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Credit Management Insights
March 2, 2021
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The domino effect of insolvencies: is your company ‘vaccinated’ against it?

domino effect
The following article is replicated with the kind permission of Euler Hermes South Africa

Doing business with large companies can bring major benefits to a supplier: they are generally financially more stable, and can provide steady volumes of orders. However, it is still not a risk-free endeavor. Although the likelihood of failure is lower compared to SMEs, an insolvency of a large client can be devastating to suppliers, putting their very survival at risk. And worse – much like Covid-19 – large corporate failures create a domino effect, with waves of insolvencies in their ecosystems’ supply chains due to factors ranging from lack of supply or demand, to cash flow issues and volatile prices etc.

As risk underwriters and credit analysts, our role is to protect our clients from this domino effect. In this article, we focus on the ‘highly transmissible’ nature of insolvencies of large companies as well as their undesirable effects. We also give some rules of thumb on how to spot signals and be prepared.

First, some statistics and trends: According to our Economic Research department, insolvencies of large companies (defined as those with turnover in excess of €50m) surged around the world at the start of the pandemic. In the second quarter of 2020, they increased as much as +92% year-on-year compared to the same period in 2019, or 89% compared to the previous quarter.

Retail, Services, Energy, Construction and automotive were among the worst-hit sectors. Overall, we expect the total number of insolvencies to gradually return to normal as  support measures linked to the pandemic are phased out. In practical terms, this means an annual increase in total insolvencies of +25% in 2021 and +13% in 2022. We expect to see the bulk of insolvencies in the long term as liquidity pressures worsen.

In South Africa, we saw a substantial +24% increase in liquidations in the second half of 2020 compared with 2019, resulting from the Covid-19 shock, extended lockdowns and the end of Government support schemes for struggling businesses. It should be noted that this bucked a long-term trend: insolvencies in South Africa had been declining between 2009-2018. However, this decline was concealing the continued deterioration of balance sheets in key corporates and particularly in large State Owned Enterprises (SOEs).

Who is more exposed to this risk?  Companies with concentrated exposure to a single or a few large clients  are considered as a ‘fragile population’. The risk is exacerbated if long credit terms are offered or the company is a critical supplier to the client in question, thus making it quite difficult to catch the early warning signals.

The big questions facing suppliers are: how easy is it to spot the warning signals, and what preventive measures can you take? The following are just some of the potential red flags. The more you spot, the higher your chance of being impacted!

The first is a history of liquidating other businesses. If the owners or directors have done this in the past, it means that they are familiar with this option. If you have a concentrated exposure to a large client, and especially if you are a critical supplier, it is worth investing in an external source of information (a credit bureau) to check the directors’ history, get up-to-date payment patterns, and an idea of your client’s buyers.

A second red flag is the non-strategic nature of operations for subsidiaries of large groups. If your client is part of a larger Group, it is worth considering some key questions. Is the subsidiary I am dealing with in a good financial position? If not, will it be supported by the Group? Some factors that might influence the Group’s decision to support a failing subsidiary are:

  • Does it carry the same name (reputational risk if the Group lets it fail)?
  • Is it integrated within the Group? In other words does it produce products or services that are necessary to the rest of the Group?
  • Is it sizeable enough and considered as a core activity?
  • Does it have independent bank lines? Is the Group a guarantor of the company’s loans?
  • Is there in the annual report a special resolution authorizing the Group to financially support its subsidiaries?

A third indicator to watch is your client’s management and strategy. A frequent risk associated with large corporations is complacency, notably the illusion that success will be on their side just because they are too big to fail! The good news is that the wrong strategic choices (failure of large projects, loss of competitiveness, high operating costs etc.) tend to take time to impact companies financially. If your client is a listed entity, it is worth considering the ‘noise’ of the stock market and weighing it objectively even if everything is running smoothly day-to-day.

What mitigation measures can you take to reduce the impact of a large company’s failure on your business? Nothing more than a standard credit policy! The only difference is that the exposure to a large client puts the very existence of your company in question and as such, the robustness of the credit policy has to be a priority for management, and audited regularly. Below are some critical points to consider:

  • Diversification even if it comes at the expense of margins
  • Having guarantees in place whenever possible (personal sureties, cross-company guarantees, lien over stock, etc.)
  • Obtaining credit insurance. This will help you prevent negative impact, by giving you information about your clients, but also ensure your business continuity in case of a large payment incident
  • Proper documentation. This should be considered as basic, but in reality, many companies have gaps (absence of signed application forms, open terms offered etc.)
  • Active monitoring even if no immediate/tangible danger. Finally, having an internal rating system should make it easier to track your credit risk as it allows you to automatically monitor clients. This depends on your exposure versus the rating: the weaker the rating the more frequently the client’s credit profile should be reviewed.

In short, prevention is better than cure when it comes to customer insolvencies – but even in a time of increased failures, there is much you can do to protect your company.