A financial evaluation can be performed based on concrete, objective financial indicators that can be obtained from, or calculated based on information contained in financial statements, annual reports, and other sources. These types of reports may be public or they may need to be requested directly from the potential customer.
In determining a potential customer's ability to pay, some of the financial indicators that can be evaluated from data on the balance sheet include:
overall cash balances
ratio of current assets to current liabilities
debt to equity ratio
capital or net worth
Since the balance sheet represents the financial position as of a given date, it may be advisable to review more than one.
Some indicators from the income statement include:
overall profitability in terms of net earnings
ratio of net earnings to sales
debt carrying costs, namely interest, as a percentage of total expenses
Here again, it is advisable to review income statements for more than one period, in order to make a decision based on performance over a sufficiently representative period of time.
While acceptable ranges can be applied in evaluating ratios and other financial indicators, the general idea is to have a clear picture of the potential customer's overall financial health.
Economic and market considerations for extending credit
Overall economic conditions, and conditions in your potential customer’s industry or market are factors that should enter into your evaluation. A general economic downturn affects everyone, but may affect certain companies or businesses more quickly or more severely than others. Some markets may be susceptible to cyclical fluctuations that affect a particular company’s profitability and cash flow. And markets are constantly evolving and changing, benefiting some companies and leaving others at a disadvantage.
Your small business may be local and subject to economic and market conditions in a relatively limited area or sphere of activity. Or you may be global and subject to a wide range of factors in an on-line, interrelated business world that could potentially affect your business.
This is an area that may be difficult to quantify in concrete terms, since there are so many variables that enter in, and that are often intertwined. The idea is to maintain a constant awareness of prevailing economic and business conditions, paying particular attention to how these fluctuating conditions affect your own business and that of your potential customers.