2021 is shaping up to be a risky year for companies that rely on trade credit to sell their goods and services. With an upcoming normalisation in insolvencies post-phasing out of state assistance mechanisms, all businesses will be tempted to shorten repayment terms, reduce credit lines and be more selective about who they offer credit to. The danger, however, is that undue caution will reduce companies’ ability to compete in a difficult market. How then should businesses protect themselves so they can maximise their trade credit offering without exposing themselves to unacceptable risk?
In the first two articles in our Domino Effect series we discussed the Covid-19 insolvency domino effect and how to identify insolvency risk within your supply chain. Now we offer eight steps that companies can take to protect their business from the domino effect and improve supply chain management.
When it comes to insolvency protection, where you trade can be just as important as who you trade with. You can protect your supply chains by risk-assessing where your customers are based and the markets in which they operate. An obvious step is to improve supply chain management: diversify supply chains so they are not concentrated in one area and there isn’t an over-dependence on the regions hardest hit by the pandemic.
This is a challenge that companies heavily reliant on the Chinese market experienced when the country locked down during the first outbreak of Covid-19. The importance of diversified trading networks also became clear after the 2011 Japanese tsunami, which disrupted semiconductor supply chains and triggered an insolvency domino effect in the sector. For more insight into national and regional business insolvency forecasts for 2021, read our Vaccine Economics report .
Relying and concentrating your business on specific customers or suppliers is also an obvious risk that you need to address. Check out our article Insolvency risk: understanding the Covid-19 domino effect for more information on this risk.
Extended supply chains spanning multiple partners and countries have been particularly fragile during the pandemic. Other factors such as Brexit and recent trade disputes between the US, China and the EU have also added increased complexity to cross-border trade. Both the pandemic and Brexit have also led businesses to question the wisdom of lean and just-in-time production methods. For instance, Japanese car giant Honda, a leading proponent of lean supply chains, recently closed its biggest UK manufacturing plant due to “global supply delays” triggered by the pandemic. Our global survey on Covid-19 disruption of more than 1,000 business leaders across six sectors reveals that 52% are hedging against these kinds of supply chain risks by shortening their supply chains, stockpiling and using trade credit insurance.
Achieving effective payment terms can be a delicate balancing act – build in too much time and you increase risk, demand payment too soon and you lose competitiveness. Our free Mind Your Receivables online tool enables you to quickly and effectively compare your repayment terms with trends in different countries and sectors so you can achieve the perfect balance. It also helps you visualise key insights about DSOs , past-dues, non-payment and insolvency risks across countries and sectors and over time.
Business models that are still heavily reliant on physical interaction and exchange are among the most at risk of insolvency and the domino effect. Lockdown orders and social distancing have hit offline businesses hardest, reducing and even halting demand in many cases.
Businesses and sectors that have been able to shift activity online, however, have reduced the negative effects of lockdown. A prime example of this is the rapid expansion of ecommerce, with online shopping achieving 10 years’ of growth in just three months during the pandemic, while there is a dramatic decline and countless cases of insolvencies in brick-and-mortar retail (Source: McKinsey ).
In parallel, you should ensure that you move your own business model towards proper digital plug-ins to deal efficiently with such partners: orders, payments, production, logistics, etc.
Faced with the prospect of a normalisation of customer insolvencies, you should ensure your contracts limit potential losses as much as possible. This includes inserting contract clauses which ensure that you, as supplier, legally retain ownership of goods until all customer payments are fully settled. For this to be effective, businesses should regularly audit and maintain a full inventory of all stock held by their customers, which has not yet been fully paid for.
Setting an upper threshold on trade credit is an effective way to limit your financial exposure and increase insolvency risk protection. Common methods of calculating a credit limit include:
- Fixing a percentage of your client’s net worth (its assets minus its liabilities), typically around 10%
- Using your client’s former trade references (which can typically be found on their credit report) and choosing a median value from their credit history
- Estimating your client’s real needs and not extending credit further.
Your first step, however, should be to speak to your trade credit insurer, if you have one. They will be able to leverage their proprietary risk data to ensure your credit limits are pitched at just the right level – increasing your competitiveness while also minimising your exposure. Another strategy is to ensure you always have a cash buffer for use in the event of an emergency, such as a payment default.
Trade credit insurance has much more to offer than indemnifying you against bad debt. Market-leading insurers, such as Euler Hermes, are also experts in debt recovery and debt collection, with the skills and experience needed to maintain an effective, on-going dialogue with debtors and their legal teams, no matter which country or jurisdiction they operate in. Trade credit insurers can also give businesses access to comprehensive insight about the constantly changing risk environment. For example, our risk assessments are based on data from our intelligence network which analyses daily changes in corporate solvency covering 92% of global GDP.
The speed with which a business reacts to customer insolvency is key. The ideal scenario is to identify and act on warning signs before your customer becomes insolvent. But if this isn’t possible, the second best option is to be at the front of the queue of creditors. Experience tells us that the businesses with the best insight, the best understanding of insolvency procedures and the quickest reactions recover the greatest proportion of owed funds. Not many companies have these resources and that is why it makes great sense to partner with a leading trade credit insurer who can take the stress out of payment recovery. They will investigate a non-payment on your behalf and indemnify you for the insured amount, when policy terms have been met.
The Covid-19 domino effect could potentially be unlike any insolvency chain reaction the global economy has experienced. Our analysis calculates that 126 sectors across 70 countries are experiencing an elevatedrisk rating.
Unlike many previous financial crises, however, CEOs and CFOs have been forewarned and now have a golden opportunity to take steps, such as those outlined above, to identify Covid-sensitive customers, improve supply chain management and protect against insolvency risk before the first dominos begin to fall.