When you vet your commercial customers for loans, you examine their financial statements to gauge the health of their receivables. You might consider this amount collateral as you proceed with your lending decisions.
But don’t be hoodwinked. Some borrowers exaggerate their receivables to get a loan. Savvy bankers, however, know what to look for on the receivables end so that they don’t get duped.
Watching for Fictitious Sales
Banks routinely monitor receivables from year to year and compare receivables to sales with the days sales outstanding (DSO) ratio [(average receivables divided annual sales) times 365 days]. But various expenses also should change in tandem with receivables and sales, such as freight and commissions.
If such expenses are unchanging, it suggests management may be booking fictitious sales and warrants further investigation. Also be skeptical of businesses that report significant improvements in gross margin, especially when the DSO ratio has increased.
Pinpointing Borrowers at Risk
It’s risky for a company to rely on one customer for more than 10 percent of annual sales. What happens if a key customer chooses an alternate supplier, strong-arms more lenient payment or pricing terms, or files for bankruptcy?
Unfortunately, concentration risks are common, especially among small businesses. So identify which borrowers suffer from that malady. Then keep an eye on the financial performance of their key customers and track expiration dates of any pricing commitments or exclusivity contracts.
Getting a Clearer Picture
A business’s balance sheet reports accounts receivable as of a certain date. But what happens after the accounting period ends? You can get a clearer picture of the condition of receivables by investigating how much of the balance for outstanding invoices was paid or written off, how many sales were reversed, and how many credit memos were issued within a month of year end.
Just as many receivables scams are reversed shortly after the accounting period, aggressive managers also may scramble to inflate receivables just before year end. So, pay close attention to receivables journal entries made in the last few weeks of the year. A significant increase in year end account activity suggests receivables manipulation.
Asking for More
Financial statements provide minimal information, so request supplemental schedules, such as aging reports or sales decomposition reports. For example, you might ask borrowers to compare credit vs. cash sales or break down collections by salesperson.
With permission, you also can contact the borrowers’ customers directly to confirm receivables. Confirmation letters — a routine audit procedure typically not done for compiled, reviewed or internally prepared financial statements — protect against aggressive accounting practices, such as fictitious revenue or credit memo scams. Sent to a random sample of customers, confirmation letters ask them to respond whether specific invoices were, indeed, outstanding as of a particular date.
Avoiding Unpleasant Surprises
Extra precautions such as those mentioned above make it more likely that your estimation of customers’ loan worthiness will be on target. But if you take each customer’s reporting of receivables at face value, your financial institution may be in for some unpleasant surprises.