In Part I of the interview with Mr. Rozario, we talked about the necessity of interpreting information from the perspective of risk control and the timeliness of information. Mr. Rozario also offered advice and explained how a savvy credit control professional determines whether a company is "healthy". Last but not least, he shared strategies for balancing the cost and effects of various risk control tools.
In this Part II, Mr. Rozario will analyze corporate risks through real-life cases. What criteria and techniques help evaluate a company's operating capacity? What does "blind spot" in risk management mean? How can blind spots be found through in-depth analysis? Mr. Rozario will answer the above questions with his more than 30 years of credit management expertise.
01 Comprehensive analysis necessary to discover blind spots in risk control
Xiaoan: Mr. Rozario, do you have some special experience in risk assessment? Or what do you think should be noted in doing this?
Mr. Rozario: I want to share a recent experience with you. Additionally, it is a fairly prevalent blind spot in risk assessment.
Recently, I was invited by a client to its company to train its credit analysts. During the discussion on the advantages of credit reports, a junior credit analyst said that the vast amount of data and information available online meant that credit investigation and evaluation tools like credit reports were no longer necessary. I won't go through it again because I've already done so (editor's note: Part I of the interview). I showed some trend charts and requested one of the trainees to analyze them rather than correcting the junior analyst directly. The senior credit analyst found the charts to be quite useful, while the junior one found them to be meaningless.
The charts showed data of an electronics manufacturer. One of them displayed the equipment, depreciation, and other aspects of an electronics manufacturer, as well as the ROAs' growing tendency. The junior credit analyst thought that the manufacturer's financial situation was satisfactory, seeing that the plant's ROA had stayed high for several years. A senior credit analyst, however, had a different viewpoint. According to him, the plant hasn't purchased any new equipment over the years, as evidenced by the facts that the majority of its assets are machinery rather than plants and that many of the machines are out-of-date. As a result, ROAs are still high. So, is it risky to give the factory a high credit rating just because of the satisfactory ROA?
His observations astounded me because he did that without any professional suggestions. I studied finance from the perspective of shareholders in college. This clearly differs from the thought pattern of risk control analysts. That is what I refer to as a blind spot.
Of course, shareholders would like to see aged machinery keep generating value and function continuously. As a result, they receive returns without having to purchase new equipment. Do its clients and vendors share this sentiment? Do you prefer a factory utilizing new machines or the one using old ones if you are a customer with strong requirements for quality and lead time? A plant with satisfactory output and quality is unquestionably more competitive than the one with satisfactory ROA only, even though we were examining credit limit rather than vendors.
Risk management requires thorough analysis and tools like trend charts to help better understand data and identify blind spots. The same data will be viewed differently by experts and laypeople. In order to establish an acceptable credit limit, I advise using more credit evaluation tools for data analysis.
02 Information is valuable only after properly interpreted with experience and prudence.
Xiaoan: Speaking of thorough analysis, could you please give us some more examples?
Mr. Rozario: Sure. An excellent example is the Chinese retail company listed abroad I previously mentioned (editor's note: Part I of the interview). Its disclosures indicated that both its revenue and net profits were increasing. Most people would automatically conclude that the company is highly profitable after seeing this. However, its profit margin shrank. Why? The company's costs have increased due to its extensive advertising spending. To boost sales, it took on a lot of debt, which had little effect on its cash flows. Despite a reduction in profit margin, the company's operations were still advancing, with net profits increasing. However, the vector of net profit is asymmetric as compared to the turnover, according to the trend charts. What's worse, the profit margins' vector is downward. That is why I have consistently emphasized the necessity of thorough analysis. The basis of decision making is the objective interpretation of information. Without the assistance of these charts, the aforementioned blind spots will be easily disregarded.
Here's another example. It's a trouble that many people may have encountered in their lives. Your car's engine creates unusual noises for unknown reasons. So you reach an auto repairman for help. Usually, he could promptly find the problems based on computer-generated data analysis report and relevant parameters. This example teaches us that while experience is crucial, making effective use of technology to immediately identify problems and suggest solutions is much more vital.
Once again, information from various sources is valuable only after properly interpreted. Technology and experience both contribute to more accurate and efficient data interpretation. On this basis, you can establish the credit limit, credit term and other conditions with reference to credit policy provided. If there is no credit policy or any hints, it should be considered individually. (Editor's note: Due to time constraints, this topic will be covered in greater depth in the future.)
Xiaoan: Mr. Rozario, you said that thorough analysis is required to understand the real situation of a company. Could you please provide us with any advice on determining a company's operating capacity?
03 “6Cs” to help judge a company’s operating capacity
01 Capital: Solvency. It is simple to confirm a company's solvency. Fair financial position and adequate cash flows are indicators of solid solvency. Unquestionably, companies with strong cash flows are less likely to experience payment issues. A company's cash flow situation can be evaluated by comparing revenue and costs. However, inexperienced practitioners tend to make judgments based on superficial information. Does the boss own a limo? Is the company situated in the CBD? Conclusions drawn from them are often biased. Corporate risk management differs from personal risk management. Typically, demographic information (such as education level, age, occupation, and place of residence) is used to forecast a person's ability to pay. However, due to their bias and ease of fabrication, such data are not applicable to corporate risk control.
02 Character: It means the willingness to pay. Don't take ostensibly financially healthy companies lightly. A search on the Internet may discover that they are notorious, embroiled in litigation or are complained of wage arrears. Online platforms such as China Judgments Online (http://wenshu.court.gov.cn) make such information easily accessible. But keep in mind that having lawsuit records isn't necessarily a bad signal. An objective judgement is based on comprehensive analysis of data.
Besides, trade references (editor's note: records of making payments to other suppliers) can also help us understand a company's payment performance. Specifically, it means knowing a company's payment performance according to its records of paying to others. This practice is pretty sophisticated abroad. However, it is not common in Chinese mainland to systematically obtain corporate payment records. Instead, a small-scale informal investigation is conducted to verify a company's payment performance. Relevant practice is widely adopted in individual credit check probably due to the involvement of the People's Bank.
03 Capacity: Business condition. If you are looking for a manufacturer for a significant project, you might be wondering how to determine if your potential business partner has enough or excessive production capacity. Becoming a supplier for large-scale business helps boost business. However, experience shows that globalization has many drawbacks. In particular, due to the ongoing trade disputes and the pandemic, decision makers in governments and companies at home and abroad have gradually realized that the local markets are more essential. Entrepreneurs know that understanding the capacity of their business partners is critical to the development of local markets. They believe that big is not necessarily good (editor's note: large-scale companies are not necessarily ideal business partners). Instead, those with increasing capacity are more promising.
In recent years, many companies are not content with their already successful business and recklessly entered a new industry, particularly emerging industries like Internet finance and micro-loans. But the majority of them fail because they lack experience. They don't know that the most difficult problems in financial lending, such as bad debts and delinquency, are completely different from those faced by ordinary businesses. If the two problems are not resolved, profits will be hedged at any time. In the past few years, some risk control professionals in cities like Shanghai and Chongqing have regarded this phenomenon as a danger signal (editor's note: a method for judging risk levels with reference to distinct features in credit management). Thus, greater care should be taken while evaluating potential partners' capacities.
04 Competitiveness: Corporate competitiveness. I have learned many fresh ideas on corporate competitiveness in risk control in recent years. Large companies were typically considered to be very competitive. However, this perception has obviously changed in recent years. Large companies turn down client requests more frequently than small ones as they are restricted by many factors, such as corporate policies, inter-department coordination, or foreign laws and regulations. Their prices are less negotiable for the exact same reason. A less flexible company is naturally less competitive. However, I'm not saying the smaller the company, the better. Although small companies are flexible, they lack the access to some resources to meet client needs. Therefore, medium-sized companies are more competitive in terms of resources and flexibility.
Many companies were owed payments during the outbreak, and most of them are too large or too small. On the contrary, medium-sized companies are stable in terms of flexibility and capital strength. Moreover, with China encouraging to expand domestic demands, an optimistic outlook can be foreseen for competitive medium-sized companies.
05 Condition: Market condition. What companies could benefit from the pandemic? Manufacturers of masks, disinfection and cleaning supplies must have a stronger cash flow than ever before. However, although some companies perform well in the above "4Cs", they struggled in the epidemic. For the tourism, hotel, and catering sectors, this year has been challenging. Risk management is more crucial now to help screen out problematic trading partners and reduce unneeded risks. However, not every company has the ability and time to do risk control on their own. The problem can be solved with the aid of survey tools including assessment reports, index reports, and monitoring tools. Many risk management tools now combine big data and manual analysis. They can assist us in more effectively and objectively interpreting information.
06 Collateral: Guarantee, mortgage. Don't get me wrong, the high assurance value does not imply that a company is safe. But this does not contradict what I am about to say. In my opinion, asset condition is very important indicator in corporate risk assessment. Generally speaking, more assets mean lower risk. However, assets that have been mortgaged to other people are no longer assets. Simply put, if a large company pledges all of its assets to a bank, the bank has priority to seize the collateral if the company fails. Some companies have even re-mortgaged their assets to microfinance companies, i.e. they have pledged the same assets to several parties (editor's note: second or even third mortgages). If a company has pledged its assets to many parties, it is a sign that it is in financial trouble and you should be very cautious about working with it.
It is also important to check whether the company or its legal representative or its shareholders are "highly leveraged". Such companies are dangerous as their bankruptcy index will be fairly high when the real economy is depressed. I believe that the bankruptcy index of US retail companies is generally very high. We will see many US retail establishments failing in the future, which will affect many large companies in mainland China, so they should be cautious.
Xiaoan: Thank you, Mr. Rozario for sharing so many useful methods to assess a company’s strength. Finally, can you summarize to further enlighten our readers?
Mr. Rozario: Of course, you are welcome. I am happy to share my experience. Don't get frustrated. In my experience, while many poorly run businesses suffered or even shut down during a crisis (e.g., financial crises in 1987, 1997 and 2008, SARS in 2003, or regional turmoil like the Attack of September 11 in the US in 2001 or the 1999 Taiwan earthquake), there are also a number of businesses that become more successful because of their effective risk control. Keep in mind that there is opportunity in every crisis and risk can be managed beforehand.
Finally, I'd like to share a saying "Cash is King!" It means that the simplest way to increase your cash flow is to get your accounts receivable back as quickly as possible!
Xiaoan: Once again, thank you Mr. Rozario for sharing your thoughts. I look forward to discussing other topics on corporate risk control with you next time.