Part 4 – Missing the Warning Signs of Insolvency
If you have played Trivial Pursuit, you may have come across a question in the original game pack, and I am paraphrasing, “What has been the single cause of death for every human who has ever lived?” The answer is: lack of oxygen to the brain. In turns out that companies that go bankrupt have a similar “cause of death”. All bankrupt companies became bankrupt because they ran out of money, their oxygen. Simply put: a company is said to be bankrupt when they do not have funds on hand to pay the debts that they owe as those debts become due. In other words, the company has a negative net cash flow, and has probably been in that condition for some time. When I say negative cash flow, I mean money is being paid out faster than it is coming in. When that happens, the customer is broke (or going broke), and for many customers in this situation, there is only one option: file for bankruptcy protection.
The fact that some companies find themselves in this kind on mess has broad implications for the way their suppliers conduct business. Let’s say you have a customer in financial trouble. Do you think that they will disclose their problems to you or will they try to conceal the problems from you? I suppose that some might be forthright and let you know, one way or another. In my experience, most will not. In fact, most debtors facing bankruptcy go to great lengths to conceal their condition from their creditors. For most creditors, the first warning that they will receive about the customer’s predicament will arrive too late, in the form of a bankruptcy notice. So, if you want to avoid getting a notice from your customer about a filing under the Corporate Creditors Arrangements Act (CCAA) or the Bankruptcy and Insolvency Act (BIA), then you will have to keep yourself informed about how your customer is doing. You will perform periodic credit reviews, getting updated financial information (after all, it says so in your Credit Policy). You will probably arrange for ongoing account monitoring through a credit reporting service. And you will try to read the signs. What signs? The signs or clues that something is going wrong for your customer.
What are they? For the most part, when I say signs or clues, I mean:
- Changes in financial condition,
- Changes in payment performance,
- Changes in behaviour,
- or significant events involving the customer, their management team, and their ownership.
Some signs are obvious. Deterioration in financial condition and in payment performance will be apparent from customer financial statements and from trade credit reporting. A problem with bank financing will show up in the footnotes of the customer financial statement, frequently with wording that means “currently out of covenant” with their bank financing agreement. Other signs are not as obvious. If there is an increase in staff turnover, particularly in senior management positions, that could be a sign of a problem. Has there been a recent change in company ownership? Did one of one of the owners get a divorce, and was the business part of the settlement? Has a member of the ownership or senior management team passed away? Has the business changed hands by way of succession? Did a customer, who has always haggled about prices, just stop haggling? Has your customer acquired another business or businesses? Has the company taken on a new line of business or new product line? How has the business adapted to keep up with changes in their organization? Some of these events are personal tragedies; they can also have tragic consequences for your customer, leading to bankruptcy. Some changes in behaviour may mean little to the day-to-day operations for your customer. However, they can also be the early warning signs of insolvency.
Part of the challenge of reading the signs is in deciding which changes, signs and events are significant, and which you can ignore. If a company has asked their staff to process business expenses via their personal credit cards, that can be an indication of financial trouble for the company and trouble for the company’s suppliers. If a company’s cheques are returned NSF, that could be a sign of trouble. While banks sometimes make a mistake and return cheques in error, it may indicate that the customer and their bank are about to part company, at the bank’s insistence. If that is true, this is bad for your customer and bad for you. If a company misses their regular payroll, or if payroll cheques are returned NSF, that is big trouble, because this kind of decision is not taken lightly by bank officers and almost always means that the bank has decided to recover their balances owed ahead of all other considerations. It may even mean that the bank is ready to put the customer into receivership. In my opinion, receivership amounts to the bank plundering and pillaging to recover the balance owed, and, obviously, it is also bad news for suppliers. Similarly, if a tax authority, like a province, goes after your customer for unpaid sales tax or payroll withholding tax, that is also a problem. Failure to pay these taxes is rarely an oversight; it usually means that the company is in financial distress and is unable to remit these payments when they are due.
Another part of the challenge of reading the signs is getting information to evaluate. To succeed you will need help, and you will have to show the people helping you what to look at and to listen for, and then have them report that information back to you. Who are we talking about? The Sales team, of course. In most organizations, the Sales team has the most frequent interaction with customers, on the phone, by email and face-to-face. You will need the inside and outside sales teams at your company to become your eyes and ears. For that effort to succeed you will have to enlist their help, convince them why this information gathering is important, and then explain the kind of information that you are looking for.
Sounds easy, right?
Actually, it is easy. Since you have been actively working with Sales and attending their meetings on a regular basis, when you make the suggestion to hold a session about warning signs, they will probably be willing to working with you. During my career, I have included warning signs as a part of a larger session called “Credit 101” or “Credit Basics”. Every time that I have suggested one of these sessions, Sales have accepted the invitation. These sessions are usually about an hour long. During the session, I present, in broad terms, how Credit operates, what information we use to grant Credit and how we get that information. About one third of the session is used to explain what warning signs are, and to enlist Sales staff to report that information back to Credit. In effect, the Sales team becomes the eyes and ears for Credit. And when something unusual happens, they report it. This is not a foolproof approach, and you will probably still receive some bankruptcy notices. But you should receive fewer bankruptcy notices because you put in the time and saw the signs.
Once you have read the signs and think that there may be a problem, what do you do? I suggest that you talk to your Sales Management to let them know that you have concerns (swearing them to secrecy, of course). And then, I suggest that you have a conversation with your customer, at a senior level in their organization (controller, CFO, CEO, owner). Part of the reason to talk to the customer is to try to confirm what you suspect. Tell them in general terms what you have learned (but not how you learned it) and ask if it is true. In my experience, this is the make, or break, point in your relationship with the customer. If the customer stonewalls and insists that nothing is amiss, you can draw your own conclusions about whether they are being truthful. If you trust your information more than you trust what the customer is telling you, then you can move on to mitigating your risk with a clear conscience. Suspend shipments, exercise lien rights, collect on a standby letter of credit, and do what you must to recover the balance owed.
On the other hand, if the customer admits their problem, you will have been given an opportunity.
Another reason to have this conversation with the customer is to explore ways that your company can help the customer work their way out of trouble. Yes, you read that correctly. The customer’s financial crisis is also an opportunity to deepen and broaden the relationship between your company and the customer by helping them to weather this crisis. Remember, I believe that Credit’s role is to balance risk and reward. In my opinion, it is part of the job to explore this option. Under the right circumstances, the reward for working with the customer can be exceptional and will justify the risks involved. If you are successful, Credit will help forge a stronger relationship with the customer, which will help your company make more money.
Your first step is to assess whether the customer can be helped. In other words, is a plan to work their way out of trouble feasible? If it is, work with your management and with the customer to make it happen. If it is not, then you can move on to mitigating your risk with a clear conscience, as I said before.
How can you accomplish the goal of helping the customer work their way out of this mess? By remembering some ground rules:
1. Do not increase your risk. In fact, mitigate your risk, if you can, by negotiating a collateral (security) agreement that allows the customer to operate, but also protects your company’s interests as much as possible.
2. Do not increase your exposure. Remember, the object of this plan is to work the overall balance down, not up. The plan you develop must adhere to this requirement.
3. Do be as flexible as possible. Try to remember that the customer will not always be able to meet their commitments exactly the way you want them to. This part of the plan will involve making judgement calls and may induce some sleeplessness and heartburn. (Welcome to the big leagues.)
4. Do have a signed agreement, spelling out the terms, expectations, and milestones (deadlines). Make sure that the customer understands what you expect from them, by putting it in writing. Both parties should sign this agreement.
5. Do have regular communication with the customer and arrange for frequent updates concerning their financial condition and their relationship with their bank. For this to work, the customer will have to be completely transparent with you.
6. Do regular internal reviews of the plan with your management to ensure that it is on track. Adjust the plan as necessary.
There you have it. Read the signs, and respond by coming up with a plan to help your customer or to mitigate your risk or both. Execute, and adjust as necessary.
And if you are really stuck trying to figure out how to read the signs of insolvency, reach out to the Credit Institute of Canada; we can recommend some experienced Credit Managers to advise you.
Coming up: Part 5 – Leaving Credit Decisions to non-Credit Staff