When you are extending trade credit to a major trading partner use a scoring model that incorporates multiple variables, including such things as trade experience and ratings, company and principal history and a deep dive in to your customer's financial statement.

While public financials are readily available, it is not always easy to get financials from private companies. With that said, if you require them as an essential element of your credit evaluation, here are some of the things you should look out for.

I've found that traditional credit scoring focuses mainly on the income statement and balance sheet, with a lack of emphasis on the statement of cash flow. A company's cash flow is critical to its future solvency. The statement of cash flow demonstrates a company's ability to meet its cash operating expenses, capital expenditures and debt payments as they mature.

A strong credit scoring system can have up to 50 financial ratios, including 20 cash-flow ratios, and it should be based on direct reviews of thousands of trade accounts where the system has historically produced very low bad-debt levels.

Credit scoring with financial statement analysis essentially sets credit limits for viable customers, sets prudent risk ratings, helps you increase sales and cash flow, decrease bad debts, allows for more frequent credit reviews, improves decision-making, and reduces operating costs.

Three Hypothetical Situations
To demonstrate how adding cash-flow analysis to your credit scoring model can augment sales and reduce bad debt I've outlined three hypothetical situations, each of which is common for a credit analyst.

Hypothetical Situation One: The income statement shows a large net loss stemming from non-cash items such as write-downs of assets, restructuring charges, and early extinguishment of debt, leaving many reviews to curtail or eliminate the credit line.

Solution, Utilizing Cash-Flow Analysis: The statement of cash flow reveals positive cash flow from operations and no cash burn rate; operations are profitable outside the one-time charges, thus offering support for a credit limit.

Hypothetical Situation Two: Highly leveraged company prevents credit limit

Solution, Utilizing Cash-Flow Analysis: The cash flow statement reveals the company is generating significant cash flow from operations, with no cash burn rate, strong cash reserves to meet interest payments on its debt, is funding future working capital requirements, and thus shows justification for a continued credit.

Hypothetical Situation Three: You have companies in your customer base you're concerned about because they sell mature products with little sales growth, eroding gross margins, weaker cash flow due to lower profit margins and declining customer bases. These facts often combine to cause pressure on a business to increase in borrowing and leverage.

Solution: This is a dangerous situation where liquidity, cash flow, profitability, and leverage are all negatively impacted, leading to a potential bankruptcy. A strong credit scoring system is designed to catch these red flags, revoke credit limits, and greatly mitigate bankruptcies.

Automating the Scoring System
Automating a credit scoring system will significantly enhance turnaround time for a credit decision. In addition, automation frees up credit personnel time for other issues. Additionally, automating credit reviews with credit scoring will help support SOX compliance with a highly reliable system to greatly minimize bad debt.

Trend or comparative analysis is pertinent for credit scoring for both domestic and foreign customers and for companies with audited or unaudited statements. When all you have are unaudited financial statements, it's a good idea to increase the risk rating score, conduct at least a semi-annual credit review, and reduce their credit limit (for example, you might set the limit at half of that used for a company with audited statements). This will help you keep legitimate business and reduce exposure to bankruptcies.

Although it cannot absolutely project future performance (no credit scoring model is perfect), scoring can assign and quantify risk based on prior indicators better than scoring models that don't use financial statement analysis.

Credit scoring with financials does not completely eliminate all credit risk. For example, it does not aid in the predication of losses due to nature, fraud, or inadequate audit reports. Whatever system you use, it should be based on thousands of credit reviews. This will strengthen the risk-scoring classifications and ultimately the credit operation. Credit scoring through financial statement analysis presents the best model to evaluate credit risk. It can be used as a standalone credit decision making tool in perhaps 80 to 90 percent of credit decisions.

All other scoring modules that just use metrics such as pay performance, management history, strength of competition or customer base, years in business, lien and suit searches, fall short of the pertinent information gleaned from financial statements. But there are certain situations where data other than financial data is important.

In summary, credit scoring with financial analysis benefits should include the following: sales growth (or decline), profitability, and cash flow.

Due to SOX compliance measures it is most difficult for public companies to commit fraud and heightens integrity of financial scoring models. Credit scoring with financial statement analysis should be based on 45-50 financial ratios representing thousands of companies from large to small, different industries and all parts of the world. It is low-priced, has financial scoring analysis that assesses customer strengths and highlights red flags, as well as helps you with credit limit recommendations. It is recommended that a credit scoring model have the flexibility to fit trade customers in a variety of lines of business, including, for example, retail, manufacturing, biotechnology; software, or construction.

A well-constructed scoring model allows you the flexibility to adjust ratios to improve the integrity of your results. It should also place emphasis on cash reserves relative to debt obligations and working capital requirements, as well as the loss of a major customer or ongoing market competition.