Don't Rely Too Heavily On Financial Statement Analysis to Manage Credit Risk
By Michael C. Dennis, MBA, CBF

Some credit managers rely too heavily on financial statement analysis without understanding its limitations. If the recent accounting scandals have demonstrated anything, it is that financial statements are subject to various forms of manipulation - some of it allowable and some of it improper and possibly illegal. Here are some of the limitations of financial statements:

• A customer's past financial performance - good or bad - is not a perfect indicator of future performance.

• The more out-of-date financial statements are, the less valuable they become to the credit department.

• In some instances, unaudited financial statements are worse than nothing - because they can be entirely fictitious and intended to be used to defraud creditors.

• More broadly, it is impossible to know how accurate unaudited financial statements are. For this reason, it is imprudent to rely too heavily on them when evaluating credit risk.

• Unless a customer or applicant provides a prior period financial statement for comparison, there is no starting point from which to determine whether or not the risk of offering open account terms to the company under review is getting larger or smaller.

• Most creditors do not receive copies of notes to the financial statements except from publicly traded companies...but without these notes it is impossible to get a clear picture of the company's financial health.