Managing Credit Risk

Christopher M. Dube
Director, Corporate Department
Published: McLane.com
March 30, 2020
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Managing trade credit risk can be challenging even during the best of times.  When evaluating an opportunity to do business with a new customer or one in financial difficulty, suppliers weigh protecting the strength of their own balance sheet against the desire to remain competitive in the marketplace.

During periods of widespread financial strain, the stakes are even higher.  Suppliers need to be deliberate about monitoring the financial strength of their customers; even a longtime, reliable customer can quickly become a troubled account.

What to do?

Monitor payment history closely.  Analyze the payment history of each customer.  Determine the 12-month payment history; specifically, the average number of days between invoice date and the date of actual receipt of payment.  Compare that against each recent transaction, looking for transactions that fall, or are close to falling, outside the 5-day period on either side of the average.  When a customer begins to deviate from historical patterns, your “preference avoidance” exposure (i.e., risk of having to return payments received) potentially increases if your customer ultimately files bankruptcy.

Monitor changes in frequency and quantity of orders.  Have a system that requires prior approval for changes in order frequency and quantity.  More frequent orders or reduced quantities may be signs of your customer’s reduced liquidity.  Increased quantities obviously increase your risk.

Communicate with your customers.  Do not simply rely on your sales force to tell you how your customers are doing.  Check in with your customers directly.  Ask how they are doing and what they are seeing in the marketplace.  Listen, and allow the focus to be on them; you will learn more and it conveys interest, engenders goodwill, and builds loyalty, all of which could pay dividends if resources become limited and they need to decide who gets paid.

Evaluate financial condition.  If you identify changes in an existing customer’s ordinary course of conduct, consider requesting a balance sheet or CFO certification of financial condition.  Request current references from new customers and, importantly, contact the references.

Implement protections to mitigate credit risk.  If you sense risk, take action.  The following are some of options that can help mitigate your risk:

  • Require prepayment.  Where prepayment in full is not a viable option, consider requesting a deposit in an amount sufficient to mitigate your risk for out-of-pocket expense.
  • Change terms to COD.  As an alternative to prepayment, consider requiring that the customer wire funds as a condition to release of goods for shipment or upon delivery.
  • Require a purchase money security interest (PMSI).  Obtain a written instrument that expressly grants a security interest.  Notice must be provided to the customer’s secured creditors who have a competing interest in the goods.  These steps must be completed at least five days prior to first delivery of goods to be covered by the PMSI.  These rules apply to goods sold as inventory; slightly different rules apply to other types of goods.
  • Request a security interest in the customer’s assets.  This also requires specific granting language, and there are filing requirements to perfect the security interest.  Keep in mind that, while a security interest gives your claim to the debtor’s assets priority over unsecured creditors, the practical value of a security interest depends on the value of the customer’s assets and the amount of secured debt owed to others ahead of you in line.
  • Request a guaranty of the owner or parent company.
  • Request a letter of credit.
  • Obtain credit insurance on accounts with good payment history that represent significant exposure.

Many of these protections require strict compliance with legal requirements to be effective and to provide maximum benefit, so consider consulting with counsel in your planning process.

Finally, it is important to note that trade credit risk is greater than the risk of not getting paid.  If a troubled account becomes a debtor in bankruptcy (whether liquidation or reorganization) there is risk that you will have to return payments received during the 90 days immediately preceding the bankruptcy filing.  For information regarding “preference recovery” exposure, see Avoidance of Preferential Transfers: Is this for Real?!