When we analyse a business as credit assessors, we want to consider whether it’s sustainable into the future and so a vital aspect of the business that we need to understand is its place in the market – that is, does it sell something that someone actually buys and will continue to buy?
We call this the market environment and here we take a look at the semi-external components of the business – those elements that are to some extent within the control of the business itself.
Let’s take a look at what is usually considered in this environment and some of the questions that an analyst might ask;
- Product(s); what products or services does the business sell? Is there a steady or growing demand or is demand falling due to changes in consumer behaviour? Is the product ecologically sound? Is the product perishable or can it be safely stored for a long period?
- Location; where is the business situated in relation to its customers and its suppliers? Different types of businesses have different location needs. For example, the retail type of business needs to be close to its customer and in a location that is easily accessible. On the other hand, manufacturers need to be nearer to the supplier of the raw material so that procurement is easier and lower stock levels can be held at any one time. As part of your analysis of the business’ location, consider also it’s distribution channel, i.e. how does it get its goods to the customer and how secure is that channel?
- Seasonality; the bank needs to understand the seasonality of the business as it will have an impact on its working capital requirements during the year. This can be demonstrated by a cash flow projection completed by the managers of the business.
- Pipeline business; what business is in the pipeline for the near future? This applies to manufacturers, contractors and distributors as well as some service-type businesses but not to retailers. The bank wants to know that the business can be sustained with longer-term orders and/or contracts.
- Customers; the bank would want to know who the customers are, how many there are, where they are situated, and what credit terms are offered (if any). Especially of concern is the relative size of the customer as large corporates and government institutions tend to take a long time to pay their debts and this impacts on the client’s cash flow. The bank also does not want to see a small number of customers as this means that too much of the client’s business is concentrated into a small customer base. There is obviously danger here should those customers decide to obtain their supplies from another company. The location of the customer is important – whether they are local or foreign, for example, can affect cash flow, and can lead to other concerns such as political and economic changes in the customer’s country.
- Suppliers; as with the customers element, the bank would want to know who the suppliers are, how many there are, where they are situated and what credit terms are available (if any). In addition, it is useful to know whether there are any alternative suppliers of the necessary inputs that the client needs to run the business. The bank would be uncomfortable with only one supplier of a key input for the client’s product.
- Competitors; obviously the bank cannot expect the client to know all the competitors in the industry but the client should be aware of the key ones and what their relative strengths are. It would be useful to know from the client what he or she considers to be their competitive advantage relative to their main competitors.
- Substitutes; these are products/services that are similar but not the same – they are sufficiently similar to satisfy the needs of the consumer. Substitutes pose a threat when the switching costs are low, when the substitute has a lower price or the perceived quality and performance of the new product are superior. The bank would need to be satisfied that the risk of this is reasonably low in the client’s industry.
- Entry barriers; low entry barriers into the industry lead to higher levels of competition. Obviously, if the client’s industry has high entry barriers the bank is more comfortable about the possible threats of new entrants.
In our e-book, Business Lending Essentials Part 1; Assessing Business Risks, we set out some background to this analysis and provide some tools and techniques to enable analysts to apply a logical approach to the assessment of a business. The ebook is free and can be downloaded from www.businessbankingcoach.com by clicking here.