There are ways to mitigate insolvency risk though no organisation can eliminate the issue completely.
According to trade credit insurer Allianz Trade, accessing insolvency risk is the first step toward mitigation.
The company advised organisations to keep an eye on the following warning signs.
- Declining profitability: For example, are your sales lower or your cost of goods sold higher?
- Declining capitalisation (also referred to as “book value”): Has your debt to equity ratio fallen below 30%?
- Poor interest coverage ratio: This shows operating profits may not be able to cover interest expenses.
- Weakened balance sheet.
- Cash flow and liquidity problems: Are your fixed costs or interest payments creeping up, or do you have a high number or amount of customer overdue payments? Check out our business liquidity calculator to assess how your liquidity could evolve depending on external factors such as a drop in sales, payments delays or one-off losses.
- Operating margins: Are they becoming thinner?
- Debt maturities, refinancing, and ability to raise capital: Under what terms can you refinance your debt? Can you go to the capital markets or turn to your line of credit to raise money if need be?
- Your order book: What does your future business workload look like?
How to identify supplier and customer insolvency risk
In addition, companies need to watch out for the following warning signs of potential supplier or customer insolvency, Allianz Trade advised.
- Are they taking longer to settle invoices or make deliveries?
- Have they asked to renegotiate contracts, to extend (if they are customers) or to shorten (if they are suppliers) payment terms?
- Is there a trend toward disputes over billings or deliveries?
- Has your customer recently lost a major client/supplier?
- Are they attracting negative press coverage?
- What is happening in their sector or country? This is part of the economic climate in which they operate and can impact customer insolvency. Check out our country risk reports and sector risk reports for insights.
- Keep your eye on news reports or business organisations which may circulate information about your clients: large turnover among staff and executives, or difficulties such as meeting their payroll.
- There is also the natural climate to take into account. In the last several years, extreme weather, climate-change-related events, and the pandemic have halted business operations or shut down supply chains at an accelerated rate.
How to prevent insolvency
The trade credit insurer also advised organisations to take the following steps to help prevent risks and create insolvency protection.
- Shorten your supply chains and avoid concentration in one geographic region.
- Always evaluate your client’s creditworthiness before signing agreements.
- Make sure your client portfolio is balanced so you are not relying heavily on one or two clients for most of your income.
- Create a cash buffer that your business can access in an emergency.
- Review the credit terms you extend to customers and suppliers, and benchmark your trade terms against the rest of your industry. For example, you could include a right to terminate the contract should your customer or supplier enter an insolvency process, or a right to charge interest on late payment and to recover your costs of enforcing payment.
- Go digital as much as possible to make “pivoting” easier. Think of the retail shift to online when Covid-19 shut down bricks and mortar establishments overnight.
- Invest in payment monitoring and debt recovery processes, including professional insolvency risk services.
