Company accounts are an interesting piece of the jigsaw when evaluating the solvency of your clients.
If you have critical clients it is essential that you collect as much information about their financial affairs as possible: the bigger the client the more pertinent the assessment of their financial affairs. There are many ways of assessing their ability to pay and this article will concentrate on their company accounts.
You can get a copy of their company accounts from Companies House. For most companies these will be Abbreviated Accounts which limit the level of digging you can do, but it will give you some useful information.
Before you start looking into the accounts take a look at whether they have been filed on time. Late filing is well known to be correlated with later insolvency and you can also look at changes in directorship as this can show instability. As with all measures they should be viewed as part of a wider picture.
In the accounts you should focus on the balance sheet and be looking for two things: cashflow and leverage.
You can get a view on the company’s ability to pay their short term debts by employing the current ratio, calculated by dividing your current assets by your current liabilities. The higher the number the greater liquidity the company has. Cash is the best current asset, and then the strength of debtors and stock will depend on the industry. For example, debtors in the construction industry are notoriously unreliable so consider whether this is likely.
The value of stock can also be misleading, but this will vary depending on industry, and some stock is worth less than recorded on the balance sheet or very hard to sell.
Again this is looking at the balance sheet but taking a view on how the company is funded, so its long term liabilities. Looking at whether the company is funded by debt or equity allows you to see whether they are tied into repayments which can put a strain on the business. You can also see if there are other types of long term debt, typically mortgages, where repayments can be burdensome. In abbreviated accounts it’s not always clear what everything is but it’s a good starting point.
Profit & Loss
It’s worth looking at the revenue and profit figures on the P&L to look at trends over a period of time. What is happening to revenue is important: steadily growing or stable revenue over many years indicates the safest proposition. Variable, declining or spikes in revenue can mean the company is inconsistent, struggling or expanding quickly. Expansion sounds good but a lot of companies can run into problems by overtrading and getting into financial difficulties trying to grow too fast.
Looking at accounts is one part if the picture which should feature in your due diligence. Remember, don’t take the numbers at face value – contextualise them with the type of business you are assessing.