Ten hiding places for business credit risk.(REQUIRED READING)(commercial credit insurance analysis)

Business credit risk often poses a dilemma for both borrowers and lenders. A bank's first B I priority when extending credit collateralized by trade receivables is to protect the interests of its investors. Lenders typically rely on over-collateralization techniques as a primary means to insulate investors from losses on a receivables pool.

White this undeniably helps reduce risk, borrowers are often frustrated by gross advance rates as low as 40 to 50 percent, leading to deterioration of otherwise good customer relationships. The lender also gives up maximum utilization of its funds to the extent that advance rates are set lower than they safely could be.

The problem is rooted in the fact that many lenders simply do not have the time and resources it takes to sift through 10Ks, 10Qs and other financial statements to get a true picture of a borrower's financial health and review potentially troublesome issues, such as cross default agreements and debt trigger covenants.

To address this situation, a growing number of lenders are turning to business credit insurers for highly specialized trade credit underwriting expertise and their ability to analyze company balance sheets to uncover credit risk that is often not readily perceived.

With commercial credit insurance in place, lenders outsource much of the work involved in accurately assessing the security of accounts receivable, while transferring the bulk of the actual risk to the insurer. This allows the lender to safely increase advance rates, reduce concentration risk, and provide additional working capital, while meeting risk-rated return thresholds.

Most financial professionals agree that the place to begin is the cash flow statement. Cash flow statements convert accrual accounting, which is frequently manipulated--whether intentional or not--into cash basis accounting. The goal is to identify where cash is derived, how it is used, and provide insight into the quality of earnings. Balance sheets and income statements can be misleading, and profits may not identify the weakness in operations.

It's important to look at the cash conversion cycle to get an idea of the number of days of financing a company needs to support its operating cycle (Operating Cycle = DSO Inventory + DSO A/R). It is also important to identify whether cash is being generated by operations, financing or asset sales. If a company has a solid current ratio, it may be because it has high-cost financing supporting inventory and current assets over its liabilities. This can be very costly to a firm.