Getting on top - Dominate your Credit Risk

Until recently, when debt became more expensive and harder to come by, companies generally had a blasé attitude toward managing their trade-credit risk. Most corporations, big and small, don't have credit risk procedures any more sophisticated than the sub prime lenders did. In which case you are flying in dangerous territory with your defenses down.

A simple tip but one that's been largely ignored until recently: Be more wary before extending credit to new customers. Make them prove their creditworthiness. Currently, companies take more a of shy unassuming approach to trade credit by quickly granting it to every new client that comes across their threshold. Once aboard they hope for the best and follow the client's payment performance over time.

Companies too often get into the habit of not asking for any financial information from their customers in favor of speeding up a much coveted deal. Suppliers have been doling out credit based on what little information may be available on their privately held clients, despite the fact that private firms have a higher rate of bad debt. Even after a credit account has been granted, the supplying company may shy away from asking for financial data because they don't want to offend a brand-new client. Clearly the banks have a part to play in all this because they too have been willing to extend credit lines far beyond reasonable doubt.

Companies should ask for customer and bank references up front. Although, that information may be biased and unreliable because of the struggling financial institutions. Will the bank and lenders be there in the long term for their customer? Are they going to provide financing or will they make a quick exit and leave the company with a liquidity shortfall, which may or may not cause the demise of the company? Are the financial institutes responsible for the ongoing viability of their clients, i.e. the corporate companies. What support and backup can they provide a struggling company when they themselves are in difficulty. These and many more, are all questions vendors need to ask themselves when looking over a customer's bank information.

Companies should request that all customers, new and old to fill out a one-page credit profile every year. The sheet should include the company's cash position and the most up-to-date contact information. A type of credit probe which may or may not provide the correct level of information in the right format, in a timely manner. This will lead to more overhead in the accountancy dept or with the business analysts, but if addressed properly, it may provide early warning of difficulties.

If there is any good news to be had during this economic downturn, it's that everyone is in the same boat. Your customers are asking their customers for more financial information. It's now become perfectly acceptable to ask about a client's financial status because everyone is being scrutinized by every supplier. Its a big global circle of accountants, checking each others assets.

If it's impractical to demand financial information up-front, then come up with a triggering number for when your company will demand it. A simple threshold or framework will suffice. If clients cross the established and agreed amount, then they must provide their trade creditors with financial statements to validate their credit. The type and level of the threshold can vary depending on client, industry, item value, uniqueness, development costs, credit exposure, etc. Its not a numerical value, its a way of thinking about and controlling your risk exposure.

Another way to improve your credit /risk management is to conduct a detailed assessment and calculate each customer's probability of default. With such precise knowledge you can price your services accordingly, and by showing your client the calculations, you can easily justify a premium rate. Cash has always been king and currently it is even more critical to companies health and financial welfare, but many companies have no idea who they're selling to, never mind who owns the company or their cash position. Its never been more critical to know your customer.

Moreover, suppliers can no longer rely on traditionally held views that big-name companies are safe from sudden and dire financial problems even if they don't have strong cash flow. Many of these companies have lived on extended credit lines for years and are not asset rich. Other companies can have negative cash flow and positive net worth. They're sitting on land or occupy buildings that no one's willing to buy. If their credit is pulled and they end up going bankrupt, the asset value won't cover the debts.

Experts also suggest sales and credit departments improve their communications between salespeople and the collections side. Your salespeople are trying to maintain the vendor /customer relationship at the same time as maximising their commission payments. This is a tightrope, and is a very dangerous situation for the company to ignore. It must be very, very tightly controlled. Don't allow salespeople to grant extended payment terms, without justification and authorisation, before checking in with their credit counterparts. Companies should use these negotiations to get more financial information out of their privately held clients and reprice future services if possible.

Moreover, salespeople may be able to offer the credit department more insight into a customer's financial situation. Therefore it is imperative that they have the influence, motivation and the time to actually get involved in credit and collections questions. Its a team effort and everyone better be on the team or the game is over.

Slash your credit exposure

The current credit slump and downturn gives companies an excellent excuse for demanding that customers share more financial information with them. This is not for the direct benefit of the customer but to keep on top of the clients' ability to pay and stay viable. You don't want the stream to dry up.

The distinction between dependable and unreliable customers has never been distinct and now it is even less so.

Corporate clients that are paying you on time may in fact be financially unstable and maintaining a good public image, could be delaying payments to other trade creditors. Should you be concerned?

At the same time, some customers may be withholding their payments, not because they're in dire straits, but because their banks is shortening their normal credit lines. More worrying is, if they are not willing to lend to them at all, in the near future.

Indeed, some companies want their suppliers to practically fill in as bankers, by extending payment terms and giving their working capital some room. Ifcustomers are asking their vendors to provide cash flow for them, then this is a very uneasy situation. If you have somebody who was once paying you every 30 days and is now paying you every 60 days, your own credit exposure is going to double. You have to evaluate if you want to take that kind of risk, at this time, with this customer.

It's never been an easy task especially now. Companies need to get a better handle on their corporate customers' ability to pay. Nearly one-quarter of publicly traded businesses worldwide are at risk of defaulting on their debt, according to some recent indexes of "troubled" public companies, whose default probability exceeds 1 percent. During the past 17 months, their risk-management firm's monthly barometer of 21,000 public companies in 30 countries has been creeping closer to the September 2001 all-time high of 28 percent.

What's less-known is how many private companies are at risk of defaulting on their promises to creditors. They tend to keep their vendors in the dark about even basic financial information. Their suppliers are sometimes stuck, relying on only basic bank information.

Of course, the rising number of hurting companies isn't news to accounts-receivables departments that have been well aware of their corporate clients' slipping ability to pay for several months. But there have been some surprises: Now, even customers once considered to be "excellent payers" are taking an extra month or more to pay their bills but then maybe their just taking advantage of your loose credit checks, risk profiling and accounting practices.

In fact, the trade group's latest monthly barometer of its members hit a record low of 40.1 in December. The survey asks 800 credit managers to rate favourable and unfavourable factors in their business cycle (unfavourable factors include rejections of credit applications, monetary unit {cash in} collections, and amount of credit extended). All those factors declined between December 2007 and December 2008.

The overall problem is, suppliers, especially small businesses need to tread carefully before pressing clients to pay up. Every company wants to keep their most valuable customers and not lose them to disagreements or hurt feelings over payment terms. The vendor-customer relationship is symbiotic, very personal and emotional.

However, no company wants to get burned by being too nice and seeing old invoices pile up or payments seized after a customer goes belly up. Trade-credit experts say that by the time you notice a customer is on the brink of insolvency, it's unlikely you'll get all the money that's due to you. So do your homework. Analyse your clients' risk profiles and get on top of your riskiest customers. Then you may have a chance to see the impending crash and minimize the damage to your receivables.

In particular, trade creditors want to avoid having to return payments received within the 90 days before a customer files for bankruptcy. Bankrupt companies can sue for those payments up to two years after they've entered bankruptcy court. So, if a company suspects a client is close to going under, the company can demand cash on delivery, payment in advance of a shipment, or a letter of credit. All of which are methods of payment that are not subject to preference claims.

Another way to avoid unexpected losses: Ask bankrupt customers to add your company to their critical vendor list. Depending on the bankruptcy judge's ruling, this group of vendors may be paid immediately over other suppliers if the debtor can show that the vendors' products or services are crucial to the company's survival and turnaround efforts. At this point the ship is on the rocks and you may just be looking around for flotsam to cling.

Lay-offs and litigation - lawyers win both ways

With potentially costly legal claims by dismissed employees soaring, employers need to make sure their job reduction and elimination plans are substantiated.

Nothing in life is free. While companies are jumping to reduce head count because they see an opportunity to save money in the short term and a way of openly validating those savings i.e. the economy is sinking. Be aware, they should be prepared for the possibility of punitive legal actions against them by aggrieved workers, and they need to consider how they can underwrite the accompanying legal costs.

The number of litigation actions is rising in tandem with the pace of job reduction and eliminations. These cases are boom-time for the defense and employment lawyers. They're seeing a major spike in their business that will not abate anytime soon. Its an ill wind, that usually helps some lawyer or other.

The main categories of lawsuits are those in which employees claim their dismissal was discriminatory, usually based on age and those, which requires advance notice for mass layoffs and plant closings.

Attorneys advise that cautious planning when making layoffs will help avoid a trip to court. They suggest that when you do decide to commit your company to a layoff of any size, then take good advice and plenty of time to make sure it's done right.

The Finance Dept. and accountants may not be directly involved in executing layoff plans, but with the risk of a sizable legal judgment, it gives them plenty of reason to stay involved. If only to satisfy themselves that the plan is legally and therefore, financially sound.

The first step in any staff reduction exercise, should be creating a detailed business plan that explains the need. Included in this will be;

• what facilities or businesses will be affected,
• the number of positions affected,
• what type of positions will be lost (What effect will this have on the future business)
  
• when the layoffs will occur, and
  
• how they will be announced,
  

All this must be clearly defined and approved before any actions are taken. There have certainly been some times when the legal or finance dept. have had to tell management to either come up with a more defensible reason for the layoff or rethink the decision. Analyse and assess the risk.

Juries will side with the employees when the employer doesn't have adequate documentation. Internally everyone is in such an emotional and stress driven crisis mode when they're involved in workforce reductions. Therefore, things that they may think are obvious to the world, are not. It pays to get an objective, knowledgeable view on these things.

The potential for discrimination lawsuits makes it essential that employers create an objective selection process for deciding which employees to let go. If 25 workers are dismissed and 20 of them, say, are over age 50, the chances of a lawsuit will rise dramatically. Its not to say don't do it its just to say, be prepared to defend your decision in court.

Is you wish to be seen to be logical and fair about the selection process, then some lawyers suggest that executives create a list or matrix of criteria for evaluating employees. This can include;

• years of service,
• qualifications,
  
• experience in the field,
  
• job performance,
• team working ability,
  
• disciplinary history.
  

A weighting should be assigned to each criterion, and each employee should receive a numerical rating in each category. Clearly if only one person is allowed to do this, then it will only be one persons opinion and that is difficult to defend.

To avoid subjective bias and statistical anomalies, companies should consider hiring a statistician to objectively evaluate the layoff selection criteria and ensure that none of them is in itself discriminatory.

It may prove difficult to avoid exceptions to the process. For example, a job-performance measure may take into account employees' past three annual reviews, but some people will have been hired more recently. Diligently document and explain in detail any reason for deviation or breaking from the official process.

But even a thoroughly objective selection process, while defensible in court, is no guarantee a lawsuit won't be filed. As a further safeguard, companies should conduct an impact analysis of how layoff decisions will affect the makeup of each protected class of employees. If a protected group is disproportionately affected, the plan will look discriminating and the company may want to alter it accordingly.

A company's legal concerns don't end with the selection process. Executives who deliver the bad news must tread carefully with their word choices so as not to come across as apologetic or sugar-coat the real reason the employee is being dismissed.

By saying, 'This isn't your fault, this is our fault,' you will be falling on your own sword." The employee can easily use such a loose statement against the company in court.

Watch out for a rise in the number of whistleblower cases coming from former employees. As more and more people get terminated, there's going to be more and more litigation and cries of protest.

Red Flags - Customer's falling credit status

When it comes to credit risk profiles, watch closely for these red flags in the companies you depend most on for financial stability, your customer.

The stringent credit markets make spotting a soon-to-be insolvent company increasingly difficult. It's difficult to determine who's really on the edge and ready to go out of business, versus who is having tough times and struggling, but will survive.

To avoid losing future payments, companies should be on the constant lookout for red flags. Signs that a customer is having serious financial problems. The following don't necessarily indicate that a client is on its knees or in contingency mode. But depending on how any of them are relevant, should trigger a warning bell for your credit department. Worst case, the customer deserves close monitoring, and perhaps their payment terms renegotiated.

Changing Payment Patterns.
Perhaps the most obvious clue that something could be financially amiss, but one that cannot be ignored, particularly these days. Previously reliable customers that suddenly start missing due dates warrant attention: If your customer is falling further and further behind in making payments on their invoices, that certainly should be a tip off that something may not be right.

Renegotiation requests
If a company asks to spread payment windows from 30 days to 45 or 60 days, this should raise eyebrows. Hone your credit skepticism on requests to reschedule payment agreements, such as paying off one service over four months rather than all at once, as previously agreed upon.

Shifting Buying Habits.
Even if regular customers are paying on time, are they still purchasing? Examine and analyse the trends. If their previous buying was consistent, but their manner of placing orders has changed, this could suggest trouble. Also, keep a lookout for regular customers that suddenly start buying more. Pre-bankrupt companies have been known to stock up on inventory, knowing they won't be liable for the goods later on. This is a very unpleasant maneuver and should be stopped. Fix your customers' credit /risk profiles and keep them within their credit thresholds.

Rejection levels, Haggling or Higher Demands.
Is your customer returning items more often, or unjustifiably asking you to make deductions off invoices because of damages? Customers that start making unreasonable demands on delivery are sending you a warning. Your customer, may start saying his company expects a discount if a shipment doesn't arrive within very tight deadlines, especially if he knows that you can barely meet. Be warned and look behind the request.

Shrinking Cash Flow.
Keeping a close watch on your customers' cash balances over time, is what the good companies do all the time, if you have access to their financial statements. Find out how much they rely on equity, short-term debt, or long-term debt and adjust their credit /risk profile accordingly.

Large Accruals.
Many distressed companies carry sizable accruals on their balance sheets, so these figures need to be explored and justified. First you need to get access to their balance sheets, that in itself may cause difficulty and could also give an indication of solvency.

Tight Lips.
Customers that previously shared financials with your company, but now suddenly claim it's against their policy to share financial data. This should only make you more determined to find the true picture but if in doubt, err on the side of extreme caution. Shorten their credit lines until they come up with strong evidence to convince you.

High DSO (Days Sales Outstanding).
Companies that have fallen behind on collecting their own receivables may be unable to contribute to yours.

Managerial Shuffling.
Unexplained or questionable changes in management could mean that there's a disagreement between executives and the company's board or owner. More obvious signs of trouble in this regard would be the hiring of a chief restructuring officer or turnaround company. Its a warning flag, but at least they are addressing their issues. Tighten credit lines in the short term, til the re-structure is effective and things improve greatly.

Persistent Rumors.
Credit experts recommend keeping your ears open for any negative news about your customers, which may be the only way to garner helpful financial information about privately held clients. Pay attention to news articles, whispers from your sales teams, and other companies' credit managers. There are industry-specific credit groups that are invaluable for uncovering past-payment records of customers, search for them and make friends with them.

Tax Liens.
A tax lien against a company is the number-one indicator that it's going under. If a customer has postponed paying its taxes, you're not likely to see its overdue payments either. Sound the alarm!