Why Businesses Overlook Trade Credit Risk? Part 1

“We’ve collectively lost sight of what insurance actually is: a way to protect yourself against a possible future outcome. Some of the people who buy the insurance will eventually be affected by that outcome. Others never will be. But since none of us can know beforehand which camp we’re in, we’re willing to pay a little bit now for the peace of mind of knowing we’re covered, just in case.”      Stephanie Slade, Reason Magazine

Stephanie Slade’s quote perfectly describes the value of all kinds of insurance. For insurance to make sense, we must accept that we have risk. Otherwise, we’d be paying for something we don’t need. We readily acknowledge risk and buy many types of insurance:

1. Homeowners insurance protecting against serious damage to our homes
2. Flood insurance (just ask people in Houston!)
3. Auto insurance to protect against the cost of repairing or replacing both our own and other people’s vehicles and property
4. Life insurance to replace income in case of an untimely death

In the business world, there’s one potentially large, unknown risk that is often overlooked. In fact, many business owners and financial managers are oblivious to it. This risk  has the power to seriously damage a business; even to the point of ruin and is present whenever a customer owes a significant amount of money to their supplier and can’t or won’t be able to pay. It’s called trade credit risk and it’s the cause of 25% of all commercial bankruptcies.

Why do business owners and financial managers overlook or understate trade credit risk?

“We don’t have losses”

One lesson learned (but now seemingly forgotten 9 years later) in the Great Recession was that “past performance doesn’t guarantee future results”. Companies with no history of financial problems all of a sudden went bankrupt or defaulted on their obligations. For suppliers, many of these defaults came as a total surprise and created losses that rippled through the economy. With the next recession due at any time, the moral to the story is: just because you haven’t had losses doesn’t mean it won’t happen.

“We know our customers really well”

For most businesses, “knowing the customer” means taking a few trade references and watching the a/r aging report. Clearly, this is a reactive mode of operation that doesn’t allow a financial manager to look ahead to see potential customer financial problems. It’s like “driving a car while looking out the rear-view mirror”.

With the high cost of carrying employees and the requirement for each person in a company to manage multiple responsibilities, it’s often impossible to proactively manage and monitor customer financial performance. (For a solution to this problem, see next month’s Part 2 of this article.)

In short, trade references, your own pay history and reactive monitoring of the a/r aging aren’t enough.

“My bad debt is less than your premium”

Do you expect to wreck your car on the way home from work today? If not, why not cancel your car insurance? After all, the cost of the insurance is likely to be more than the repairs for the accident you don’t expect to have, right?

The same argument is sometimes made about a potential solution for credit risk:  trade credit insurance. Since “we don’t have losses”, our bad debt expense is zero and protecting ourselves costs money. What is overlooked is the uncertainly that we can’t know about (see above) and the ROI on protecting receivables against credit risk (yes, there is an ROI – stay tuned for next month’s article: Part 2).

Lack of financial resources

For some companies, even if they recognize their credit risk, there simply isn’t enough cash to create a bad debt reserve. Working capital needs, cash flow to fund growth, poor cash flow in general and other reasons make it hard to put away cash for any purpose. As a result, having an emergency fund is an extravagance. For these companies, when an emergency comes in the form of payment default, it means:

• borrowing from their line of credit (bankers love this!)
• juggling payables
• stopping new projects
• postponing cash distributions to owners

Conclusion

Trade credit risk is real and can have a huge impact on businesses of all sizes. By taking a few proactive measures, this risk can be handled. But first, it must be acknowledged.

In Part 2 of this article, I’ll describe several steps all businesses can take to manage credit risk.