There’s no getting away from the fact that effective credit risk assessment begins with an understanding of the business and central to that understanding is having a clear insight into what factors drive the revenue, profit and cash flow of the business. These are what are known as business drivers.
Every business has a different set of drivers because businesses are subject to numerous external and internal factors that are often the result of the industry in which they operate.
That makes defining the drivers for a particular business not always easy and, generally, we can’t get that information without engaging the management or owners of the business by asking focused questions that will give us the insight we need.
So, what is it that we’re looking for? Essentially, a business driver should be something that is measurable. The reason for that is so that we can determine the impact on the business of a future change in the driver.
Generally, we would want to find out firstly what drives the revenue of the business since that has a knock-on effect on profits and cash flow. All things being equal, if revenue increases profit and cash flow should eventually increase- and, of course, the reverse is generally true too. The main concern for us as lenders is that revenue drivers are usually external to the business and so are not under its control. That makes them dangerous for the business’ future sustainability.
For example, for many businesses, consumer demand influences their revenues but that in itself can’t really be accurately measured. What we do know, though, is that consumer demand is in turn driven by factors such as interest rates, inflation rates, GDP etc – so these are the real underlying drivers of revenue since changes in any or all of them will ultimately affect a business’ revenues.
Having determined that, let’s say, GDP is a revenue driver for a business that we’re assessing, we can think about what might happen to that business’ revenues in the next year or two because we can get a view on what GDP will do over that time period.
That’s why understanding the business drivers is so important – it gives us a forward-looking view of the near-term prospects for the business.
Profit drivers will, more often than not, actually be cost drivers. That is, the factors that most influence profit (after changes in revenues) will be the costs of operating the business. Primarily, these would be basic input costs such as raw materials or inventory, labour cost, maintenance costs etc.
Cash flow drivers will be those that drive revenues and profit but will also include factors such as the speed with which accounts receivable are collected, accounts payable are paid and how inventory turns, all of which are measured in days or number of times per year.
A perfect example of the effect of business drivers was reported in South Africa’s Business Times newspaper on 22 August 2015 (http://www.timeslive.co.za/sundaytimes/businesstimes/2015/08/23/Gold-mines-on-the-rocks).
In SA, the gold mining industry is in steep decline and really has very little time left before it disappears altogether. But the article described some of the reasons for the decline which, if we group them in terms of their effect on revenue and profit (which both ultimately affect their cash flow) we find the following;
- Revenue drivers: falling gold price; strengthening dollar against the SA rand; decrease in demand from China due to reducing economic growth there; declining gold output.
- Profit drivers: rising electricity costs; production time lost due to maintenance, labour disputes and injuries; declining quality of ore; increasing depth of shafts to reach gold-bearing ore.
Notice that all these factors can be measured in some way and the trends in those measurements can be assessed so that we can get a sense of what might happen in the future. This is the value in understanding business drivers.