Liquidity and solvency are important in determining debtors' financial health and repayment ability. The former describes the ease of selling an asset or security with minimal impact on its market price. While the latter is an entity's ability to fulfill its long-term debt obligations.
Creditors use solvency and liquidity to assess the risk of lending to a company or organization. But how exactly do you check for them?
This article will show you how you can check the liquidity and solvency of your debtors to determine their financial stability and likelihood of financial commitments. Let's dive right in.
What is liquidity?
As mentioned, liquidity is how quickly a company can convert its assets into cash, usually to pay its debt. It's how much money a business can access if asked to pay its debts within a short time frame, like 48 hours or less.
Liquid companies can meet their short-term obligations effortlessly by liquidating their assets into cash. Illiquid companies, on the other hand, struggle to do the same since their assets don't have a ready market.
Selling these assets might require a price reduction to entice buyers, further compromising the companies' debt repayment ability.
Liquidity is expressed in three ratios, namely:
- Currency ratio: This is the ratio of a company’s total assets (cash, stock, account receivables) versus liabilities due within the year. The higher the currency ratio, the stronger the company’s ability to repay its debt.
- Quick ratio: Unlike currency ratio, the quick ratio measures a company’s ability to repay short-term debts. It's the ratio of the sum of accounts receivable, market securities, cash, and cash equivalents versus all current liabilities.
- Debt-to-equity (D/E) ratio: This ratio indicates a company’s leverage. It’s the ratio of a company’s total debt to its shareholder equity. It shows the extent to which a company is financing itself using its own resources rather than debt. The higher the D/E ratio the more debt a company has, and the riskier it is.
What is solvency?
Solvency, as described earlier, is an entity's financial capability to meet long-term financial commitments. It indicates the entity's financial stability and is usually obtained by dividing the assets owned by its liabilities. Owning more assets than liabilities makes a company solvent. The opposite - more liabilities than assets- makes it insolvent.
Solvency is expressed using the solvency ratio, which is the ratio of a company’s net income plus depreciation over its total liabilities. The higher the solvency ratio, the better a company’ financial health.
Why you should check your debtors' financial health
While it's true that lenders and debtors sit on opposite sides of the negotiating table, hostile relations are unnecessary. Lenders can sidestep these adversarial dealings by conducting viability assessments before extending credit or entering financial agreements.
By checking your debtors' financial health, you can be confident in your lending decisions. You'll also be less inclined to use dubious methods to check a debtor's financial situation, which may result in damaged relationships.
Checking a debtor’s financial health also gives you peace of mind since you can anticipate potential risks and prepare accordingly. You'll also foster a positive and mutually beneficial business relationship over the long haul.
Most importantly, doing so helps you prevent bad debt that could cripple your operations and overall profitability.
Methods of assessing debtor liquidity and solvency
The exact method of checking liquidity and solvency depends on the lenders’ terms and the availability of information. Conducting a credit check is the most foolproof way of gauging your debtors' financial health.
A credit check refers to the process of reviewing a debtor’s borrowing history to determine their viability for financing and creditworthiness. In some places, credit checks are also called credit pulls or credit inquiries.
The purpose of these credit checks is to:
- Assess the likelihood of a debtor repaying their loan
- To develop fair and acceptable loan repayment terms and conditions
- To comply with regulatory requirements of UK financial authorities like the Prudential Regulatory Authority(PRA) and the Financial Conduct Authority (FCA)
- To safeguard your assets by guiding your lending policies
- Act as a safety net against losses
Lenders conduct credit checks through credit checking or referencing agencies. These are independent organizations that gather and hold financial information like:
- Accounts
- Credit application
They'll also have information on businesses' and consumers' overall financial behavior, particularly their borrowing, plus the number of defaulted and on-time payments. These credit agencies make this information readily available to lenders and other authorized parties (employers, landlords, insurance companies, etc.)
The three main credit reference agencies in the UK are Experian, Dun & Bradstreet, and Equifax. Experian and Equifax are international credit reference agencies, while Dun & Bradstreet is localized to the UK.
Aside from Equifax and Experian, TransUnion is a popular credit checking agency in the US, and Ilion holds the fort in Australia.
These and other credit bureaus will give you comprehensive reports to guide your decision-making when extending credit or evaluating financial risk.
The benefits of using credit checking agencies to determine creditworthiness
Credit bureaus offer a simple and convenient way to get financial data on your debtors. The other alternative would be to manually dig up this information, which is not only time-consuming but also wastes resources.
That said, the benefits of credit reference agencies for determining debtor viability include:
Effective risk assessment tool: credit reports by these agencies help determine the risk of lending to your customers. Cash flow is king, and disruption to yours can devastate your operational stability.
Ensures supply chain continuity: Leading from the previous point, unpaid invoices can cripple your supply chain leading to disgruntled suppliers and customers alike. Credit agencies can help you make more informed lending decisions, reducing the likelihood of disruptions to your supply chain.
Enhancing credit monitoring: contrary to popular thought, credit monitoring isn't a one-off event. The first time you look into a customer's creditworthiness is only the beginning of a continuous process of looking into their financial stability for future transactions. Credit reports will give you a complete picture of their financial health and guide your future dealings.
How to interpret credit reports from credit bureaus
Credit reports contain around 3 to 40 pages, depending on the Bureau and the customer's financial activity. Information contained in credit reports includes:
- Personal information
- Credit accounts
- Collection items
- Inquiries
- Public records
Besides the credit report, you should also review your customers' financial statements. These are detailed records of their financial activities. Income. Pay particular attention to:
Balance sheets: These statements detail what a customer owns (assets) and their debt (liabilities). It lets you assess whether a customer has borrowed too much and the liquidity of existing assets.
Income statements: Income statements are good indicators of a company’s financial performance over a specific time frame. It focuses on four main aspects of a company’s finances, namely:
- Expenses
- Revenue
- Gains
- Losses
At its core, an income statement shows how a company converts its revenue into earnings, therefore showing its overall profitability
Cash flow statements: This summarizes a company's spending arrangements- which elements of a business generate cash and which ones spend it. Cash flow statements show how a company manages its cash position.
All businesses in the UK, except dormant ones, "small" companies, and micro-entities, must submit the above information to the Companies House and His Majesty's Revenue and Customs (HMRC) annually. You can easily obtain this information via the Companies House website or by contacting the HMRC directly.
Quick side note: Companies House is the UK's version of the United States' Securities Exchange Commission (SEC) and Australia's Australian Securities and Investments Commission (ASIC).
What about non-financial data points?
While acquiring financial information is a great starting point for assessing your customers’ viability, it's only half the equation. For the other half, you'll have to look into non-financial data points, specifically
Trade references
This involves acquiring information on the customer's financial behavior from business partners, suppliers, and vendors. You can gain insight into the customer's company's payment patterns, transaction volumes, and even history of disputes.
Company legal form
A company’s legal form lays out its legal structure, liability and regulatory requirements. Sole proprietorships, for instance, have unlimited liability, meaning the owner is responsible for all debt obligations. A Limited Liability Company (LLC), on the other hand, separates the individual from the company's liabilities. Companies with unlimited liabilities are generally less risky than their limited counterparts since lenders can access personal assets to settle outstanding debts.
Standard Industry Classification (SIC) Codes
SIC codes are four-digit codes that provide insights into industry-specific risks for default. Companies are grouped into low-risk and high-risk companies based on their primary activity and the volatility of their industries. By understanding a company’s business environment, you’ll be better placed to check its creditworthiness and likelihood of defaulting.
Ownership and group structures
Investigate the company’s ownership and group structure to understand how the company distributes ownership. In doing so, you can better understand their decision-making processes, overall stability, and ease of conflict resolution.
Group structures will also give you an idea of the parent company's stability and whether it can step in to provide financial and operational support during troubled times.
Banking information
A company’s bank can speak volumes about its financial reputation and operational health. Companies with questionable banking partners are more likely to default since they lack a proper financial support system.
Ethics and reputation
Examines a company’s reputation in its market environment to gauge its trustworthiness. What do suppliers, investors, and partners say about the business? This information will reveal the company’s reliability, business ethics, and integrity. Steer clear of companies with histories of unethical practices.
Why should you continuously monitor your debtor's financial health?
It's important to stay on the lookout for warning signs of financial instability in your clients. The business environment is largely unpredictable, so staying informed about your debtors' financial health is a proven way to proactively manage risks and take proper actions to protect your financial interests.
With Chaser, you can credit check your debtors and access continuous monitoring, and alerts to keep you updated on your clients' financial health and likelihood of default.
The Late Payment Predictor assesses the risk associated with specific customers based on their historical payment patterns, invoice details, invoice due dates, and other factors. The Payer rating, which categorizes customers into low, medium, and high-risk brackets and assigns a risk percentage (0% to 100%), with a higher percentage indicating greater risk.
The benefits of utilizing these tools include:
- Reduces the likelihood of bad debt
- Enhances your decision-making with concrete insight into customers' creditworthiness
- Improves your cash flow by reducing late payment instances
That said, you can also employ the following best practices to manage risk when extending credit:
- Establish clear credit policies that involve regular credit checks, continuous monitoring, and active communication with clients
- Establish clear criteria for accepting or denying credit applications
- Set reasonable credit limits based on the customer's financial health and stability
- Conduct regular reviews of your debtor's information by consulting the appropriate credit bureaus and other financial institutions
Reduce your organization’s credit risk with Chaser
Are you looking to strengthen your risk mitigation efforts? If so, explore Chaser's broad range of features, like the late payment predictor, payer ratings, and credit checks and monitoring, to streamline your credit checks and risk mitigation framework.
Try it for free for 10 days, or speak to an expert today.
