Video"It's just business, don't take it personally."
That's what the sales and marketing team at Arrow Electronics told CFO Paul Reilly seven years ago, in the last major credit-cycle downturn, when a large customer missed two payment dates. Reilly didn't take it personally. In fact, he didn't take it, period. With the backing of Arrow's CEO, he stopped shipping to the customer altogether: six months later the customer went bankrupt. Reilly's quick action had effectively saved the Melville, New York–based Arrow tens of millions of dollars.
Judgment calls on trade credit are rarely as clear-cut, but all signs indicate that other CFOs may soon have similar chances to save the day. Claims filed by trade-credit insurance policyholders jumped 53 percent in 2007 at insurer Euler Hermes ACI, building progressively throughout the year, says Joe Ketzner, the carrier's commercial director. "The uptick is in the slow-pay sector — businesses that are extending payments out further," Ketzner says.
In addition, The Credit Department Inc., an outsourcer, has handled more requests from clients to analyze trade credit for companies that have missed debt payments or violated lending covenants, says president Pam Krank. And at United Industries, where 65 percent of the business is supplying steel tubing to automotive-parts manufacturers, 10 to 15 percent of customers have cash-flow problems that could result in uncollectible balances. "If there's a question about a particular invoice or billing, it just sits on someone's desk until you threaten to not ship them product," says CFO Becky Chewning. "It's their modus operandi for managing cash."
The problem looks to get worse. Kamakura Corp.'s monthly index of troubled companies — derived from inputs on 20,000 public companies in 29 countries — hit 12.1 percent in January, the second highest reading since December 2003. Unlike the credit-rating agencies' models, Kamakura's factors in macroeconomic conditions. It also uses an annualized 30-day default probability to account for company liabilities that have a short maturity, like accounts payable. "The index is representative of the largest kind of credit exposure that most companies have," says Kamakura CEO Donald van Deventer.
In response to weaker receivables performance, CFOs have several choices, including reeling in marginal customers and tightening sales terms. But trade-credit decisions are not as straightforward as some banks' lend-or-no-lend determinations, even in the toughest economy. They require dispassionate evaluation of data and a willingness to swap some risk for potential profits. The trick, of course, is to be aware of heightened risk well before a customer asks for extended terms.
Deciphering Customer Health
That's not easy. Companies need to look for a sudden deterioration in profitability or evidence that an account balance is approaching very high levels. Too many firms rely on customer payment history, internal knowledge, and Dun & Bradstreet scores to manage counterparty risk, says Matthew Kreider, a senior consultant at research and consulting firm REL. Such a "rear-view-mirror" approach, however, "can lead to surprise customer bankruptcies that can have significant impact on a firm's bottom line, not to mention working capital," adds REL president Stephen Payne.
Instead, Kreider recommends a risk "dashboard" made up of the top 25 accounts by size and the top 10 accounts by risk globally. The focus of counterparty risk analysis needs to be on capital structure, liquidity, and future cash flows. The latter is especially important in a credit downturn, says Krank. "As cash flow deteriorates, we watch the 'defensive interval' — how many days of cash a company has to survive on," she says.
At $14 billion Arrow, Reilly monitors traditional credit metrics such as days sales outstanding (DSO), percentage of current accounts receivables, and an aging schedule of receivables to help decide where collections should be concentrated. He also checks customers' balance-sheet leverage, using calculations such as debt to equity, tangible book value, and interest coverage; and he factors in qualitative assessments such as the customer's critical products, where a product is in its life cycle, or where the customer is investing product-development dollars. "We try to look at where the company is going, not just where it has been," Reilly says.
Gene Dixon, director of credit for Southfield, Michigan-based ThyssenKrupp Materials NA, takes a similar forward-looking approach. But he focuses solely on the large and midsize customers (75 percent of the business), where the distributor of metals and plastics has the most money at risk. In a tight credit market, Dixon scrutinizes these companies' debt structures, taking into account long-term liabilities, debt financing, and lending covenants. He also wants to know a customer's clientele, competitors, and major obstacles to success. "If a customer relies on four accounts for 75 percent of its business and one of them is in financial distress, that customer may have trouble paying us on time," Dixon says.
Of course, customer analysis is difficult if the counterparty is private and audited financial statements are not publicly available. In those cases, information from an industry trade group whose members exchange credit information can be a good early warning system. Dixon has gone so far as to actually scan employee blog posts to evaluate a company's financial health — especially customers backed by private equity, where there is seldom any transparency. Still, says Payne, if the customer is unwilling to share audited financials, "it typically has something to hide. That's an immediate red flag."
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