Many organisations will request that customers provide details of their financial performance before granting credit. Key suppliers and contracts are also requested to display their financial strength to keep supplies going or complete contracts. However, the face of financials has changed due to the pandemic. They are no longer what they used to be and it is perfectly excusable to be cynical and sceptical on the numbers you see.
The June 2020 reporting period will not look pretty for many companies. Revenue drops, losses, asset write-offs and spike in unpaid receivables will be common. Nevertheless, directors and business owners will be keen not to scare their trading partners, may it be investors, lenders, customers or suppliers. Many will be tempted to embroider their financial performance.
Below will help you make better sense of the numbers.
Revenue - Many of your customers and suppliers will report sharp revenue reduction. Things could have been much worse. Businesses were not affected by COVID until late January this year and this means that for at least 7-8 months of the 2020 financial year things were normal. So, if you see a 30% annual reduction revenue, in reality the situation is far more serious!
Probing the financials to find revenue sources is important. The pandemic has affected certain industries and markets more than others. For instance, if your customer depends on the aviation industry, they are more likely to face financial strife compared to a customer supplying goods to supermarkets.
Companies in the short term are saddled with the customers and markets that they have built over time. Knowing whether your customers and suppliers exposed to industries and markets heavily affected by the pandemic is vital. It will help you reduce exposures to the more vulnerable.
Profitability - What’s true for revenue is also true for Profits – the reduction in profits or losses would have been far worse if not for the pandemic prevailing only for the last few months of the June 2020 financial year.
While revenue reduction may be out of control, companies have some control over their costs. Where the cost base is more variable than fixed, costs can be reduced proportionate to revenue reduction. Some businesses will have reacted better than others as well, scraping the more exuberant expenses, reducing staff or negotiating better deals with suppliers. While profits may have reduced in dollar terms, the better managed companies will see a lesser impact on their “margins” such as the gross profits or net profit margins.
Losses will be common too and you cannot necessarily ditch every trading partner who made a loss. However, sometimes the losses will be substantial to the extent that it will cripple businesses and threaten their existence. Planning to end relationships with such businesses will be vital for your own survival.
Leverage - Owners will be patient with the money they have provided to their own businesses – call it capital, retained earnings or owners-loans. They will forego returns for their money and will wait for good times to return. External lenders will not. Where a business has borrowed from external sources, the lenders will expect their interest and capital payments to be made. The banks will require the covenants linked to their lending to be met, such as being profitable, and if breached may call the loans.
Companies who have funded operations with less external borrowing will find that they are under less pressure. Pressure that extensively geared companies would face with large interest payment and loan repayments.
Having no banking relationships at all is not a good thing either. Provided loan limits are not fully utilised, and provided a good relationship has been built with the lenders, the companies having access to external borrowing will have access to cash and will weather the storm better. Its all about the right balance between share capital and debt capital. It will be wise to limit relationships with trading partners who have got the balance wrong.
Liquidity - Companies need cash to pay bills, wages, interest and taxes (barter is not back in vogue yet).
Your customers short on liquidity will not be able to pay you and the suppliers or contractors who are short on liquidity will not be able to keep supplies going or complete your contracts.
Beware though – traditional liquidity measures can be highly deceptive in these pandemic times!
There are a few ways to assess the liquidity of business. A common measure for instance is the Current Ratio which gives a number when Current Assets of a Business is divided by its Current Liabilities.
In other words, the current ratio measures how well a business can pay their near-term obligation such as supplier payments or interest payments using short term (or liquid) assets such as cash, stocks and debtors.
Here’s the problem. The pandemic has made some of the current assets, perceived traditionally as liquid, well…, not so liquid. Stocks that were previously sold and turned into cash are languishing in warehouses. Debtors who used to pay in a few days are delaying payments for months or worse, may never pay. The so-called liquid assets are becoming longer and harder to turn into cash.
So, are the companies with good cash reserves better placed? They will be in the short term, but cash will eventually runout. Unless trading continues so that’s stocks become sales and customers keep paying up so that debtors become cash, liquidity issues will come knocking.
You will need to probe deeper into the financials and look beyond traditional measures to understand the true liquidity position of your trading partners.
It’s never a good time to get hit with bad debts, slow paying customers or disruption to your key supplies due to suppliers becoming insolvent. When businesses are already doing it tough such adverse outcomes can be lethal. It is vital to understand the true financial performance of customers and suppliers. To do so, make sure you analyse their performance through the COVID lens.