How to Analyze Trade Credit - Pt. 1

Never before in recent years - and even more so now in the post-Covid era - has there been such an awareness of the fact that having a profitable business in terms of turnover alone may not be sufficient in itself to guarantee the good health and continuity of the company, even though it undoubtedly represents a necessary condition for achieving these objectives.

Of course, a good turnover means that the company is well positioned in relation to the market it addresses and in which it finds itself having to compete, and this is undoubtedly no small thing. However, if a system is not put in place that provides for careful monitoring of trade credits and the liquidity associated with them, an increase in turnover could actually be counterproductive, and in the long run lead the company into a condition of financial tension .

Although it may seem counterintuitive, in some companies it happens that liquidity decreases as turnover increases. Most likely, these are companies in which some credits towards customers are not collected, or in any case are not paid with the right timing, that is, with the promptness necessary to allow the payment of debts, especially those towards suppliers.

In fact, as we will see better later when we talk about the monetary cycle , the economic manifestation (costs and revenues) in most cases does not coincide with the financial manifestation (payments and collections) but rather precedes it (except in some rare cases, such as large-scale retail trade and the insurance sector), with the consequence that a certain amount of time will pass from when the company pays its suppliers to when it receives the proceeds from sales. In fact, most companies have to deal with a market that allows for more or less deferred collections, and with suppliers who demand close payments.

This temporal misalignment inevitably creates a need for liquidity : it must not be forgotten, in fact, that the credit granted to customers represents an investment in all respects (just like stocks), therefore:

• they absorb liquidity when they increase;
• they release liquidity when they decrease,

thus behaving like a sort of “sponge”.

It is therefore necessary to be very careful to focus business development only on turnover . If you only look at increasing turnover without simultaneously improving or at least trying to maintain margins, instead of creating liquidity there is a significant risk that it will be reduced, both due to the increase in operating costs and the dynamics relating to Net Working Capital (NCC) .

As can be seen from the following figure, in fact, the operating Cash Flow , one of the most important quantities to monitor as it is an expression of the liquidity created or absorbed by the company's core business, is given by:

From the figure it can be deduced how the operating cash flow is influenced by these two quantities:

• EBIT, which is assumed to be positive otherwise the company could not survive as it would mean that its business does not create but destroys wealth;
• the CCN which, with its expansion/reduction dynamics, is able to absorb/generate liquidity respectively.

Trade credits are the most significant part of the CCN, which in turn plays a fundamental role in the creation/absorption of corporate liquidity, so credit management becomes an aspect of primary importance, a real strategic lever capable of significantly impacting profitability, financial management and the creation of liquidity.

In this series of articles we will address the analysis of trade credits in relation to two key indicators which, in the context of implementing a handmade control system, undoubtedly represent a valid starting point in the management of this very delicate – and often not adequately considered – balance sheet item:

• Days Sales Outstanding ( DSO), a measure of the time dimension of receivables;
• the Collection Effectiveness Index (CEI), a measure of their quality.

In the next articles we will see in detail how these indicators are calculated, and what valuable information they can give us, if these are constantly monitored within an organizational, administrative and accounting structure that is adequate pursuant to art. 2086, paragraph 2, of the Civil Code.

(continued in part 2 )