In the last issue of Creditworthy News Rich Hill discussed the importance of the Statement of Cash Flows. It has long been recognized by those who analyze financial statements that this is the most revealing of the five components of a financial statement.

One of the classic examples of the importance of this document was the events leading up to the bankruptcy filing by the Southland (7-11) corporation in the early 90’s.  Southland was the first company to file a prepackaged bankruptcy petition, meaning they had creditor approval of their reorganization plan prior to filing bankruptcy. This type of filing is the blueprint for the proposed Chapter Ten filing in the revised bankruptcy law.

Southland was unique in that the majority of its trading partners were wholly owned or majority held subsidiaries. The company chose to take itself private just when the economy was heading south in the late 80’s and ultimately found itself heavy with bondholder debt while income from operations were declining. In order to repay the bondholders timely it began to sell off its’ subsidiary companies. Unfortunately the economy did not recover sufficiently and after selling off all its assets Southland was faced with either selling all its remaining stores or seeking protection from its creditors.

Those creditors who studied the statement of cash flows were prepared for the inevitable because they recognized the cash was coming from investments and being used to pay down bondholder debt rather than from operations.

The majority of credit professionals report that they are unable to obtain financial information because the customer refuses to provide it and if they push for it they risk the customer switching to the competition. Furthermore, they often state, incorrectly, that there is no law that provides them access to this information.

For those who sell product, Article Two of the Uniform Commercial Code provides for obtaining financial or similar information. §2-609 provides for both the buyer and the seller of goods the Right to Adequate Assurance of Performance. §2-609(1) reads in part: “when reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return”.

Extension of credit is founded on the principles of the three C’s. Character, capacity and capital. Capacity and capital generally are determined by financial information contained in the balance sheet. Capacity is equal to current assets minus current liabilities and capital is determined by subtracting total liabilities from total assets.

§2-609(4) reads: “after receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract.”

Financial statements are an integral part of credit analysis and should be required from all customers who seek credit terms. First and foremost a financial statement is “managements report card” and the businessman who does not have a current financial statement is not privy to what he owns and what he owes.

Today, more than ever, it is important for us to recognize and communicate to both the internal and external customer that credit is a privilege that is to be earned by providing the necessary information that allows us, as credit professionals, to do our job efficiently.

I wish you well.