How to Analyze Trade Credit - Pt. 5

Let's imagine a concrete case, with sales subject to VAT 22%, a 365-day year, practically no seasonality and collection times of 40% after 30 days, the remaining 60% after 60 days.

Example #4

Let's leave aside the various 30, 60 and 90 day DSO formulations, and focus only on the one on an annual basis, which leads to a result of 50.2 calculated as follows:

Now imagine, all other things being equal, that we add the amount of 65,000 to the “Credits” column, which represents a hypothetical bad debt.

The new table, containing the stranded credit, appears as in the following figure, in which the annual DSO value goes from 50.2 to 68.5.

Let's now put ourselves in the shoes of an external analyst , who does not know of the existence of the bad debt of 65,000. Given that we know that the company has historically always collected on average at 48-50 days, this abnormal value of 68.5 will lead us to make the following reasoning.

The company invoices on average 1,064,000 / 365 = 2,915 euros in one day, which with VAT becomes 3,556 euros.

If we believe that 18-20 days of credit is in excess of the normal operating activity of the company (as derived from historical data), multiplying the daily credit by an intermediate value, e.g. 19 days, we would obtain the following result:

So the external analyst with this type of analysis essentially obtains a sufficiently reliable estimate of what the bad debts could be (which only we know for certain is equal to 65,000!).

In this case, therefore, the DSO analysis allowed us to discover that the company has some difficulty in collecting its credits!

At the end of this brief journey inside the DSO indicator, we could conclude that a chronically too long cash-out time brings with it:

• a profitability problem: the capital invested in this way does not yield enough;
• a liquidity problem: existing cash and readily convertible assets may not be sufficient to pay short-term debts, thus generating a continuous financial need;
• This inevitably leads to increasing indebtedness , which in turn further reduces profitability.

This triggers a vicious circle that must be addressed before the situation gets out of hand, degenerating into situations of illiquidity that are difficult to address, if not irreversible, and capable of seriously undermining business continuity .

Only with a timely control of this fundamental component of the CCN is it possible to monitor and regulate the absorption or generation of the related cash flows.

This is even more true in sectors where margins are low: in these cases, the financial dynamics linked to credits assumes, as is easy to imagine, a fundamental role. Having a gap between payment days/collection days that is too unbalanced in favor of the former, inevitably leads to a need for financing that - all other things being equal - increases as the turnover increases.

(continued in part 6 )