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Managing Customer Credit During a Recession

By AICC Staff

July 15, 2020

Over the past few weeks, in addition to the tremendous volume of discussions about Paycheck Protection Program loan eligibility and forgiveness, I have begun to field a lot of calls about customer credit issues. Many converters are getting requests from potential customers, and lots of these inquiries include requests for significantly extended terms. If a normal situation is something like a 2% discount if paid within 10 days, with the undiscounted balance due in 30 days (2% 10, net 30), these requests are more akin to a 2% discount if paid within 20 days, with the undiscounted balance due within 90 or 120 days (2% 20, net 90 or net 120). In addition, there are more requests for converters to carry significant inventory levels of customer product that cannot be invoiced until it is shipped. Is it madness to contemplate high inventory levels and 90-day-plus terms to induce a potential customer to move his business to you?

If a customer is insolvent and has either filed for federal or state insolvency (bankruptcy) protection or is threatening to do so, you will be lucky to get 10 cents on the dollar for your accounts receivable, and there is not much that you can do to compel the customer to take the inventory that you have already produced to take care of their future orders. If you give a customer extended terms and agree to carry high inventory levels, this exposure is increased tremendously, so the first issue in making these types of decisions is the overall credit risk being taken. Since we are currently in a recession that is likely to deepen, companies that were previously low credit risks can become high credit risks very quickly, so the first thing I would do is make sure that the customer is willing to send you current financial information and willing to let you tour their facilities. If it is a significant piece of business, have your attorney run up-to-date lien and litigation searches to make sure there aren’t secured creditors who are already in danger, or significant pending litigation. If you have access to credit insurance, pay keen attention to how much risk the insurance company is willing to take with respect to this potential customer. The bottom line is that if you are considering giving a customer extended terms or agree to carry large amounts of inventory, you must be certain that the overall credit risk is extremely low.

The next consideration has to do with the cost of capital. When I first entered the business world in the late 1970s, the incremental borrowing rate for most businesses was approximately 20%. With that kind of cost of capital, extended terms and high inventory levels could have disastrous implications. Let’s say that a potential customer is expected to purchase about $50,000 per month of product and, in order to properly take care of the customer needs, it is determined that you need to keep $50,000 of inventory in your warehouse. If you give them 90-day terms, your overall exposure will be about $200,000. If your overall cost of capital is 20%, this will cost you $40,000 per year, and if your cost of capital is 4%, this will cost you $8,000 per year. So, while your cost of capital is fairly low, it is easier to entertain extended terms, but if this situation changes, you might have to rethink the situation.

If the credit exposure is minimal, your overall financial position is strong, you have enough space to handle the additional inventory, and your cost of capital is low, the final issue is the overall profitability of the business. How long is the payback period on the resources that you have expended in terms of receivables and inventory? If your credit risk exposure is $200,000 and the expected contribution margin of the business is 30%, it will take approximately $667,000 in sales to generate enough cash to cover a potential loss of $200,000. In this example, it will take approximately 13 months of sales at a 30% contribution margin to break even, and this assumes that you don’t have to add any additional overhead to your operation to take on this new business.

Extended terms and high inventory levels seem to be becoming the “new normal” these days, especially for larger customers, and therefore they cannot be ignored if you want to continue to grow your business. In order to make a good decision, you need to make sure that both the initial and ongoing credit risk is small. Very often, the customer credit is not rechecked after the initial credit application. In any situation in which credit exposure is significant, this must be updated at least annually. If a customer starts paying slowly, it is usually too late to do anything about the problem. In cases of extended terms, you need to put into place a more comprehensive monitoring system, which should allow for regular visits to the customer premises and periodic financial reporting.

In summary, if you are entertaining giving extended terms to customers, you must take into account the inventory levels that you expect to carry for that customer in the overall evaluation of credit risk. Your balance sheet must be strong enough to withstand the credit loss, and your cost of capital must be low enough to ensure that your earnings will not be significantly impaired. You should calculate how long it will take before you can at least break even on the situation—before you decide to proceed. All too often, I see companies take on marginal business from difficult customers because they are seduced by the additional volume of business. In my experience, when a company is having financial difficulties, the first thing that they do is look for additional suppliers. So be careful with new credit risk during this business downturn, and above all, stay safe.

Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or