Part 2 in FinCred’s Credit Risk Management series
Part 1 of our new three part series on Credit Risk Management looked at the procedures you can put in place to identify risks to your business, and the 4 key steps you can take to fully assess their creditworthiness.
But what should you do with this information? How can you use it to make your business more competitive? How can you improve your credit risk management process?
In Part 2, FinCred details how to spot the red flags a customer may be facing financial difficulty.
Red Flags
The first key step to improving your credit risk management is understanding the red flags, and how to spot them. Here are some of the early warning signs that your customer may be experiencing issues with financial health:
Failure to File Statutory Accounts
Filing statutory accounts is a legal requirement, failure to do so can reflect poor management practices, or be a sign a customer is masking financial difficulties. There is often a correlation between companies that have not filed accounts and subsequent failure of the business. You should also check for any changes to accounting periods.
County Court Judgement
A CCJ is an order made against a company to enforce debt repayment. It is a serious step taken by creditors once all other methods of recovering the debt have been exhausted. Be wary of any other legal actions such as statutory demands and winding up petitions.
Poor Financial Performance
Checking customer financials on Companies House, with a credit status agency or your credit insurer can play a key role in your credit risk management process. Be wary of whether a business can meet its commitments if the financial performance is poor.
Late Payments
In a recent survey, over half (55%) of the small and medium-sized enterprises (SMEs) that responded said they still had unpaid invoices from the previous tax year.
Late payments are a sign that a customer is experiencing cash flow difficulties. A change in the pattern of payment, or letting payment times slip, can also signal cash flow problems and perhaps prioritising creditors. You should also be on the lookout for an increase in queries or disputes as they may be a tactic to delay payment.
Frequent Changes to Directors
Changes in management are not necessarily a prerequisite for a business failure. Frequent switches in key roles, or alterations to structure, can point to signs of instability such as management issues, or a lack of strategic direction, that could impact financial performance.
Complicated Group Structures
It can be a challenge to trace ownership and ultimate financial responsibility when group structures are convoluted, with many subsidiaries and parent companies. This can make it easier to hide financial problems. Complicated group structures can also increase the risk of non-payment with a higher chance of supply chain disruption.
High Levels of Debt
Today’s economic climate is layered with difficulties. Factors such as rising interest rates may affect a company’s ability to meet financial obligations. Also watch out for poor liquidity. Cash is king. The amount of cash will vary by industry, but your credit risk management process should be asking if the business can meet its short term liabilities. Businesses need to look to reserves if they have few assets and poor cash flow. If the company has limited reserves, they may turn to borrowing which will cause more financial strain.
Negative Media Attention
What is the media saying about a company? Is the industry sector receiving negative coverage? Poor press often precedes a company’s insolvency by weeks and sometimes months.
Extensions to Credit Terms
Any request to extend terms is not always a positive development. Extensions to credit terms can be a red flag for potential cash flow issues.
Deteriorating Service
Are you struggling to contact the credit control department? Do you receive prompt responses to your questions? Failure to return calls could be a sign of staff leaving with no notice or other problems within a business. Unreasonable behaviour or empty promises for payment should also not be ignored.
Supply Chain Shocks
Supply chain issues have been common in the construction industry for a few years. This domino effect of business failures often starts with a larger insolvency, such as Henry Construction and Buckingham Group.
We saw the same in 2018 when Carillion collapsed. With Carillion in particular, many of the red flags from this article, like changes to credit terms and payment practices, were already apparent.
High Risk Sectors
Make sure you are commercially aware of industry sectors under geopolitical or economic strain. Your credit risk management strategy should currently flag any business operating in construction, hospitality and retail.
Changes to Purchasing Behaviour
If a company is ordering less than usual, or changing their buying patterns, it could be a sign of weak demand for a product or service. Try to maintain good communication with your customers.
What Are the Next Steps?
Once you’ve identified any red flags as part of your credit risk management strategy, the next step is to gauge the potential impact on your business if the risk is materialised. Next week, in Part 3 of our credit risk management series, FinCred will take an in-depth look at how to evaluate risk, and the steps you can take to minimise and monitor the uncertainty.