With the current credit crisis and economic downturn, finance departments of most companies, regardless of size, are preoccupied with “cash in, cash out”. Being caught in a tug-of-war between accounts receivable and payable, between customers and vendors, creates increased difficulty in preserving trade credit – the largest source of capital for small and medium businesses in the U.S. and the world. Trade credit in the U.S. exceeded bank credit by almost 20% in 2007.
Companies are turning to tightening up extended payment terms given to customers while holding onto cash by postponing payments to banks and to vendors. Even if your customers are paying on time, they may, in fact, be financially unstable and – without your knowledge – could be delaying payments to other trade creditors. Alternatively, other customers could be delaying payments, not because they are unstable, but out of fear that their banks will tighten up on their credit lines or not lend to them in the future.
In a recent survey of corporate credit managers, 94% said they suspect that their customers are leaning on them for their working capital needs more than they were during the past few years. This push-pull condition between receivables and payables creates a strain, particularly for smaller companies, by wanting to hold on to valuable customers during tough times but still needing to get cash in the door. And granting extended payment terms, when requested by valuable customers, can make it more difficult to assess a customer’s financial viability.
What are signs that your customer might be tanking?
Buying Habits Changes.
Even if customers are paying on time, are they still purchasing in previous patterns? Also, beware of customers that suddenly start to buy more. Pre-bankrupt customers might be stocking up on inventory, knowing they won’t be liable for the goods later on.
Changing Payment Patterns.
This could be the most obvious clue. If your customer is falling further behind in making payments, or requests to spread payment windows out further or a payment plan over a period of time, or requests renegotiation of previous arrangements, this calls upon you to hone your credit skepticism.
Higher Demands or Nit-Picking.
Higher product returns, requests for discounts because of damages, unreasonable demands on delivery, such as taking discounts if goods do not arrive timely in a tight delivery schedule, could all be warning signs.
Financial Information.
If you have access to your customer’s financial statements or other financial information, consider the following:
- Shrinking Cash Flow. Watch cash balances over time, and note how much they rely on equity, short-term debt and long-term debt.
- High DSO (Days Sales Outstanding). Customers who are struggling to collect their own receivables may have trouble paying yours.
- Large Accruals. Often companies in financial stress carry large and/or increasing accruals on their balance sheet.
- Tax Liens. Since companies usually pay their taxes on time, this is the first indicator that the company is likely going to default on your payments.
Tight Lips and Persistent Rumors.
If a customer previously shared financial information with you, but now claims it is “against policy”, consider if this is a “red herring” to distract you from catching problems. At the same time, keep your ears open for negative news about your customers by paying attention to news articles, comments from your sales team and other companies’ credit managers.
Steps You Can Take
Tighten up on how you extend credit.
Just like the banking community, until recently companies have granted credit too easily based on little or no financial information, in order to speed up a sales transaction or to not risk offending the customer. Use the current economic environment to get more extensive financial information from privately-held customers and to rein in sales people giving extended payment terms.
Closely Monitor Outstanding Balances.
If a customer used to pay in 30 days and is now paying in 60 days, your credit exposure is going to double. You need to evaluate if you wish to take on this additional risk, especially without compensation, such as pricing increases or late payment finance charges.
Riskiest Customers.
Bankrupt companies can sue for payments made within 90 days of filing for up to two years after entering bankruptcy court, requiring you to return payments already received (preference claims). If you suspect a customer may enter bankruptcy, you can demand cash on delivery, payment in advance of a shipment or a letter of credit, all of which are methods of payment not subject to preference claims. If a customer is already in bankruptcy court, ask them to add your company to their “critical vendor” list. Depending on the judge’s ruling, this group of vendors may be paid immediately over other suppliers if the bankrupt company can demonstrate that the vendor’s products or services are crucial to the company’s turnaround efforts.
The economic downturn and credit crisis has required that companies of all sizes keep a careful watch on their suppliers’ credit terms, as well as their customers’ continued viability, in order to protect their own trade credit financing and operating results. While choices for smaller companies may be more limited than those for large companies when trying to maintain ongoing business relationships for the time when the economic hardships ease, the considerations in this article should provide ideas for striking a balance between enhancing business and managing risks.