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Five ways to evaluate the risk of bad debt

Company failures are likely to increase in 2021, exposing suppliers to the risk of bad debt that could threaten their survival. Here are five ways to determine whether your business is at risk.

With the extreme financial pressures on businesses at the moment, you might expect corporate insolvencies to be on the rise but remarkably the opposite is true – for now.

The latest official insolvency statistics show the number of corporate insolvencies in England and Wales in November was lower than in 2019. There was a total of 889 company insolvencies in England and Wales, a 41% year-on-year decrease. In Scotland there were 46 company insolvencies, down 47% in comparison to November 2019 while in Northern Ireland, there were only seven company insolvencies, down 77% from November 2019.

Unfortunately, this picture of low insolvencies is a mirage. As the Insolvency Service’s accompanying commentary conceded, the reduction “was likely to be at least partly driven by government measures put in place in response to the coronavirus (COVID 19) pandemic”, for example the temporary legal changes included in the Corporate Insolvency and Governance Act 2020 and the Chancellor’s package of financial support for business. The inescapable conclusion is that many companies who are currently on life support will fail when these Government measures expire, potentially leaving their suppliers unpaid. Experts from Coface predict insolvencies could be 33% higher in the UK next year.

For businesses trading on credit terms, every bad debt is a financial blow while a catastrophic bad debt has the potential to strangle cash flow so the business is unable to pay its own suppliers or running costs. Rather than run that risk, it’s time to appraise your exposure to bad debt.

Here are five tell-tale signs to look for:

1. Increasing DSO

A key performance indicator in any business, your Days Sales Outstanding shows the average number of days it takes for you to receive payment after invoicing. Typically, the higher the DSO, the greater the level of risk because it points to greater strain on your cashflow, even before a bad debt. While high DSO could reflect longer payment cycles in your sector, another interpretation is that customers are unwilling or unable to meet payment terms.

Your accounts team probably already calculate DSO on a monthly or quarterly basis. As well as looking at the latest snapshot, it makes sense to look at the longer-term trend. If the DSO is increasing over time, it could be a sign that you need to review your payment terms and put more effort into credit control, perhaps even outsourcing payment collections to a reputable provider.

2. Size and volume of receivables

Examine your receivables ledger to see if there are any trends over the last six months. For example, has there been an increase in the average amount owed by customers or the volume of outstanding accounts?

Of course, your receivables are considered an asset in accounting although this is immaterial until you have converted the amount into cash. You should also see these records as an indicator of your business’s potential exposure to bad debt and monitor them closely.

3. Customer concentration

If you are in the business of providing a niche product/service, your customer base may naturally be quite small but still be alert to any contraction due to customer insolvency.

A small customer base isn’t necessarily a problem if the margins are healthy and those customers are financially stable. However, it could mean that your success/survival is overly reliant on the financial health of one or two companies (who are reliant on a major customer in their turn). We have all seen how the collapse of a giant such as Carillion can have a domino effect all along the supply chain.

For this reason, it’s worth monitoring what proportion of your sales over the month is made up by each account customer. Decide what is comfortable for you (say, 10-20%) and then consider how you might reduce your exposure. On option would be to obtain credit insurance for your key customers so you are reimbursed for losses due to insolvency or late payment.

4. Customers’ payment history

Effective credit management is about monitoring the payment behaviour of existing customers, as much as carrying out due diligence on prospective ones. Even with valued customers, you should stick to your established credit checks if they request an increase credit limit or relaxed payment terms.

In fact, any deviation from the norm is worth investigation. In the current volatile climate, things can change rapidly so it pays to be alert to potential problems. Ask your accounts team to review the payment record of major customers over the quarter or half year and obtain a credit report where this has deteriorated. Coface’s information services range from a snapshot assessment of a company’s creditworthiness and payment behaviour to a comprehensive business report, incorporating late payment and claims data and analysis from our underwriters.

5. Sector specific trends

Finally, pay attention to the risk factors and late payment trends within your trading sectors and markets. Obviously, the pandemic has caused considerable upheaval, including restrictions on trading and movement but some countries and sectors have been affected more severely than others. More positively, the change in US administration may help restore some normality to international trade after the tensions and tariffs of the Trump years.

Of course, it’s one thing to keep your eye on events in the news but it is not always as easy to understand the consequences. Coface’s quarterly country and sector risk assessments are a valuable resource because they shed light on the social, economic and political risk factors, as well as current and predicted insolvency/payment trends. These reports are freely accessible at https://cofaceitfirst.com/news-hub

 

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