Cash Will Always Be King

"We're really not all that concerned about our cash."

The CEO telling me this last year runs a $100 million manufacturing company and didn't see the need to get his customers to pay him on time. This public company had substantial cash equity infusions at the time and a large bank credit line available. Most likely, his thought was "What's the point in spending resources to maximize cash flow when you can easily raise whatever debt or equity you need?" If that CEO hasn't changed his tune by now, his lenders will most likely be forcing him to reconsider.

So what are companies to do? It's time for that CEO and everyone else to focus on maximizing cash flow from operations and creating efficiencies in their order-to-cash cycle--including turning those receivables to cash as quickly as possible.

Here are some quick strategies to implement now:

1) Most importantly, analyze the risk of default for EVERY SINGLE CREDIT CUSTOMER to price the risk appropriately and to set credit lines within your risk tolerance. With the ongoing deterioriation in receivables quality, you must constantly monitor the ever-changing credit quality of your customers so you can minimize bad debt losses on high-risk accounts.

2) Whenever practical, offer cash discounts for early payment to speed up cash flow.

3) Focus on the large, frequent slow-pay customers to firmly enforce your contract terms. Work with them to secure timely payments.

4) Automate the collection activity. No collection department should be working from paper agings or spreadsheets. Databases, including automated scheduling, will organize the work to maximize collection efforts to get you paid faster.

5) Challenge unauthorized short pays over your tolerance. Don't allow customers' payment shortages to just be written off to some type of "slush fund". Challenge customers with their deduction claims and aggressively collect back the deductions taken in error. You can prevent future short pays by swiftly dealing with these types of receivables balances.

This credit meltdown has knocked many companies off balance from their years of relying on the debt and equity markets to make up the difference in their poorly executed order-to-cash cycle. It's time for companies to take control of their own cash flow and focus on what's most important for them to survive the meltdown. Sales, assets, and profits mean very little without cash. Cash has been, and will always be, king.

They're Good For It

The prospect looked great on paper. They told the creditor that they had been in business 10 years, their sales were $50 million, and they provided those commonly-requested three trade references. The creditor's research showed high credits from $20-$100,000, net terms, all prompt payments. Unfortunately, for the creditor, they suffered a $30,000 loss on a first sale to this customer by following a very common, yet outdated business practice of checking trade references to make credit decisions. The company turned out to be as bogus as their references.

In this day and age, it's still common practice for companies to check trade references to help make credit decisions. This is an ancient practice urgently needing updating. Nothing is more naive than granting credit based solely on heresay. Can you imagine a bank providing loans based only on your references? This sounds ridiculous, but commercial creditors everywhere rely on heresay to make their own credit decisions everyday.

While it isn't always a worthless process to check references, it needs to be done smartly:

1) Skip checking trade references unless you know the creditors to be reliable. If you've never heard of the company or can't verify their integrity, don't bother.
2) ALWAYS, ALWAYS, ALWAYS check bank references unless you can verify cash balances and credit line information through a public source.
3) If you do check reliable trade references, take their information in the context of their risk versus yours. If the reference comes from a big company and you're small, don't kid yourself that you'll be paid the same way. Larger companies generally have more power than small companies to get paid within terms.
4) NEVER simply rely on trade references to determine credit worthiness. Pull a D&B or Experian to see how your prospect pays ALL their creditors, not just the top three they handpick for you to call.

Companies that rely solely on trade references are only analyzing a small piece of a large puzzle. When companies default on payments based on an incomplete process, you'll then have a chance to realize which pieces you should've taken the time to put together.

Are You Suffering From Credit Insanity?

Einstein once said that the definition of insanity is doing the same thing over and over again and expecting different results. With the current credit meltdown and challenging economy, we're seeing companies sticking to the old "bill it and they will pay" along with the "check the references and if everyone else gives 'em credit, let's join the group!" These are fatally-flawed processes that companies haven't bothered to update. It was easy to have success in the past when most companies paid their bills; it's not so easy now.

WHY THE DIFFERENCE NOW?
The challenges in the economy aren't just the experiences of construction companies and retailers any more. The giant slowdown in the economy has trickled to most parts of the economy including manufacturers and distributors that may have been further removed from consumer cycles in the past. We can't keep thinking that managing our receivables the same way as we did last year or 5 years ago will get us through this storm.

WHAT CAN BE DONE TO CHANGE THE OUTCOME?
Some experts are already predicting massive credit defaults in the commercial markets just as the mortgage companies have experienced in the consumer markets. Much of the credit meltdown had to do with the fact that due diligence on the debtors was negligible. Who cares that a buyer making $50,000 was purchasing a $700,000 home they couldn't afford? Lenders and brokers were gathering their fees and selling off the mortgage so they didn't care about the risk; buyers of the debt were ill-informed about the risk they were purchasing.

In the world of trade credit, there's no excuse for ignoring what the customers can afford to buy from you--and only concentrating on what you want to sell them. Time and time again, companies are dumbfounded to find out they were major creditors to a company that was insolvent. Why did this happen? Because creditors ignored the signs that their customers were buying products and services without the ability to afford them. The only way to understand this is to change the strategy to ensure the outcome you want. Due diligence is critical to the process.

FALSE SENSE OF SECURITY
We're told by some creditors that they're "comfortable" with risk because they've insured their receivables. That's nice, but that's like watching the carpet in your office burn out of control and not worrying about putting it out because the building is insured. What about the deductible? What about the time it'll take to recreate all that was lost? What about when your insurance company stops insuring your building because they have too much risk with fires?

How do you do the deals that Sales wants and your credit insurance company won't cover? This is now happening in the credit insurance business right now. Insurance companies are taking hits and have stopped covering your customers that either won't provide financials or that have maxed out coverage with other vendors. Now what?

DUE DILIGENCE IS KEY
Companies need to stop relying on old, outdated practices like reference checking (thanks Uncle John for giving that vendor a great reference for me!) and "gut instincts" to give credit approvals. Real, solid due diligence is critical right now to understanding credit risk. Gather any and all information you can find on your customers, including the ownership risk. Use that information to make an intelligent, well-thought out decision that weights those pieces of information that will be the most predictive for future ability to pay vendors.

You can start now to create your own due diligence process to ensure minimum write-offs to your receivables. If you want an expert group to perform this task for you, let us know. Give us a call at 800-451-0164 to see how expert decisioning can help you stop the credit insanity.

Risky (Small) Business

Many credit managers tell me that monitoring their big accounts is relatively easy: they get information on their public customers from quarterly financials; and they routinely visit, work with their sales people, and/or obtain financials on their large, privately-held customers. The big gap for most credit managers is in the millions in credit risk offered in lesser, individual credit lines to small companies.

Why the gap?
In the past, there hasn't been much concern over losing 2 or 3 small accounts that owe you $20,000 total. However, with default rates increasing dramatically, these smaller credit losses can be significant as the numbers of accounts defaulting is increasing.

One challenge is the lack of information available on these small businesses. Bureaus don't usually overwhelm us with their massive information feeds on small business pay habits and financial condition. Many small businesses do most of their trade with other small companies who don't report to bureaus, adding to the difficulty of monitoring risk.

How can we better manage these small business risks?
While so many companies rely on credit reports, we know that slow pay indicators, whether customers slow down payments to you or to other creditors, are reactions to cash flow shortages and can be too slow in coming for us to recognize problems until it's too late to react to the risk.

Our challenge, then, as creditors, is to recognize trouble before it starts by understanding small businesses and how they end up defaulting on payments:

1) Customer Concentration. Do you know if your customer has a client that accounts for more than 10% of their sales? If so, you'd better know who they are and make sure you're on top of THEIR credit worthiness as well as the contractual relationship between them. If it goes sour, so goes their ability to pay you.

2) Cashflow management. Are they collecting their receivables timely? What is their cash conversion cycle? If you don't obtain full financials, at least ask the questions to understand these trends. If they can't convert sales to cash timely, they will have trouble meeting obligations (including paying you).

3) Bank relationship. Most small companies are extremely dependent on bank credit lines. Do you have information on these? Are you monitoring them? Many banks are terming out credit lines now on higher risk customers or just asking these accounts to leave the bank. What do you know about this for your small customers? You should not be the last to know the relationship between your customers and their banks.

4) Public filings. Are you monitoring public filings (liens, judgments, bankruptcies) on these small companies AND their owners? You should be getting daily updates on these to keep up on important risk changes to react accordingly.

5) Market trends. Do you know what type of business your customers are in and how they're adjusting to market changes? If they're not responding to changing customer demographics, evolving demand, and/or new technology, they could be headed for default.

In our world of monitoring thousands of risks, we're tracking all of this data and 'scoring' the risk appropriately depending on what we find. Determining risk is more than just pulling a credit report, reading it, filing it, and deciding whether you'll join the large creditors or set a conservative line.

Extending credit to small businesses is a dynamic, ever-changing, complex process that you need to understand. Once you know the real risks of small business, you can gather the right information and make the appropriate decisions. Without it, you can count on many surprise losses coming your way in the next few months.

Who IS Getting Paid On Time?

This past week we've been fielding calls from the press trying to understand the significance of the latest reports from credit managers reporting slowing customer payments. Of course our response is that companies need to perform actual credit work to know which customers will pay slowly in the first place, but what to do when you've already made these decisions and now need to get paid?

Here are our recommendations:

1) Get rid of lazy, passive practices like sending form letters out (except for really small balance accounts where it costs more to call than to send out a letter).
2) Improve your collection technology so that collectors can actually spend most of their time making calls and NOT trying to figure out whom to call.
3) Create metrics to improve your calls per hour made. Unless your customer calls involve very complicated billing transactions, most collectors should be able to make 10-20 calls per hour.
4) Train your collectors on negotiations tactics. They'll be competing with all of the other collectors calling your customers, so they'd better be good. There's no such thing as a "routine call" in a tough economy. They've got to step up their game now or be left without any part of the customers' cashflow.
5) If you haven't already done so, separate the credit work from the collections work. Collection calls are best made one-right-after-the-other (just like sales calls). Stopping and starting so credit applications can be reviewed or orders released is not efficient nor effective.

Sure, some creditors are reporting slowing payments; but some companies are very successful at minimizing delinquent accounts receivable (TCD clients, for example) even in these difficult economic times.

Make changes NOW to get your company paid on time!

This Credit Crisis is Nothing New

As complicated and severe as the problems are with the Bear Stearns collapse and the government bailout, organizations remain ignorant as to how to manage their own credit risks. As a friend of mine said today, this crisis will separate the mediocre credit managers from those of us who have well-thought-out plans, processes, and strategies to manage the risk.

Why isn't risk managed well in corporations?

1) It's seen as inevitable that unpreventable losses will occur regardless of credit management practices.
2) Companies don't spend money to prevent anything (ie, credit work); they use all their resources cleaning up the messes (ie collections) which costs so much more.
3) Credit risk is an intangible until the losses pile up. It's hard to justify spending money to manage something you don't understand.

This week I received a call from a Chinese firm looking for information and assistance in collecting from a Russian customer. While I'm doing my best to consult with my client to successfully collect his 1-year old $300,000 receivable, the bigger question is "why didn't you contact me before you granted $300,000 in unsecured credit to a customer with unknown financial resources?" This client has learned his lesson the hard way. Unfortunately, this is a typical practice in granting credit for most companies. They're just betting on averages that their risks will pay off--just like Wall Street did.

We've got to change the mindset when it comes to managing trade receivables. It's not enough to ship it out and pray for payment. There needs to be an analysis performed on the risk to know whether it makes sense to provide credit before the deal is signed.

There are many more Bear Stearns-like scenarios out there. Some analysts are putting the eventual price tag at somewhere around $900 billion.

How much can you afford to lose before you transfer your resources to the smarter strategy that actually manages the risk--and not the strategy that simply reacts to the poor risk management decisions?

You Can't Pay Your Bills With This Cash

As if credit analysts didn't have enough difficulty deciphering and analyzing customer financial statements, now we're finding out that "Cash" on a balance sheet doesn't necessarily mean real "Cash".

Turns out that the trouble in the credit markets has hit what was represented in corporate financial statements as "cash equivalents". Apparently, many of these entries are auction-rate securities, which are long-term bonds with interest rates reset monthly through an auction process. Now with the market demand drying up for these securities, corporations are taking big losses against their "cash" accounts. Lawsuits have begun against the investment houses, but the sudden drop in liquid assets has become a concern for creditors relying on these assets for debtors to pay for the goods and services they purchase on terms.

Auditors have caught on to the practice and are recommending companies remove such securities from their cash balance accounts and move them to the more-appropriate "investment" accounts line on the balance sheets.

What are we unsecured creditors to make of this recent development in the credit market meltdown?

1) Most of us have started asking for clarification on the cash balances to ensure the cash line on the balance sheet represents low or no-risk assets that won't suddenly disappear.
2) We're verifying actual demand deposit accounts in the bank accounts.
3) Those "cash equivalent" balances that are actually investment assets are moved to the investment lines in our analysis.
4) Many of us are taking out a percentage of the investment assets from working capital calculations to be conservative in predicting cash flow strength.

Now that "Cash" doesn't necessarily mean "Cash", maybe companies will pay attention to ALL the risk in their assets--even those over-valued, underworked receivables!

Pam Krank
President
The Credit Department, Inc

History Won't Repeat Itself This Time

Many companies boast of their minimal bad debt write-offs as a measurement of successful credit management practices. However, our analyses of hundreds of receivables portfolios show that low bad debt write-offs AREN'T usually a result of good, strong credit policies or expert underwriting guidelines.

These results have historically been strong because of a once-growing economy where customers were making money and banks were lending cheap money so defaults were rare. Unfortunately, low bad debts have created a false sense of security and an ambivalence about the need for implementing disciplines in the credit approval/credit management areas. The results of this ambivalence are just starting to show now as creditors suffer through increasing credit losses.

Kamakura Corporation, the leading provider of risk management information, reports now that 12.1% of global public companies are now classified as "troubled". That's the worst performance since December, 2003. Even if your customers aren't public corporations, creditors should be alarmed at the growing risk within their receivables portfolio.

Just as too many people wait for a toothache to visit the dentist, creditors shouldn't be waiting for a big suprise bad debt loss to figure out that they need a strategy to know where their risks are and what they'll be in the future. The time is NOW to update your credit files and policies:

1) Send credit applications to all customers to renew their lines. Banks won't give you information if your customer applications were signed 5 years ago. Also, if your customer does get into trouble, you'll have contacts with other creditors to help you.

2) Update those bank references. When you don't have financial statements on customers (generally with at least 90% of the customers), this will be the next best tool to understand the company's cash flow position.

3) Monitor your customer base with the credit bureaus. D&B has a great product called DNBI that will keep constant alert on your customer risks and update you whenever there's a change. Experian has similiar services, as do several trade credit groups.

4) Establish a process for updating files and for managing the marginal credit risks: Don't leave this to chance or allow it go get done when people have the time. Make it a TOP priority to keep your credit files fresh and meaningful. You should be able to see companies deteriorate over time--very rarely does a company just fall apart overnight. When you see deteriorating credit quality, adjust your strategy by lowering lines, changing terms, discussing with Sales to adjust pricing, etc.

Your historically-low bad debt write-offs aren't likely to repeat in 2008 and beyond. The smart companies will be preparing NOW to prevent losses and improve their credit management capabilities.

Who's your customer?

Last week a number of people contacted me regarding the sudden Axium/Chimes bankruptcy out of California. Apparently, the company had a large concentration of business in Hollywood and the writers' strike crippled their ability to cash flow the business. Unfortunately, thousands of companies around the company are out millions of dollars in losses because of this far-away bankruptcy including hundreds of companies here in Minnesota. Most likely, many of these companies will now follow suit and close their doors as well.

How could this have happened? First and foremost, some of the companies suffering losses had the same customer concentration problem as Axium/Chimes: one customer accounted for too much of their total revenue. Secondly, too many of these businesses didn't even consider Axium/Chimes as their customer in making business decisions, as they had no choice from the end user but to bill through Axium/Chimes. Thirdly, and most importantly, many of the companies I talked with had NO IDEA that Axium/Chimes posed any type of loss possibility to their receivables.

Customer concentration is a huge risk for all size companies, but especially small businesses. Not only does concentration give too much power to the customer in negotiating, but it usually results in lower margins. In the case where the customer isn't an "A+" credit, the concentration can be deadly as we'll see with many of the smaller customers losing their businesses.

Why didn't these companies consider Axium/Chimes as their customer? Because their RELATIONSHIP was with the end customer. They failed to fully understand the impact of having the "customer in the middle" where the risk lies. While the customer relationship may have been where their people physically resided in providing services to the end user, their real customer is the one who paid the bills: the now bankrupt Axium/Chimes. Apparently, many of them didn't have well-defined contracts and actually THOUGHT the end user was the customer.

Speaking of billing on credit, how could so many companies not understand the credit risk of dealing with this company? Easy--very few did any research on the financial stability of the customer. They secured the business, priced it, and started billing it. They thought that payments would be somehow "automatic" once you started billing. If this were true, there'd be no need for credit managers employed throughout the world.

Determining creditworthiness is sometimes a complex process, but it's critical to understand the probability of default when you decide to grant credit terms to a customer. In this case, Chimes had had a precarious financial situation for at least 4 years--the time we started analyzing them. Even before they were acquired, the company had a high risk of defaulting on payments.

Creditors have got to decide what amount of risk warrants an in-depth look at the risk. When they understand the risk, they can then employ strategies like following up immediately on past dues, billing often, and holding service until the customer is current to minimize potential loss exposures. If the risk were known in this case and the margins were insufficient to make up for any losses, a company could have chosen to walk away from the business.

Know thy customer is the #1 rule when you are deciding whether or not to take on a client and bill them on credit. It's too late for some of the creditors in this case. However, the rest can look to this as a warning to understand the risk that's left in its portfolio.

Who Needs to Know?

When my teenagers approach me with a bit of fear in their voices, I know they're about to ask me for money. Generally, they're not asking for school lunch money because that conversation goes more like "I need money for lunch". It's easy for them to be direct and confident when they know the answer is a foregone conclusion. It's not so easy for them to ask us if they need money to go to the movies or shopping for clothes they don't need. Then, we parents start firing questions like: "why do you need that?" or "didn't you just see a movie with your friends last weekend?"

I've had a number of conversations this week with financial people who are fearful about asking their customers for financial information. Just as with my teenagers, they're afraid of the responses back from the customers: "Why do you need this information?" "What will you be doing with it?"

Credit Managers need to remind the customers that they're providing hundreds of thousands, even millions of dollars of unsecured credit to them without understanding the probability they'll be paid on time or at all. In exchange for a large credit line, the credit manager is owed financials to justify the line.

Typically, credit managers' only inkling of future payment ability is by reviewing credit reports and internal payment records--ie, how the company has performed in the past. How many banks could you walk into and get $500,000 credit without showing them financials? None! This practice, though, is common for trade creditors.

Credit managers tell me customers don't want to provide financials. I say there are only 2 reasons for reluctance from the customers: 1) They don't trust what you're doing with the information and/or 2) The information won't have a positive effect on your relationship with them.

To alleviate the fear that you'll do something nasty with their financials (like showing them to your sales managers or posting on the internet), provide customers with a confidentiality agreement. This will give them some sense of trust that only your credit department will be looking at them--and no one else. Also, tell them exactly why you need it (ie, your credit line has exceeded the maximum amount we can give to a customer without financials).

If the customer is afraid that you'll see things they don't want to see, you should at least get basic information to help you make a decision. Many companies won't share their P&L's (for fear suppliers will think they make too much money and will raise prices) but will hand over balance sheets. Great--take them! Always ask for balance sheets, income statements, and cashflow statements. If we only get partials, we then model the remaining part of the statements to measure changes in financial performance. That's one of the biggest keys to analyzing risk: comparing the condition of the company from period to period.

When you only have the choice of one statement, I'd choose the cashflow statements (bank reference will give you cash asset totals from the balance sheet). After all, companies don't default because they run out of sales or assets. They fail to pay you because they run out of cash.

If you want to accurately assess the risk of default of your customers, you need to analyze financial performance. Don't be afraid to approach your customers for the information. Sign confidentiality agreements, meet them in their office or obtain partial financials over the phone to get what you can to make better informed decisions. The more information you have about the customer, the better the credit decision.

Who needs to know? YOU DO!

No Letters Please

Happy New Year! It was a fun holiday season, but it's time to take down the decorations and get back to work now. There's something about getting back to our routines that just feels right. I'm the type of person who needs that "fresh start" so I feel ready to take on new challenges. Maybe it's from living in Minnesota where we have 4 distinct seasons and fresh starts every 3-4 months.

As I look through all the letters and cards I received from friends far away during this season, I think about how nice it is to keep in touch with people--to say "hello", to let everyone know how you're doing, and to read about all the fabulous accomplishments of your friends' perfect children. So, what about beyond the holiday season? While most of us look forward to getting our mail during the holidays, we're not so eager to run to the mailbox in February or July. We've come to expect bills and junk mail the rest of the year. So, we become very blase' about written communications when we can't get excited about what's inside.

When people ask me about collection strategies, they're always so excited to show me their collection letters. Now, granted, most of these letters are bloated with too many pointless phrases like "thank you for your attention to this matter" and "you've been a valuable customer to us". Mostly, however, creditors are missing the point: letters aren't NEARLY as effective as telephone calls in getting companies to pay you; they should be used on an extremely limited basis.

People expect letters as part of their junk mail at work. If they're like me, they go through their inbox every few months to make sure there isn't something important they're missing. For most people, they tend to ignore letters--especially the collection kind. This is especially true if they have cash flow challenges. No one will necessarily see them tossing your letter into the garbage, but it's incredibly difficult to keep dodging those pesky collection calls.

So why don't creditors just make the calls? Many claim not to have the time (translation: deficient process, terrible technology or both). In reality, though, most just don't want to call. It's much easier to tell your boss that "the account has been worked" with a letter/email/fax than to pick up the phone and make the call. This is especially true if the collector doesn't deal well with rejection ("Now what? They don't want to pay!"). The letter strategy works much better for the customer not paying the bill than for the creditor trying to collect.

It's weird to walk through a credit department and not hear anyone making collection calls, but it's strangely common. Why are they there? What are they doing? Weren't they hired because the receivables are past due?

Whether your customers are small businesses, government, or larger companies, they'll respond much better to a live person on the phone asking for money than to some notice they can delete or toss. They've already mastered the "dump the junk mail into the recycle bin" at home in February and July--but they'll still hit the button to listen to those voicemails!