Abbreviated Survival Guide for Extending Business Credit

On Monday of this week, I saw an article that retailer Circuit City was in financial trouble and looking for a company to buy them out. Other household names like CompUSA, Linens ‘n Things, Ann Taylor, Sharper Image, Levitz Furniture, and Zales Jewelry are also reported to be in financial trouble, closing stores, or filing for bankruptcy protection. Some are even liquidating. Even though there are only a few names mentioned here, the big list is rather daunting!

Not just retailers are in trouble in today’s economy. Companies that manufacture consumer goods, building material and the many other industries are also reporting difficulties.

Why should the average business owner care? Because another business that sells to one of these troubled companies may also be heading for disaster and that business might be YOUR CUSTOMER!

How much of your accounts receivable can you afford to write off in bad debt this year?

In late 2001, I was working in the banking industry in the Houston area when Enron collapsed. Before the collapse, the bank I worked with loaned money to many businesses that sold to Enron. I remember distinctly one business owner that did business with Enron a year before the collapse. He was doing nearly 100% of his business with Enron. In banking, this is called a 100% concentration of credit. Back in those days, banks and other lenders didn’t see Enron as a risk so some of them would loan money to companies doing business with Enron despite such a high concentration of credit. This one wise business owner decided to go against the trend though. In the year before the Enron collapse, he aggressively courted other customers. At the time Enron did implode, less than 10% of my client’s total outstanding accounts receivable was due from Enron. My client had to write off a $250,000 loss, but more importantly, he dodged a big bullet by diversifying his customer base in the months before Enron collapsed. This client didn’t have a crystal ball; he just recognized that it was good business to diversify. He not only survived (others didn’t), but he continued to grow his business for another several years and sold it at a high premium.

Businesses can do quite a bit to prevent a disaster caused by the failure of a customer in tough economic times:

1. They can make sure they don’t have significant concentrations of credit. Any customer with over 20% of total outstanding accounts receivable should be looked at carefully. How credit worthy is that customer? Now is the time to update credit files on all customers and evaluate credit limits.

2. Businesses can transfer credit risk by selling invoices to a non-recourse factor. A factor is a company (or bank) that buys invoices from credit-worthy customers (debtors). A non-recourse factor assumes all the credit risk when the invoice is sold.

3. Consider using a business credit insurer. These insurance companies insure against your customer’s inability to pay because of insolvency. They also insure foreign customers against other risks like political risk. There are three major credit insurers serving the U.S.: Atradeius Credit Insurance, CoFace USA, and Euler Hermes ACI. Each of these insurers has considerably different criteria and industry preferences, so it is wise to check all of them. Recently, I was involved in a financing transaction that used credit insurance to protect against a large concentration of credit. Because of the credit insurance purchased by the loan customer, the bank lender was able to give the customer a rate that was much lower, saving the borrower significantly more than the annual policy premium of the insurance. This was good for the borrower in two ways, first it allowed the borrower to substantially reduce its cost, and secondly, the borrower is protected in case its customer becomes insolvent and unable to pay.

4. If you don’t keep credit files on your customers, now is the time. “Know your customer” is the most important consideration. Watch payment history closely and keep your A/R current.

5. Be wary about customers that suddenly want to move all their business to you from your competitor. The competitor may have just put this customer on COD. You don’t want to take on your competitor’s bad accounts. Move cautiously with these kind of customers. Get a bank and trade reference sheet for new customers and check the references. Set realistic credit limits and be particularly cautious during the first 90 days of a relationship. If trouble is going to happen with a new account, it usually happens within 90 days.

I encourage readers to post their own ideas about protecting against bad debt write-off. I am sure there are many ideas that small business owners have discovered that would benefit all of us.