To many, the word “credit” immediately evokes thoughts of lenders. However, the idea of credit extends far beyond lending. The Merriam Webster definition of the word includes nothing about lending, but focuses on the notions of trust and confidence:
credit (’kre-dit) noun 1/ reliance on truth or reality of something 4/ credibility 6/ something that gains or adds to reputation or esteem Etymology: Latin, credere, to believe / entrust
Credit is the cornerstone of forging trust between companies across a wide variety of relationship types. Understanding the creditworthiness of counterparties is essential for beginning new business relationships and managing existing ones.
One valuable source of credit information is a company's financial health, which can be derived from cash flow data. The critical insights drawn from evaluating financial health are relevant for many businesses beyond lenders – below are a few examples of these businesses:
When a business leases commercial space, the landlord will evaluate financial information about the business. This is similar to the way residential landlords evaluate individuals’ financial information before renting an apartment or house, but the value of commercial leases are much higher. As such, the evaluations are more in-depth. Landlords are primarily interested in several insights:
- Does the business have the cash flow to pay their lease payments on time?
- If operations don’t provide enough cash for regular payments, does the business have some other way to meet the obligations (e.g. cash savings, bank guarantee, access to equity financing)?
- Will the company continue to operate through the term of the lease?
Commercial landlords are not looking to take risk. Analyzing the financial health of a business before taking them on as a tenant is paramount. Further, keeping tabs on business health periodically helps them get ahead of tough situations, like late payments due to financially hard times for their tenant.
When a business applies for a new insurance policy, the insurance company begins a process of evaluating the business. This allows them to decide whether or not to cover the business and to shape an insurance policy for them. The insurance company wants to check in on two primary factors:
- Does the business have the financial capacity to pay their premiums?
- Is the business financially distressed or otherwise likely to file undue or fraudulent claims?
Properly pricing and extending an insurance policy allows the insurer to begin on the right foot and, hopefully, embark on a long-term mutually beneficial relationship with the insured business.
Vendors and Service Providers
Taking on a new customer is not always an obvious decision. This is because many vendors are paid well after their goods are delivered or services are completed. This leaves the vendor open to the risk of incurring the cost of their goods or service and never getting paid, or getting paid late. Evaluating customers’ financial health allows vendors to modify the terms of the relationship to manage this risk, based on a few considerations:
- What size orders can the customer reasonably take on and what should their total order / spend limit be as a result?
- Based on the customer’s financials, what is the right time period to require payment within (a concept called net terms)?
- Is the customer’s financial position materially better or worse than when the vendor initially set the terms with them? Businesses change, and a vendor’s terms should too.
Vendors can use financial health evaluation to ensure that they’re offering the best possible engagement terms with their customers while also managing their own risks (late or non-payment). Further, they can begin conservatively and offer the customer better terms as their business strengthens.
Customers and Purchasers
It may feel less intuitive, but evaluating the financial health of vendors is also important for customers of that vendor. New vendor relationships require investment - whether that means implementing the vendor’s software, re-arranging a supply chain, or relying on a contractor to complete a project. Customers often look to financial health of their vendors to give insight into a couple of questions:
- Will this vendor stay in business long enough to make the investment in them worth it? (highly relevant for large companies considering purchasing from startup companies)
- Does this vendor have the financial stability to execute on their part of the deal - on schedule, within budget, and without requiring additional resources? (highly relevant for engaging contractors to work on projects)
As a business, purchasing a product or service from a vendor often requires an upfront investment. Evaluating financial health of the vendor can increase the chances that the investment will be worthwhile.
Business partnerships can take many forms and are often complex. Nevertheless, there are some common reasons why it is wise to do an evaluation of the financial health of a vendor before committing to the partnership. There are a couple of key questions that partners may want to consider:
- Will the partner have the ability to meet obligations, including quality of service and support? (highly relevant for distributors or resellers)
- Does the partner have the financial capacity to share in contributing to stability and growth? (highly relevant to joint ventures, co-marketing agreements, and licensing agreements)
Despite the wide variety of partnership arrangements that exist, having confidence in a partner’s ability to contribute to its success is critical. A strong financial standing provides the foundation for this contribution.
Direct lending is just the tip of the iceberg when it comes to the use cases for credit evaluation. By leveraging financial health insights derived from cash flow data, companies can make informed decisions about who they do business with. Understanding the financial health of counterparties not only minimizes risks but also unlocks new opportunities for collaboration and growth, leading to a thriving and robust business ecosystem.
At Basis, we’re building the tools to power better financial interactions between businesses by providing the data needed to evaluate and monitor financial health.