At its core, the credit department is all about risk management, with a primary focus on safeguarding the revenues of your business against loss due to nonpayment. The basic credit risks B2B trade vendors face today are not fundamentally different from the concerns that have existed for decades, but the volatility and uncertainty of the modern economy have put a new face on old problems.
This post discusses strategies for managing B2B trade credit risk amid economic uncertainty, with a particular emphasis on three prevalent modern issues: rising interest rates, excessive leverage, and persistent inflation.
Economic uncertainty magnifies credit risks
Uncertainty arising from political, social, or economic factors can impact the creditworthiness of customers and, as a result, the credit quality of your receivables portfolio. At few other times in history has the global economy experienced tumult of the sort seen from 2020 onward.
The nearly unprecedented uncertainty in the modern economy is being driven by persistent consumer and producer price inflation, volatile energy and commodity prices, labor shortages, supply chain disruptions, skyrocketing wages, foreign and domestic political unrest, war, and a myriad of other factors. Coupled with a significant surge in corporate bank and bond debt – nearly $13 trillion as of March 2023 – and the gradual upward march of interest rates as central banks try to rein in record-breaking inflation, the current macroeconomic environment for B2B trade creditors is perhaps one of the riskiest times in history.
Add to that laundry list the nearly $4.9 trillion of aggregate accounts receivable on corporate balance sheets. That figure has roughly doubled in less than ten years, far outpacing GDP growth and magnifying B2B trade credit risk. Against that backdrop, it is more important than ever for corporate credit departments to monitor their portfolios for warning signs and red flags, proactively manage credit risks, and mitigate potential credit losses.
Rising interest rates
The anathema of leveraged businesses everywhere, rapidly rising interest rates need no introduction. When central banks began taking benchmark interest rate actions in an effort to curb rising consumer prices, speculation was rampant as to where the “terminal rate” would end. In the United States, economic pundits have repeatedly revised their views on this issue upward, but leading indicators such as hiring data suggest there may be no end imminently in sight.
For customers with variable-rate debt or upcoming debt maturities, rising interest rates increase financing costs and reduce borrowing capacity. Businesses that were highly leveraged but still had ample liquidity during the last few years are suddenly finding themselves in the awkward position of being both overleveraged and liquidity-constrained. Restructuring – including bankruptcy – becomes more likely as borrowing costs and debt-service constraints multiply and consume available liquidity. The result is a significant increase in the risk of trade vendors being left holding the bag.
As central banks continue trying to thwart persistent inflation with benchmark interest rate hikes, it is imperative that credit departments understand their customers’ interest rate exposure and take proactive steps to mitigate the risks arising from it.
High-performing credit departments can use the customized forms and file upload tools in modern, online B2B credit management platforms to gather relevant information about both new and existing customers’ interest rate exposure, such as:
- Recent financial statements, both audited and interim,
- Debt information, including through the use of user-customizable forms that solicit key terms and covenant information quickly and efficiently, and
- Periodic entity structure and ownership questionnaires / certifications designed to identify ownership changes and shifts in organizational structures that could result in heightened leverage.
An overleveraged balance sheet inhibits a business’s flexibility to endure financial and operational shocks – like the volatile input costs, labor shortages, increasing interest rates, and upstream and downstream supply chain disruptions the global economy has experienced for the last three years.
Excessive leverage renders customers vulnerable to credit rating downgrades, increased refinancing risks, and financial distress, which can affect their ability to pay their vendors. To put the point a little more bluntly, many overleveraged customers are just one hiccup away from catastrophe – including the possibility of defaulting on the balances they owe your company.
Identifying excessive leverage in publicly traded customers
For publicly traded companies required to file periodic reports with the SEC, public filings on SEC EDGAR are a helpful starting point for assessing customers’ total leverage, principal bond and loan covenants, financial position, and financial performance, both at the credit underwriting stage and throughout the customer relationship. Financial statements typically are reported at least quarterly, and certain significant events give rise to interim reporting requirements. As an added bonus, the information is available for free, although a number of commercial services offer alerts, specialized search functionality, and in some instances, analysis.
Identifying excessive leverage in privately held customers
Privately held customers present a more difficult situation. Proactively identifying and mitigating the risks of excessive customer leverage can be significantly more difficult with respect to privately owned customers. Potential sources of data include, among others:
- Industry-focused credit groups,
- Credit reporting services and other proprietary databases,
- Ordinary commercial news outlets,
- Subscription news services focused on the leveraged credit and debt markets, and
- The customer itself.
Warning signs of excessive leverage and financial stress
Each of these sources of data can provide insight into the customer’s financial health and assist you in spotting the traditional red flags and warning signs of financial distress, including, among many others:
- payment trends (both with you and with other suppliers),
- ratings information for rated debt,
- director and executive officer arrivals and departures,
- professional retention by the customer,
- professional retention by bondholders or lenders,
- significant asset divestitures, and
- litigation or other disputes.
Each of these red flags and warning signs, among many others, can help you identify the kinds of trouble that stem from excessive leverage and other forms of financial stress.
The customer itself can be one of the most important sources of information available to you. Privately held customers, particularly those with institutional ownership, frequently are reluctant to provide full financials (audited or otherwise) or loan documentation. However, through the use of specific information requests either directly or through your credit management platform, you may be able to obtain specific, fundamental information about your customer’s leverage position and covenant status.
Inflation erodes purchasing power and can cause customers to require more credit even if their ordering and payment patterns remain unchanged. At the same time, during periods of sustained inflation, each dollar you receive from your customer is worth less than the time of sale.
Unless your business is graced with a negative cash conversion cycle, you are paying your suppliers with money worth more – sometimes significantly more – than the dollars you will eventually receive from your customers. The net result is hidden margin compression.
To bring this article full-circle, stubborn inflation persisting more than a few months usually prompts central banks to implement contractionary monetary policy measures, such as increasing benchmark interest rates. In turn, higher interest rates lead to increased debt service costs that drain customers’ liquidity, exacerbating the stress they are already facing from higher raw material, energy, labor, and other input costs.
Careful evaluation can identify customers’ sensitivity to rising input costs and empower you to reduce your credit risk by controlling total exposure, incentivizing prompt payment, and deploying risk mitigation tools such as credit insurance as a backstop against an outright payment default.
Economic unrest and uncertainty can make the job of the credit department more difficult, but also make the risk assessment and mitigation functions of the credit department more important than ever. By carefully assessing macroeconomic, portfolio, and customer risks and using available tools to gather relevant information about customers’ financial situations, astute credit managers play a crucial role in preventing payment losses.