Five Factors to Consider for Your Due Diligence Approach
Before reviewing a borrower’s financial statements, consider the industry in which it operates to determine what’s most relevant. Doing so will help frame your due diligence efforts and credit risk assessment.
Focus on five factors
In 1979, economist and Harvard Business School professor Michael Porter identified five competitive forces to consider when developing business strategy. This five-factor approach remains useful today.
- Power of customers. Start by understanding the borrower’s target market. A company that relies heavily on a few customers for a large portion of its revenue may be at the mercy of key customers, especially if there are multiple competitors in the industry and no long-term contracts. This factor affects the prices and terms a borrower can negotiate with its customers.
- Power of suppliers. Likewise, identify the companies that a borrower purchases raw materials and resources from. Consider the existence of long-term contracts and possible alternative suppliers, if a key supplier goes out of business or breaches a supply contract.
- Competition. Familiarize yourself with other companies that sell similar products to the borrower’s customers, including their pricing, reputation, financial position, channels of distribution and market share. Then compare your borrower’s business model to those of its competitors. Is your borrower a market leader or follower? What factors differentiate your borrower?
- Ease of entry. How much money does a start-up need to participate in the industry? If entering an industry requires licensing, compliance with local or federal regulations, or a significant investment in equipment, property and inventory, it lowers the risk that new competitors will emerge and take away market share.
- Product substitution. Evaluate whether there are alternative products that customers could use instead of what your borrower sells. Too often companies overlook substitute products and are blindsided when customers make an unexpected shift in their buying patterns.
Real-world examples can help demonstrate the power of this tried-and-true approach. To illustrate, consider the butcher (a niche retailer), the baker (a custom service provider) and the candlestick maker (a commodity manufacturer).
Suppose one of your retail borrowers is a local meat market. It sells grass-fed, hormone-free meat and dairy products primarily to high-net-worth families in a suburb of a large U.S. city. Its major asset categories include perishable inventory, which is supplied by two local farms, and equipment to prepare and store its products. Your borrower is the only meat market in town and has a long-standing reputation in the local community.
Full-service grocery stores offer less expensive meat products, and you recently read on Facebook that Whole Foods plans to open a store in town next year. The borrower is uncertain about how the new competitor will affect sales.
Alternatively, consider a borrower that creates custom gourmet baked goods that serve as promotional tools for businesses across the United States. The baker uses an online distribution channel to broaden its geographic reach and eliminate overhead costs associated with having a brick-and-mortar store. Its challenges include timely delivery, food safety issues, online data security and finding skilled artisans to produce its one-of-a-kind treats. There are numerous substitute products that customers may use to promote their brands, such as pens or hats. In most cases, customers make one-time or seasonal purchases, rather than regular orders.
Intangible assets are critical for this borrower. It closely guards secret recipes for frosting and cookie dough. Other intangibles include its easy-to-remember Web address, user-friendly website and mobile reorder app.
The candlestick maker
Last, consider a low-cost, high-volume domestic manufacturer of scented candles that sells to large retailers with significant bargaining power. Production of this scale requires a hefty investment in automated equipment, factories and warehouses. Customers negotiate new supply contracts every year. Shipping delays, quality issues and price increases are likely to result in the loss of a major customer. Battery-operated candles represent a substitute product that’s gaining momentum. Overseas competitors with lower labor and raw material costs are another major threat.
Take a novel approach
Each of these borrowers faces a different set of opportunities and risks. (See “Create your own borrower scorecard.”) By thinking about industry risks before reviewing the financials, bankers can adopt a customized due diligence approach. To find out more about a borrower’s industry, research industry trade organizations, read the local news and talk to other business leaders, including CPAs who specialize in your borrower’s industry.
Create your own borrower scorecard
Here’s how a banker might apply the five-factor approach to assess industry risk for the borrowers described in this article: