publicly traded companies. These financial statements, when combined, give the reader a good idea of the financial strength and condition of a company. Between these four financial statements, the reader can see where the cash and other assets of a company are now, where they came from, and where they went. If prepared properly, these statements should assist with a credit professional’s ability to make a sound credit decision. An overview of these four financial statements is provided below.
Balance Sheet: The balance sheet shows the value (according to GAAP) of the assets of a company at a particular point in time and how these assets were funded. Assets can be funded with either debt (liabilities) or equity. This creates the basic accounting equation of assets (A) = liabilities (L) + shareholders’ equity (E). Assets are generally listed based on how quickly they can be converted into cash. Liabilities are generally listed based on their due dates. Certain ratios that will be discussed in this guide will allow the reader to understand the leverage and liquidity of a company’s balance sheet in order to determine the company’s ability to meet short and long term financial obligations. Understanding the balance sheet can also give the reader an idea of the company’s ability to raise funds in the form of debt or equity in order to buy additional assets or to pay back other debt obligations.
Income Statement: The income statement shows the revenues and expenses that a company generates over a particular period (i.e. month, quarter, year, or year-to-date). These line items are generally calculated using the accrual accounting method that conforms to GAAP. Accrual accounting follows a matching principle and records transactions at the point of sale. Basically, accrual accounting calculates the receipts instead of the actual cash. In accrual accounting, the transaction is made at the time of the sale, even if it was sold on a credit account and the cash isn’t collected for a few weeks or months. The other method of accounting is the cash basis. This method is used less frequently and only calculates transactions (revenues and expenses) when cash actually exchanges hands.
The top line of the income statement is the revenues (or sales) generated from the sale of goods and/or services under normal operations. The next line is generally the direct costs involved in making those sales. The net figure of these two gives the gross profits and gross margins, which will be discussed later when we get into profitability ratios. Other operating expenses such as selling, general, and administrative expenses are then deducted from gross profits to get to operating income, which will again be discussed in more detail later. Depreciation and amortization expenses are also deducted. These expenses are non-cash expenses used to spread out the cost of large and long-term assets over the periods they are used. After other non-operating income and all expenses, including taxes, have been taken into account, the bottom line shows the net income (or loss) of a company. Again, the net income (or loss) is not necessarily the cash that a company generated, but the difference between the sales receipts and the expense receipts for a particular period of time.
Statement of Shareholders’ Equity: This statement ties both the balance sheet and the income statement together. The statement of shareholders’ equity starts with the net income (or loss) from the income statement. From there, distributions/dividends or capital injections can be made to reconcile to the equity section of the balance sheet. The amount of net income left over after distributions/dividends is retained in the business and increases the retained earnings account in the equity section on the balance sheet. All of the changes in the equity section of the balance sheet are detailed in the statement of shareholders’ equity. Other equity sales and purchases, such as stock repurchases, are also detailed on the statement of shareholders’ equity and reconcile to the other equity accounts on the balance sheet. Many non-publically traded companies have simple equity accounts and do not create or provide a statement of shareholders’ equity. Typically, the difference in retained earnings from one period to the next is equal to the net income of the company. If the amount is less, than the difference is typically the amount of distributions/dividends that were taken; however, this should be verified with the company for accuracy. The dates on the current balance sheet and the prior period balance sheet should match up to the date range of the income statement in order for these calculations to work.
Statement of Cash Flows: While the income statement can tell a reader whether a company made a profit based on receipts, a statement of cash flows can tell a reader whether or not the company generated cash from these receipts. Many financial statement users are vitally interested in the actual cash received since sales receipts alone cannot pay creditors, which makes this statement very important. The statement of cash flows uses the amounts from the income statement as well as the period-over-period changes from the balance sheet to outline the trail of the inflows and outflows of cash. Under the indirect method of preparing the statement of cash flows, the statement uses the accrual method figures from the income statement and adjusts them up or down depending on the changes in the balance sheet accounts from the prior period. Using the direct method of preparing the statement of cash flows, the accountant shows the items that affect cash flow, such as cash collected from customers, interest received, cash paid to suppliers, etc. The statement of cash flows gives the reader the true picture of the sources of cash (starting with net income/loss using the indirect method) and the uses of that cash. This statement is broken out into three activities: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. This way an analyst can easily dissect the cash flows of a business and be able to look at operating cash flows separately from the other activities. This statement ultimately reconciles the difference between the cash on hand at the beginning of a balance sheet period to the end period balance of cash on hand.
Examples of these four basic financial statements have been included as exhibits in the appendix for two fictitious companies: ABC Corporation and XYZ Corporation. ABC Corp. is an example of a financially strong company and XYZ Corp. is an example of a weaker company that would pose heightened credit risk requiring additional steps and information that would be needed in order to potentially approve them for credit. The financial statements in the appendix are used to work through the five categories of ratios that will be discussed in detail. The five categories of ratios are as follows: leverage, liquidity, efficiency, profitability, and debt coverage ratios. The individual ratios in these five categories will be further discussed to educate a credit professional on the basics of credit analysis. It should be noted that financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis. In addition, there is no one definitive set of key financial ratios, there is no uniform definition for all ratios, and there is no standard that should be met for each ratio.
Notes: In addition to the four basic financial statements, there are also notes to the financial statements that are found after these four basic financial statements on audited financial statements and many reviewed financial statements. Although the appendix of this guide does not include an example of notes to the financial statements, this is a very important section of the financial statements that should also be analyzed by a credit professional. Notes help to further explain the numbers that are in the four basic financial statements such as inventory valuation methods, depreciation methods, and debt repayment terms, to name a few. The notes also help to analyze the strength of a company by including additional information that can’t be found in the numbers such as bank information (line of credit commitment amounts, maturity dates, and covenant information), subsequent events, and contingent liabilities, as well as other important items. These important disclosures should be read carefully by the credit professional as they may end up making or breaking a credit decision.
There are many equations and ratios in financial statement analysis, but there is only one known as the accounting equation. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders. The reason the balance sheet is called a balance sheet can be demonstrated with this very simple yet often poorly understood equation.
Assets = Liabilities + Equity
This equation represents the left side of the balance sheet (assets), which is equal to the right side of the balance sheet (liabilities + equity). The fact that the totals on the left and right side of the balance sheet should match is why it is called a “balance” sheet. Each side is a picture of the company and their assets, capital, and debt structure. The left side (assets) shows everything a company owns, and the right side (liabilities + equity) shows how those assets are financed. It is important to understand the left side of the balance sheet and how assets are broken down into long-term and short-term assets. An asset is categorized as long-term or short-term based on the projected period of time it will take before that asset is converted into cash (liquidated). Changes in what percentage of assets are long-term and less likely or more difficult to be converted into cash (less liquid) and what percentage are short-term and easier to convert into cash (more liquid) can have dramatic implications on a company’s ability to pay its bills and meet other operating commitments. Understanding the asset structure and liquidity of an organization is very important and will be covered further in another chapter. For the purposes of this section, we are going to focus on the right side of the balance sheet and how a company’s assets are financed.
As stated above, the right side of the balance sheet, or the accounting equation (liabilities + equity), show how a company’s assets are financed. It is worth noting that liabilities=debt, and equity=net worth. Don’t be confused to hear or see these terms used interchangeably; they are the same. No matter how large or small a company is, every asset is financed with capital from debt or equity. Imagine all of a company’s assets boiled down to a single dollar which represents every asset within the company. That dollar can be broken down into what % is financed by creditors (liabilities) and what percent is financed by contributions from owners/investors (equity). The higher the % of assets financed by creditors/liabilities, the higher the leverage of the company. This is a very important concept to understand as a creditor because as leverage increases and more of the company’s assets are financed by debt, the higher the burden of risk becomes for the creditors. The percentage of assets financed by debt can be measured with a variety of different metrics, some of which will be discussed below. The standard for those leverage metrics will vary widely by industry, so it is helpful to have an idea of what metrics would look like for a typical company in a given industry. Throughout this guide we will be referencing excerpts from two very different example companies (ABC Corp. and XYZ Corp.). Both of these companies’ financial statements can be found in the appendix to this paper. Below are calculations and analysis of three common leverage ratios:
1) Debt to Equity ratio: Total Liabilities divided by Total Equity.
Total debt to equity can be a very helpful tool when trying to understand how leveraged a company may be. The higher the debt to equity ratio, the more leveraged a company is. Stated another way, a high debt to equity ratio means more of the company’s assets are financed through debt, and the higher the burden of risk for creditors. If a company’s debt to equity were equal to 2, then for every $1 in equity the company has $2 in debt. If the debt to equity ratio is less than 1, the company has more equity than debt. For example a debt to equity ratio of .50 would mean that for every $1 in equity the company has $.50 in debt. If the debt to equity ratio is negative, the company has negative net worth and is insolvent. Insolvency likely represents a much higher risk for creditors due to a much higher likelihood the company will default on future debt or other obligations.
Example ABC Corp: $12,449 = 0.64
Example XYZ Corp: $129,733 = 17.7
In the examples above, the total debt to equity for ABC Corp. shows for every dollar in equity there is $0.64 in debt. We know that because the debt to equity is below 1.0, meaning that ABC Corp has more equity than debt. XYZ Corp. on the other hand shows that there is $17.70 in debt for every $1 in equity. XYZ Corp. is much more leveraged than ABC Corp., which would likely mean an increased risk for creditors.
2) Debt to Tangible Net Worth: Total Liabilities divided by Tangible Net Worth.
Tangible Net Worth is the Total Equity minus the total of Intangible Assets.
(Equity - Intangible Assets)
The total debt to tangible net worth is essentially the same ratio as the debt to equity calculation in example 1 above but with the removal of intangible assets from equity. Intangible assets are usually not able to be liquidated (converted into cash), and thus they are rarely able to assist a company in meeting its debt obligations. It is thus very important to understand how a company’s intangible assets may be shaping their leverage and debt to equity ratio.
Example ABC Corp: $12,449 = 0.78
$(19,512 - 3,531) =
Example XYZ Corp: $129,773 = -135.0
In the case of ABC Corp. above, the removal of intangible assets has a minimal effect on the leverage, going from a total debt to equity of 0.64 to a total debt to tangible net worth of 0.78. This does not represent a large change, and would likely not dramatically change our perception of the company or the risk of extending them credit. However, in the case of XYZ Corp., the removal of intangible assets caused tangible net worth to become negative. This means that without relying on the value of these intangible assets, the company owes more to its creditors than the value of all of its tangible assets combined. This indicates a very high risk position for creditors of XYZ Corp., and it would be reasonable to expect a higher probability of bankruptcy and/or default on the debt.
3) Assets to Equity (Leverage Ratio): Total Assets divided by Total Equity
The total asset to equity ratio, also known as the leverage ratio, shows the total assets of a company compared to equity. Stated another way, if a company has a high leverage ratio or their leverage ratio is growing, they are more leveraged and a higher percentage of their assets are being financed through borrowing from creditors as opposed to being financed by investment from owners.
Example ABC Corp: $31,961 = 1.64
Example XYZ Corp: $137,061 = 18.7
In the examples above, ABC Corp. has a leverage ratio of 1.64, so for every $1 in equity the company has $0.64 in debt/liabilities. You can tell from their leverage ratio, that the majority of the assets of the company are equity financed, and thus they have lower leverage and would likely represent less risk for a creditor. Conversely, XYZ Corp. has a leverage ratio of 18.7, so for every $1 in equity there is $17.70 in debt/liabilities. Clearly, XYZ Corp. is much more leveraged than ABC Corp., and that would make them a much higher credit risk. If the leverage ratio equals 1, then the company has no debt, and everything they own is owned outright by the company’s owners. If the leverage ratio goes below 1 and is negative, that means a company has negative net worth. Having a negative leverage ratio would result in a higher probability of bankruptcy and thus a higher credit risk.
You will notice that the leverage ratio is higher than the total debt to equity ratio by exactly 1. This will always be the case due to the accounting equation (assets = liabilities + equity). Based on the accounting equation, the leverage ratio can be used interchangeably with the total debt to equity ratio to get to the same conclusion on the leverage and related risk of a company. Both ratios are shown since credit departments prefer to stay consistent, and some use the leverage ratio while others use the total debt to equity ratio. In addition, the leverage ratio can be used in more advanced financial analysis when using the DuPont analysis for calculating the return on equity of a business (discussed in more advanced readings).
It is important to understand how leverage and changes to leverage affect a company’s financial strength and help us predict their ability to repay debt. As a rule of thumb, higher debt means higher leverage and higher leverage means increased risk to creditors.
What is liquidity? And why is it so important for the credit professional to understand it? Specifically, liquidity is the ability of an enterprise to generate sufficient cash amounts (from the conversion of their raw material purchases, product development, product sales, and cash collection - also known as the ‘Cash Conversion Cycle’) to meet their own firm’s required cash needs in order to properly operate their day-to-day business. Generally speaking, a trade creditor (like the company you work for), has very short customer credit terms (i.e. Net-7, 10, 15, or 30) with their debtors (or customers); hence, a customers’ liquidity position, or solvency readings, becomes very important to quantify (and gauge) from a credit management standpoint.
If your firm’s standard credit terms are Net-30, then you’d expect your customers to pay you in 30 to 35 days. Calculating the more common ‘liquidity metrics’ (which we’ll do below) will give you (the credit professional) more confidence in your customer’s ability to pay your firm on a timely basis, after you have released your firm’s products to them. There are three ‘key’ liquidity ratios (of which all of their components are found on a standard balance sheet) as shown below:
- Current Ratio
- Quick Ratio
- Net Working Capital
These three ratios are explained in detail below and looked at between two different companies: ABC Corporation and XYZ Corporation:
Current Ratio: Total current assets divided by the total current liabilities:
Total Current Assets
Total Current Liabilities
The current ratio (shown above) is probably the most widely used of all the liquidity ratios. (Note: This ratio is simply a measure of how many times your customer’s total current assets (which generally consists of: cash, accounts receivable (AR), pre-paid assets, inventory, etc.) can ‘cover’ their total current liabilities (which generally consists of: accounts payable, debt due within one year, notes payable, accrued liabilities, etc.). Since this is a ratio we are working with, the outcome your calculation produces is something compared to the number ‘1.’ So, in the below example, and shown on any GAAP balance sheet, you’ll be able to discern how many times your customer’s total current assets can cover (i.e. 1x, 1.5x, 2x, etc.) their total current liabilities, which, of course, would include your firm’s invoices to this customer.
Obviously, the higher the final calculated ratio, the better the chance of your company getting paid, and hopefully within your assigned customer credit terms. Generally speaking, you’ll want to see a current ratio result of over 1.5 to 2.0 times, which would indicate a healthy result; but, this result should be compared to your company’s related industry average for their peers as well. Below are calculations and analysis of liquidity ratios using our example companies, ABC Corp. and XYZ Corp:
ABC Corp: Current Ratio= $18,576 = 2.41 ( also expressed as 2.41x or 2.41:1)
XYZ Corp: Current Ratio=$109,337 = 0.95(also expressed as 0.95x or 0.95:1)
The current ratio (CR) result for ABC Corp. of 2.41:1 suggests that there is $2.41 of current assets for every $1.00 of current liabilities, which is usually a good sign. As a comparison, however, XYZ Corp.’s CR of less than 1, at 0.95:1, suggests this firm has only $0.95 to cover $1.00 of their current liabilities. This could portend a potential problem. However, it would have to be further looked into because some industries have very low CR results and have no problem paying their vendors.
Quick Ratio: Total current assets minus the inventory amount, all divided by the total current liabilities:
Total Current Assets - Inventory
Total Current Liabilities
The second key liquidity ratio (shown above) is the quick ratio (QR). The QR is calculated the same as the CR, but you would subtract the customers’ inventory amount shown in the total current asset section of the balance sheet. This ratio is also called the acid test ratio. We subtract the inventory balance (and some finance professionals also subtract the ‘prepaid assets’ amount, too) because inventory is the ‘least’ liquid (i.e. it could take the longest to be converted into actual cash) of all the total current asset components. Here’s a quick example of this ratio for these two different companies:
ABC Corp: Quick Ratio = $18,576 - $6,833 = 1.52:1
XYZ Corp: Quick Ratio = $109,337 - $63,723 = 0.40:1
You’ll note that the above result for the ABC Corp. (1.52:1) is a smaller ratio than the current ratio result shown above (2.41:1) because we have subtracted for the Inventory amount and hence made the numerator a smaller number. The above result would suggest that this customer (ABC Corp.) should be able to service their short-term debt (total current liabilities) without first having to sell-off their inventory to raise additional liquidity (cash) to pay their short-term obligations. We would read this result as this customer has $1.52 in ‘quick’ assets, for every $1.00 in total current liabilities (which would, again, include your firm’s invoices to this customer). Then if we look at XYZ Corp.’s quick ratio result of only 0.40:1, this would imply that XYZ Corp. only has $0.40 for each $1.00 of their current liabilities. This could pose a problem for XYZ Corp. should they have a problem converting their inventories into salable products. Again, as with all ratios, the quick ratio should be monitored for period-over-period trends (both positive and negative) and also compared to your firm’s industry norms as well.
Net Working Capital: Total current assets minus total current liabilities
Total Current Assets - Total Current Liabilities
The third liquidity calculation (and remember, there are other liquidity ratios used in actual practice) is the net working capital calculation, shown above. This calculation is used to designate the amount by which current assets exceed (or are less than) current liabilities. Simply put:
ABC Corp: Net Working Capital = $18,576 - $7,719 = $10,857
XYZ Corp: Net Working Capital = $109,337 - $114,983 = ($5,646) or -$5,646
The net working capital amount actually quantifies a liquidity (or solvency amount) in dollar terms. Unlike the above two methods which are ratios (some result compared to the number 1), this amount actually shows the credit professional the ‘actual’ dollars available to finance trade creditors. Some firms like to reduce the amounts they have ‘tied up’ in their net working capital amounts to help reduce their carrying (interest) costs with their lenders; however, this can make them less credit worthy.
As shown above, ABC Corp. has a ‘positive’ working capital position of $10,857k. This would imply a favorable result. However, some further research the credit professional would need to do to believe this would be to understand their customer’s monthly payment requirements for items such as: interest costs, A/P requirements, long & short term principal payments, and other monthly operating expenses required to keep their company doors open. In contrast, XYZ Corp. has a ‘negative’ working capital position of ($5,646k). This could imply a problem with this firm meeting their day-to-day operating costs. The credit professional would need to delve more into this customer’s monthly cash requirements to see if this customer would be a potential credit risk and not be able to pay your firm’s invoices by your assigned credit terms.
Also, if a firm is getting paid very quickly from their customers (like in 1 or 2 days, like a retailer or firms in the petroleum industry whom have very brief customer sales terms), and then their vendors give them much longer sales terms (like Net-15 or Net-30), this could skew a firm’s net working capital result that’s being reported. Again, this gets back to knowing your firm’s industry credit practices and becoming more informed of overall credit management principles in general.
Efficiency metrics measure how effectively the company utilizes its assets and how well it manages its liabilities. Top performing companies turnover assets quickly and efficiently, that is to say they have a high “run rate.” Some key areas of efficiency, especially to the business credit professional, are those associated with short-term assets and liabilities. These ratios are able to tell us a lot about how efficiently and effectively a company is managing its short-term operations and working capital investments.
Keys to comparison:
- Industry: the ratio will vary from one industry to another.
- Year-to-year: trending analysis is very important. Performance of this year needs to compare with previous years’ performance to analyze the abnormalities. Seasonality of a business can potentially skew the efficiency ratios of a company when analyzed month-to-month or quarter-to-quarter.
Accounts Receivable Turnover: Sales divided by accounts receivable:
Accounts receivable turnover measures the effectiveness of a company’s sales terms and collection policy. The sooner that accounts receivable can be collected, the sooner cash is available for use. A lower turnover number may suggest the company is too lenient on credit terms or having difficulty to collect. A higher turnover number is better because it has a low days sales outstanding (DSO). Rising DSOs could increase uncollectible receivables that lead to bad debts. If a company has bad debts that have not yet been written off, then this would negatively impact nearly every other ratio that is discussed in this paper. In addition, the quality of the company’s sales might have to be questioned going forward.
To calculate this ratio, we need to get information of the sales (or revenue) from the customer’s income statement and accounts (or trade) receivable from the balance sheet under the current assets category.
ABC Corp: Accounts Receivables Turnover= $61,768 = 12.65 times per year
XYZ Corp: Accounts Receivables Turnover=$151,305 = 4.88 times per year
Days Sales Outstanding (DSO): 365 days divided by accounts receivable turnover:
Accounts Receivable Turnover
Days sales outstanding (DSO) measures the average number of days it takes a company to convert its accounts receivable into cash. Lesser days are better because it takes less time to collect the customer’s accounts receivable.
ABC Corp: 365/12.65 = 29 days
XYZ Corp: 365/4.88 = 75 days
The accounts receivable turnover result for ABC Corp. suggests that ABC Corp. collected all of their accounts receivable balance 12.65 times per year, on average. It also means ABC Corp. took 29 days on average to collect their accounts receivable. The accounts receivable turnover result for XYZ Corp. suggests that XYZ Corp. collected all of their accounts receivable balance 4.88 times per year, on average. It also means XYZ Corp. took 75 days on average to collect their accounts receivable. In this calculation, we can see there is either something in XYZ’s credit policy that is causing them longer to collect, or they have potential bad debts that might need to be written off. XYZ Corp.’s cash is all tied up in receivables.
Inventory Turnover Ratio: Cost of goods sold divided by inventory:
Cost of Goods Sold
The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a year. A higher inventory turnover ratio is better because it has a low days inventory outstanding (DIO). A low inventory turnover ratio may indicate overbuying, falling sales, unaccounted for shrinkage, or excessive carryover of obsolete inventory. If a company has shrinkage or obsolete inventory that has not been accounted for, these amounts may have to be written off (expensed), which would negatively impact nearly every other ratio that is discussed in this paper. In addition, the quality of the company’s inventory management, and even possibly sales, might have to be questioned going forward.
To calculate this ratio, we need to get information of the cost of goods sold from the income statement and inventories from the balance sheet under the current assets category.
ABC Corp: Inventory Turnover = $42,277 = 6.19 times per year
XYZ Corp: Inventory Turnover =$126,523 = 1.99 times per year
Days Inventory Outstanding (DIO): 365 days divided by inventory turnover.
Days inventory outstanding (DIO) measures how many days on average it takes to sell a company’s inventory. A lower DIO is better because it takes less time to sell inventory.
ABC Corp: 365/6.19 = 59 days
XYZ Corp: 365/1.99 = 184 days
The inventory turnover ratio result for ABC Corp. suggests that ABC Corp. sold and replaced their total inventory balance 6.19 times per year, on average. It means ABC Corp. has about 59 days’ worth of inventory on hand to support average sales. The inventory turnover ratio result for XYZ Corp. suggests that XYZ Corp. sold and replaced their total inventory balance 1.99 times per year, on average. It means XYZ Corp. has about 184 days’ worth of inventory on hand to support average sales. In comparison, ABC Corp. performed better than XYZ Corp. when turning their inventory into cash. XYZ Corp. might be carrying an excessive amount of inventory or might be overbuying materials/products for future sales needs. This should be analyzed further to see if there is obsolete inventory or shrinkage that has not been accounted for and needs to be written off (expensed).
Accounts Payable Turnover: Cost of goods sold divided by accounts payable
Cost of Goods Sold
Accounts payable turnover measures how a company manages paying its own bills. A higher turnover means there is possibility that the company doesn’t have favorable terms from its suppliers. A lower number of accounts payable turnover helps to stretch the working capital and free cash flow with longer days payable outstanding (DPO). As a creditor, a higher turnover is preferred because it is a prediction of how the company will pay their vendors.
To calculate this ratio, we need to get information of the cost of goods sold from the income statement and accounts payable from the balance sheet under the current liabilities category.
ABC Corp: Accounts Payable Turnover = $42,277 = 11.95 times per year
XYZ Corp: Accounts Payable Turnover = $126,523 = 2.75 times per year
Days Payable Outstanding (DPO): 365 days divided by accounts payable turnover
Accounts Payable Turnover
Days payable outstanding measures how many days that the company took to pay its vendors. From a credit professional’s perspective, if the number of days is high, it is a potential sign of a company struggling with cash flow and a prediction of a company’s payment schedule to their vendors.
ABC Corp: 365/11.95 = 31 days
XYZ Corp: 365/2.75 = 133 days
The accounts payable turnover result for ABC Corp. suggests that ABC Corp. paid all of their accounts payable balance 11.95 times per year, on average. It also means ABC Corp. took 31 days on average to pay its vendors. The account payable Turnover result for XYZ Corp. suggests that XYZ Corp. paid all of their accounts payable balance 2.75 times per year, on average. It also means XYZ Corp. took 133 days on average to pay its vendors.
In this calculation, we could see XYZ Corp. might be having some problems with its cash flow and they are stretching payables to compensate. They could also just have extended terms with their vendors, but this is worth looking into further especially for potential new customers where payment trends with your company have not yet been established.
Cash Conversion Cycle:
Days sales outstanding + days inventory outstanding – days payable outstanding
DIO + DSO – DPO
“Cash is King!”
This formula measures (in days) the amount of time it takes a company to convert its investments into cash, or how long it takes a company to collect cash from sales of its inventory. When understanding the cash conversion cycle, it is helpful to remember that any dollars in inventory and accounts receivable are investments in working capital that have not yet been converted into cash. Conversely any amount in accounts payable is working capital being financed by trade creditors and is allowing the company to delay spending their cash. Any investments in inventory or receivables are essentially cash that a company has not collected yet and will decrease the overall cash available to the company to finance operations.
From the calculation above, ABC Corp. took 57 days and XYZ Corp. took 126 days to turn their investments into cash. We could see that XYZ Corp. is having problems generating cash. This explains why they took longer to pay their vendors.
Note: This measurement is not as effective for service companies such as consulting businesses, technology companies, and insurance companies that have little to no inventory and might even have very quick accounts receivable turnover.
In this next section we will discuss profitability ratios. Wikipedia, Investopedia, and Bloomberg, all tell us that profitability ratios are basically metrics used to assess a business’ ability to generate earnings as compared to its expense and cover cost over a specific period. Profitability is also sometimes analyzed through earnings performance ratios. No matter what you refer to them as, they always have to do with the return on something (i.e. sales, assets, etc.). In this section we will explore three primary profitability ratios:
- Net Profit Margin
- Gross Profit Margin
- Operating Profit Margin
These ratios by themselves may yield some insight and will definitely be helpful in analyzing whether to extend credit to a customer or to determine their long term viability. You will want to use these ratios in conjunction with the other ratios discussed in this paper to get a better picture of a customer’s financial position and whether or not you want to give them open credit terms. The Securities and Exchange Commission (SEC) requires all publicly traded companies to file quarterly and yearly financials (i.e. 8k and 10k). These reports will be based on the approved GAAP requirements. For those publicly traded companies that you are doing business with, this can really help in your validation and trending models because there will be multiple months and years on file. For private companies, you will want to ask for three years, three quarter-ends, or three month-ends of data to determine a trend. The best comparison is when you can compare year-over-year to see how they are doing and compare with other like companies in the same industry. In the previous sections, we discussed how benchmarking against like companies within the same year can be helpful to analyze a company’s financial strength. This should give each credit professional the ability to analyze the current statement in a meaning full way by reviewing a trend to determine what you think will happen in the future. All of the information you need for this section can be found on the income statement. The ratios below will help you to determine the health of a company or how much credit risk your company’s policy will allow.
One of the most common profitability ratios is the net profit margin. This is also sometimes referred to as the bottom line margin. Here the number is expressed as a percentage and should be above zero. This is kind of a no brainer as a company should be profitable to stay in business. This is one of the most frequently used ratios. The net profit of a business will tell you what’s left over after all expenses/costs are taken out of sales. Historical net profit margins provide the analyst with the ability to determine if the customer is trending up or down. Are they making as much money as their competitors? Did the profit margin increase from the prior periods or did it decrease?
Net Profit Margin: Net income after tax divided by net sales:
Net Income after Tax
ABC Corp: Net Profit margin = $4,213 = 0.0682 (also expressed as 6.82%)
XYZ Corp: Net Profit margin = $123 = 0.00081 (also expressed as .08%)
While both companies have a positive net profit margin, it’s obvious that ABC Corp. is doing better than XYZ Corp. Assuming that both companies are from the same industry, we could make an assumption that ABC Corp. is controlling its expenses much better than XYZ Corp. If these companies are not from the same industry, it still won’t matter for XYZ Corp. because they are just barely breaking even. One other thing to be considered is the type of industry of the company you are evaluating. You should have a good understanding of what the margins should be in the industry you are evaluating. For example, the service industry typically has 15% to 30% margins. If either company, ABC Corp. or XYZ Corp., were in the service industry, we would say both were not doing as well as related companies in their industry.
Gross Profit Margin: Gross profit divided by net sales
Gross profit margin can be a great asset to any credit professional. If a company is able to increase their gross profit margin month after month or quarter after quarter, this typically means the company is increasing their sales prices and/or they are able to lower their direct input costs. A good example of this is where a company can increase sales at existing prices, but takes advantage of economies of scale to buy materials/products in bulk at lower costs. In the chart below, we see from year-to-year the gross profit dollars increased from $13,303 to $19,491. In the second chart below, we expressed the same numbers as a percentage to give you a better perspective to how these companies manage their cost of goods sold. ABC Corp. not only increases its gross profit dollars, but as you can see from the second chart, the percentage of gross margin increased 5% from 2013 to 2014.
In this second example (below) we can see where XYZ Corp. made an additional $2.7M in gross profit; however, the gross margin actually dropped 3%. This is a good example where the numbers alone don’t necessarily tell you the whole story.
Now you will need to determine if this is good or bad. ABC Corp. is growing their margins while XYZ Corp.’s margin is getting compressed. Here you would want to do more analysis and ask some follow up questions for XYZ Corp. For example, expenses outpaced sales as a percentage, why? You may be able to figure this out if you have a detailed page breaking out cost of goods sold.
The last ratio on profitably will be operating profit margins. This ratio is primarily used to measure a company’s pricing strategy and operating efficiency. The operating profit margin measures the part of the company’s revenue remaining after paying production cost, such as wages, raw materials, etc.
Operating Profit Margin: Operating income divided by net sales
ABC Corp: Operating Profit margin = $6,824 = 0.1104 (also expressed as 11%)
XYZ Corp: Operating Profit margin = $3,855 = 0.0254 (also expressed as 2.5%)
When determining your operating income and net sales make sure you don’t include things outside of the operating portion of the financial statement, for example one-time expense for a settlement, or some sort of other nonrecurring income/expense. The higher the operating profit margin, the better cost controls a company has. When a company is well established and been in business for a number of years, fixed cost should go down and thereby the operating profit margin go up. Here you want to see a trend where the operating profit margin is increasing every quarter and year. So it’s important to not just do the calculation on the current financials but look at previous months, quarters, and/or years.
A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds. If a company you are selling to is no longer in good standing with their bank due to the inability to meet covenants or the inability to pay their loans, then the company will either have to seek funding from their vendors by stretching their bills, or file for bankruptcy. Either way it is very important for you, as a vendor, to understand this relationship and analyze a company’s ability to pay their debt obligations. A profitable business does not necessarily mean that there is enough income or cash flow to support its debt payments. If you are analyzing a company that is profitable, how can you determine the strength of their profits? One million dollars ($1M) in net income or even operating cash flow sounds great, but what does it really mean for the company? This amount might be sufficient for a company with total debt of $1M, but it may not be good at all for a company with total debt of $100M depending on the structure of required payments. In order to fully analyze the strength of a company’s income and cash flow, it has to be compared against the required debt payments that the company needs to make. To fully analyze this relationship of income and cash flow compared to debt service, 3 basic ratios have been outlined below:
- Times Interest Earned Ratio
- Debt Service Coverage Ratio
- Cash Flow from Operations Debt Service Coverage Ratio
These three ratios are further defined in detail below. In addition, we will walk through differences in these ratios when analyzing the financials of ABC Corporation and XYZ Corporation.
Times Interest Earned Ratio: The times interest earned ratio is expressed as the operating income of the company divided by the interest expense of that company:
The operating income of a company can be found as a subtotal on the company’s income statement after all operating expenses have been taken into account. Other income/expenses can often fluctuate and include one-time items, but the operating income/profit represents the income from core (normal) operations. Interest expense can be found as a line item on the income statement. This is the amount of interest that was due and payable in the particular period that the income statement covers. These amounts for ABC Corp. and XYZ Corp. are shown below and highlighted in yellow:
ABC Corp: Times Interest Earned Ratio = $6,824 = 29.93 (also expressed as 29.93x or 29.93:1)
XYZ Corp: Times Interest Earned Ratio = $3,855 = 1.17 (also expressed as 1.17x or 1.17:1)
If the ratio is over 1, this means that the normal operations of the business are profitable enough to pay the interest payments on the company’s debt. An average company will have a cushion, perhaps a ratio of 1.50:1.00 (1.50x) or higher. This helps to apply additional funds towards principal/debt reductions or to help during periods when operations are not as strong. As shown above with ABC Corp. and XYZ Corp., both companies have a ratio over 1 and can both support interest only payments; however, ABC Corp. has a sizable cushion over 1, whereas XYZ Corp. has a much smaller cushion over 1. When subtracting interest expense from operating income, XYZ Corp. only has $547k to cover other cash needs such as taxes, distributions/dividends, principal debt payments, capital expenditures, etc.
Covering required interest payments should be maintained at a minimum. In addition to this, many companies have liabilities that require principal payments to reduce the balance on the debt over a set period of time. For instance, equipment depreciates and loses value over time, so a business will need to make principal payments on this debt to avoid having its loan value exceed the value of its asset. The next two ratios help to analyze the full ability of a company to service its required debt payments.
Debt Service Coverage Ratio: The debt service coverage ratio is expressed as the earnings/income (E) of a company before (B) the sum of interest expense (I), depreciation (D), amortization (A), and any other non-cash items (together represented as EBIDA), divided by the sum of current portion of long-term debt (CPLTD), current portion of capital
Net Income + Interest Expense + Depreciation + Amortization
CPLTD + Current Portion of Capital Leases + Interest Expense
Although EBITDA is not a financial measure recognized in GAAP, it is commonly used in finance and by banks to assess the performance of a company. The “T” in EBITDA stands for taxes. The reason why taxes have not been added back to the ratio calculation above is because taxes are equally, if not more important as paying back bank loans. Federal and state tax liens can prevent a company from obtaining funding and negatively impact their cash flow. Depreciation and amortization expenses are added back to net income since these are non-cash expenses and can be used to help service debt. These expenses can be found as a line item on the income statement or on the statement of cash flows. Since interest expense is one of the primary debt payments as shown in the previous ratio, we would also add back interest expense to the numerator. The current portions of both long-term debt and capital leases can be found under current liabilities on the balance sheet. These represent the amount of principal payments that are due within the next year. Loans/leases can be refinanced, paid off early, or issued throughout the course of a year so these amounts are simply good estimates. The figures needed for this ratio calculation for ABC Corp. and XYZ Corp. (not including interest expense as shown earlier) are shown below and highlighted in yellow:
ABC Corp: Debt Service Coverage Ratio = $4,213 + $228 + $1,029 = 6.24x
$649 + $228
XYZ Corp: Debt Service Coverage Ratio = $123 + $3,308 + $3,671 = 0.77x
$5,950 + $3,308
Just like the last ratio, if this ratio is over 1, than this means that the company has the ability to make their required debt payments. An average company will have a cushion of 1.25x or higher to help during slow periods or when floating interest rate debt is on the rise. As shown above with ABC Corp. and XYZ Corp., the financial performance of these two companies is further differentiated as we move from the times interest earned ratio to the debt service coverage ratio. ABC Corp. still maintains a very strong ratio, whereas XYZ Corp.’s ratio is less than 1 and cannot afford to make the large required principal payments of $5,950k that come due next year if they maintain the same EBIDA.
Operating profit and EBIDA in most cases is based on the accrual method of accounting, meaning that revenues and expenses are entered when invoices are issued, not when they are paid. Just because a sale was made does not mean that the company has collected the receivable and has the cash on hand in order to pay the interest [and principal] that is due. Debt cannot be paid with A/R; only cash can service debt payments. For this reason, we then use cash flow from operations in the numerator instead of EBIDA.
Cash Flow from Operations Debt Service Coverage Ratio: This ratio is the same as the one above, but uses the cash flow from operations instead of EBIDA in the numerator:
Cash Flow from Operations*
CPLTD + Current Portion of Capital Leases + Interest Expense
*Interest expense should be added back if using the indirect method.
The cash flow from operations can be found as a subtotal on the statement of cash flows. This is the cash flow that has been generated from the operating activities of a company and includes changes in certain balance sheet accounts such as A/R, inventory, and A/P to show the actual cash inflows and outflows of a business. This is slightly different than the operating profit and EBIDA of a company that shows the inflows and outflows of receipts, but does not tell you if they were paid or not. Since most companies use the indirect method starting with net income [and depreciation/amortization] at the top, interest expense will need to be added back just as it was with the last two ratios. The cash flow from operations needed to calculate this ratio for both ABC Corp. and XYZ Corp. have been shown below and highlighted in yellow:
ABC Corp: Cash Flow from Operations Debt Service Coverage Ratio = $4,758 + $228 = 5.69x
$649 + $228
XYZ Corp: Cash Flow from Operations Debt Service Coverage Ratio = $87 + $3,308 = 0.37x
$5,950 + $3,308
Again, if the ratio is over 1, then the company generated enough cash to afford its required debt payments; however, a cushion of at least 1.25x is recommended for average companies. Since this ratio includes changes in balance sheet accounts that are only taken at a single point in time, it is not necessarily bad if a company’s ratio is under 1 for a single period. When this occurs, it is important to go back and analyze the efficiency ratios that were discussed previously. As shown previously with the debt service coverage ratio, ABC Corp. continues to show a strong ratio, whereas XYZ Corp.’s ratio continued to decline showing a probable decline in efficiency ratios as previously discussed.
A more advanced debt coverage analysis will include other items, such as additional one-time income/expense items, discretionary expenses, expenses on related party assets, capital expenditures, distributions/dividends, subordinated debt, related party debt, receivables from a related party, balloon payments, and mitigating factors to name a few.
This paper has endeavored to explain some initial ‘starter’ information on the content and how to analyze what’s shown on the four GAAP required financial statements: balance sheet, income statement, statement of shareholders’ equity, and statement of cash flows. This paper has also broadly discussed the various types of audit opinions coupled with some beginning financial statement analysis. Clearly, in our professional field of credit management, an opening guide for new credit professionals to this profession would never be able to adequately cover all that a more seasoned credit professional would (and will) encounter in ‘real’ practice. In fact, most of what we learn, and need to know, is based on just plain work experience and the school of hard knocks. But, this guide has attempted to provide some ‘food for thought’ for a new entrant into the field of credit. However, there’s so much more to learn, and cover.
For those of you who want to take credit management to the ‘next step,’ the balance of this paper will aim to cover the following questions and resources: how could I further advance myself in the field of credit management? Are there any credit designations I could earn to further my knowledge in this field? What’s involved in earning those designations? What other resources are available out there that are commonly used for benchmarking and learning other tools in credit management? Well, let’s examine the first question very briefly on how to advance our career (and knowledge) in the field of commercial credit.
In your credit work, you will no doubt hear about one of a credit professional’s main credit associations called the National Association of Credit Management (NACM). NACM has more than 15,000 members located throughout the United States. NACM affiliated associations offer valuable credit services in formal credit training in the form of: classroom credit classes, online credit classes, webinars, monthly publications, seminars, and annual credit conferences, just to name a few. At your local NACM affiliate, you should be able to get your formal credit training (no matter what your background) and also meet other fellow credit professionals working toward similar goals and objectives.
At most NACM affiliates, they have the resources (courses) that will allow you to complete the more commonly held credit designations of:
- Certified Credit and Risk Analyst (CCRA)
- Credit Business Associate (CBA)
- Credit Business Fellow (CBF)
- Certified Credit Executive (CCE)
For credit professionals aiming to expand their knowledge in the international credit management arena, the following designations are also available:
- Certified International Credit Professional (CICP)
- International Certified Credit Executive (ICCE)
The first three designations require the completion of 10 to 15-week classes in: Credit Principles, Financial Statement Analysis, and Accounting. As you progress to the highest designation of CCE, you will review material in such courses as Credit Law, Business Law, and Advanced Financial Statement Analysis. Each credential requires the passing of a formal exam to demonstrate your mastery of the course material which you’ll have had to pass with a letter grade of ‘C,’ or higher. The international designations are completed mostly on the internet, but are just as rigorous (and comprehensive) in their material and test taking as the ones just discussed.
Earning a credit credential demonstrates that you’re very serious in both advancing your knowledge in the field of credit along with utilizing this information in your day-to-day credit work for your company. This information benefits both you as a credit professional and should also help you to protect one of your firm’s largest assets on their balance sheet: accounts receivable.
Along with credit credentialing, our field has some additional resources that have been around a long time which can also assist in one’s knowledge growth in our profession. For various credit departments ‘benchmarking’ tools and further learning of many different types of credit metrics (and calculations) there is the Credit Research Foundation (CRF) (www.crfonline.org). This is a paid member service, but they do offer a lot of complementary benchmarking reports on many different companies and industries. We already mentioned NACM(www.nacm.org) as an excellent resource for a full suite of credit related services along with their local affiliates. For ‘open’ credit positions in both finance and credit, there’s Robert Half International (RFI) (www.roberthalffinance.org). RFI also offers a complementary ‘annual’ salary survey for those employed in the accounting and finance positions.
A very common resource (among several others) for customer credit reports is Dun & Bradstreet (D&B) (www.dnb.com). D&B reports are run on a subscription type basis, and generally contain the following key credit information: full name of business entity, date business started, company hierarchy, and if there’s been any suits, liens, and/or judgments filed against a company, along with a Paydex score which shows how well (or slow) this company pays their vendors (potentially your company).
A helpful public website for general news on publicly-traded companies (and business news of the day) is Yahoo Finance (http://finance.yahoo.com). This popular website allows one to get the latest news developments on large companies along with investor opinions, financial statement data, and related competition information on companies. Google Finance and other search engines offer similar information as well.
Again, these are just a few credit resources which barely scratch the surface of what’s available to a credit professional and their credit department. But this is a start.
Finally, the authors of this paper wish you the best of luck in your new credit career and we hope you have enjoyed this paper and got as much out of it as we enjoyed writing it. We strongly encourage you to get involved in this very dynamic (and honorable) profession called commercial credit. We are confident that you will find it challenging, personally and professionally fulfilling, and hopefully very rewarding.
We all wish you the best of luck!
Graduate School of Credit and Financial Management – Class of 2016
Charles Edwards, CCE
Vivian Hoang, CCE
Brendon Misik, CCE
Kenny Wine, CCE
John Zummo, CCE
Glossary of Financial Terms and Ratios
Debt to Equity ratio: Total Liabilities divided by Total Equity.
Debt to Tangible Net Worth: Total Liabilities divided by Tangible Net Worth. Tangible Net Worth is the Total Equity minus the total of Intangible Assets.
Assets to Equity (Leverage Ratio): Total Assets divided by Total Equity.
Current Ratio (CR): Total current assets divided by the total current liabilities: should be greater than 1.5.
Quick Ratio (QR): Total current assets minus the inventory amount, all divided by the total current liabilities (also known as the acid test ratio): generally lower than the CR, but should still be above 1 depending on the industry.
Net Working Capital: Total current assets minus total current liabilities: should to be greater than $0.
Accounts Receivable Turnover: Sales divided by accounts receivable.
Days Sales Outstanding (DSO): 365 days divided by accounts receivable turnover.
Inventory Turnover Ratio: Cost of goods sold divided by inventory.
Days Inventory Outstanding (DIO): 365 days divided by inventory turnover.
Accounts Payable Turnover:Cost of goods sold divided by accounts payable.
Days Payable Outstanding (DPO):365 days divided by accounts payable turnover.
Cash Conversion Cycle:Days sales outstanding + days inventory outstanding – days payable outstanding.
Net Profit Margin: Net income after tax divided by net sales: should be greater than 0% and be in line with other like companies in the same industry.
Gross Profit Margin: Gross profit divided by net sales: should be sufficiently greater than 0% and needs to be compared to previous years to assure an upward trend.
Operating Profit Margin: Operating income divided by net sales: should be greater than 0% and should show improvement year-over-year.
Times Interest Earned Ratio: Operating income divided by interest expense: should be over 1 to pay interest expense on debt, and usually has a cushion of 1.5:1 or higher.
Debt Service Coverage Ratio: Earnings/income (E) of a company before (B) the sum of interest expense (I), depreciation (D), amortization (A), and any other non-cash items (together represented as EBIDA), divided by the sum of current portion of long-term debt (CPLTD), current portion of capital leases, and interest expense: should be over 1 to cover required debt payments with healthy companies reporting 1.25:1 or higher.
Cash Flow from Operations Debt Service Coverage Ratio: Cash Flow from Operations (add back interest expense if using the indirect method) divided by the sum of current portion of long-term debt (CPLTD), current portion of capital leases, and interest expense: should be over 1 to cover required debt payments with healthy companies reporting 1.25:1 or higher.
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- Fraser, L. M., & Ormiston, A. (2010). Understanding financial statements (9th ed.). Upper Saddle River, NJ: Prentice Hall.
- Dean, J. F. (2004). The art & science of financial risk analysis (2nd ed.). Columbia, MD: National Association of Credit Management.
- Supervision and Regulation Division of the Federal Reserve Bank of Atlanta. Director’s guide to credit. Atlanta, GA. Federal Reserve Bank of Atlanta. Print.
- U.S. Securities and Exchange Commission. (2007). Beginners’ guide to financial statements. Retrieved from http://www.sec.gov/investor/pubs/begfinstmtguide.htm
- Jurinski, J. J. (1994). Credit and collections. Barron’s educational series, Hauppauge. New York, NY. Barron’s Business Library.
- Ittelson, T. (1998). Ratio analysis, financial statements, step by step guide to understanding and creating financial reports. Franklin Lakes, NJ: Career Press, Inc.
- Investopedia. (2015). Operating margin. www.investopedia.com
- Accounting Tools. (2015). What is a financial statement review? www.accountingtools.com
- DiCicco Gulman & Company, LLP. (2011). Reviewed financial statements vs. audited. www.dgccpa.com
Appendix: Exhibit 1 - ABC Corporation Consolidated Financial Statements
Appendix: Exhibit 2 - XYZ Corporation Consolidated Financial Statements