Checking a customer's default risk from its financial statements
When a customer fails to pay, that revenue becomes a straight loss, and for a small business it can trigger a chain of failures. If you can obtain the customer's financial statements, a handful of ratios gives a sense of its ability to pay before you set or raise a credit limit.
Five checks, in order
- Is profit arriving as cash? Persistently negative operating cash flow, or cash far below profit, means weak capacity to pay. → Profitable but short of cash
- Can it pay what falls due within a year? Check whether the current and quick ratios are below 100%. → Current and quick ratios
- Can it carry its interest? Check whether interest coverage is below 1 or falling each year. → Interest coverage ratio
- How much debt? Check whether debt-to-equity is far above its industry or equity is negative. → Debt-to-equity ratio
- Overall signal: the Altman Z'-Score combines several ratios into one picture. → Altman Z'-Score
One weak ratio does not make a customer risky. Several ratios deteriorating together is the stronger signal.
Worked example
Treating this guide series' example company as a customer, the five checks look like this (values calculated by the Caveat engine).
| Check | Prior year | Current year |
|---|---|---|
| Operating cash flow ÷ net income | — | 116.7% |
| Quick ratio | 90% | 110% |
| Interest coverage | 6.18x | 10.67x |
| Debt-to-equity | 105.1% | 100% |
| Altman Z' | 2.79 | 2.99 (safe zone) |
The four checks with a prior year all improved and operating cash flow exceeds net income, so this reads as a customer whose ability to pay is improving. Z' sits close to the safe-zone boundary (2.9), though, so one weak year could return it to the grey zone.
Beyond the statements
- Payment behaviour: whether it pays late more often, or asks for notes or instalments
- Concentration: whether its own sales depend on one or two customers
- Timeliness: statements appear months after year-end, so recent changes are missing
Using it in decisions
Both sides: a financially weak customer does not have to be dropped; lower the credit limit, shorten payment terms, or ask for prepayment or a guarantee. Conversely, a strong customer that makes up most of your sales still exposes you to its fortunes; manage how much of your revenue depends on any single customer.
Limitations
- Financial statements describe the past; sudden recent changes do not show.
- Smaller companies' statements are often hard to obtain or unaudited.
- Guarantees, litigation or the owner's personal circumstances are not captured.
- For reference only; it does not replace credit or investment decisions.
See it in your own statements
Upload a balance sheet and income statement and Caveat calculates these for your company.
FAQ
- Where can I get a customer's financial statements?
- Listed companies and companies above certain size thresholds publish statements through their country's public filing system. For smaller companies, ask for them as a condition of trade or use a credit agency's company report.
- If I could check only one ratio?
- Operating cash flow: without cash coming in, a customer cannot pay you, whatever its profit. Still, confirm that several ratios point the same way.
- Should I stop trading if the ratios are weak?
- Not necessarily. Adjust the terms first: a lower credit limit, shorter payment terms, prepayment or a guarantee.
- Are year-old statements still useful?
- Yes, for trend and underlying strength. Recent changes are missing, so read them alongside current signals such as payment behaviour.
Country notes: Korea
- Where can I see a Korean customer's financial statements?
- Listed companies and companies subject to external audit file them on the FSS DART system, free to view. For smaller unaudited companies, ask the customer for a National Tax Service standard financial statement certificate or use a credit agency report.