The Importance of Credit Risk Analysis on Export Accounts

In a world that continues to advance and become more integrated than ever before, it is important to recognize the risk associated with this globalization. Globalization is the process of increasing cross-border interaction and assimilation of various aspects of human activity, particularly through trade and financial flows. Companies increasingly do business abroad to diversify and expand their sources of revenue and profitability. As such, a credit professional should understand the aspects of international credit risk. Aside from commercial risk, the two main types of risk in international sales are political and sovereign.

Political risk can be defined as the risk an investment’s return could suffer as a result of political changes or instability in a country. For example, a change in government could lead to discriminatory regulations, contract breaches, currency alterations, or even civil war. If you are wondering if there is an increase in political risk on a global scale, the answer is yes. Between 2007 and 2015, the number of conflicts increased twofold. These events can place downward pressure on your customer’s profits and / or business goals, which in turn could hurt your company’s bottom line.

Any risk arising on chances of a government failing to make a debt repayment or defaulting on a loan is called sovereign risk. The strength or weakness of a country’s banking system, in addition to the depth of its capital markets, are important factors to monitor. Debt obligations have the potential to become a fiscal burden or impair fiscal flexibility. Should a government fail to repay its obligations, it could send its country into a tailspin, having a negative impact on global markets as a whole.

After assessing the above risks, what might a credit professional consider to mitigate such risks? Letters of credit (“LC”) are typically used in international sales, as they provide an increased level of security for both parties. Essentially, letters of credit are “a method of shifting the credit risk from the customer to a financial institution issuing the LC” (Journal of Business Credit). This means that the issuing bank has agreed to cover the transaction and that the seller will be paid subject to meeting the conditions noted in the letters of credit. However, we note letters of credit are costly.

EXIM Bank (Export-Import Bank of the United States), is also another option in this situation. EXIM works with private banks so exporters can secure financing for overseas sales through a working capital loan guarantee. We see many companies choosing credit insurance as a means to eliminate the need for letters of credit, to level the competitive playing field, and offer attractive open credit terms with foreign customers. Export credit insurance will protect your business from non-payment of commercial debt.

Financial and political woes can have significant implications on a company’s business. Although this is often overlooked, a credit professional needs to understand how it could influence their international customer’s credit profile.

Sources: ProfitGuard, Coface, and Standard & Poor’s 

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The Importance of Credit Risk Analysis on Export Accounts

How to Buy Credit Risk Insurance II

This article is broken down into 6 key sections, with the intent of helping you understand the process of determining your credit risk insurance needs and then how to buy it.

 

2. Locate the Right Credit Risk Specialist to Assist You

 

Why this is important, what to look for

Credit insurance can be an extremely valuable tool for your company, and one that more than pays for itself in any number of ways as previously noted. However, as a custom tailored program, there is no standard “off the shelf” policy you can buy that will automatically be the right fit for your specific needs and circumstances. Further complicating the matter is the fact that there are only a few providers specializing in this type of coverage, and they each have their own risk appetites, underwriting philosophies and contract wording.

Ideally, you will seek the assistance of a credit insurance specialist. When looking for someone to help you shop for this type of coverage, you want to be sure that you are dealing with a specialist who meets the following minimum qualifications:

  • Has as their primary if not exclusive focus, the implementation and management of credit insurance.
  • Is licensed to do business in your state and is in good standing with state regulators.
  • Has appointments to represent and is in good standing with all of the providers in the market, and preferably has what is known in the industry as “direct writing” authority. That is, they work directly with the carrier’s underwriters vs. having to go through other representatives of the carrier.
  • Has established staff, resources and procedures to support both shopping for the policy and assisting with ongoing policy management.

Tell me more about Global Commercial Credit Insurance.

Specialist brokers who deal exclusively with credit insurance are more likely to have a deeper understanding of each carrier’s philosophy, risk appetite and contracts. They will be able to lead you to the ideal solution in the least amount of time, and ideally save you unnecessary paperwork and money. Most brokers do not charge any additional fees, and under insurance industry regulations, the premiums quoted through your credit insurance broker are priced the same as if you were to secure them directly from the carrier.

While some of the carriers do have their own agent networks, dealing with a competent specialist broker opens you up to more market options, and objective expertise and decision support. Your broker’s loyalty is to you and to helping you maximize the value of your investment in credit insurance.

It is important to note here that in the US marketplace, there are less than 10 traditional credit risk insurance markets to go to, and several would be considered more specialized vs. mainstream underwriters. In light of this, you will want to select one broker partner to work with. If you solicit more than one broker, you will find they end up going to the same carriers. One competent broker can effectively cover all of the market options for you, and you will avoid a lot of unnecessary confusion and complications that would arise if you try to put more than one broker to work on your behalf.

When talking with a credit insurance broker, you should expect to find someone who is interested in understanding your perceived needs and uses for credit risk insurance, and who is interested in learning about your company and the direction management wants to take the business. The best specialist brokers are the ones who do the most listening and ask a lot of questions. Since every policy is custom tailored for each client’s needs, the more your broker knows, the better the job they can do for you.

Your specialist broker can provide you with detailed information on credit insurance, including the various carriers’ financial standings and ratings, specimen policies and help you with comparative analysis of the options available to your business. In terms of ongoing support, your broker should also be able to assist with account research, coverage requests, claims filings, helping you understand the minimal reporting requirements some carriers have, negotiating renewals and shopping for account coverages you may need outside your primary policy. In short, your specialist broker is your outside expert and partner.

(248) 646-9400 – http://www.gccrisk.com

How to Buy Credit Risk Insurance II

How to Buy Credit Risk Insurance I

This article is broken down into 6 key sections, with the intent of helping you understand the process of determining your credit risk insurance needs and then how to buy it.

 

1. Determine Why You Want to Buy Credit Risk Insurance

 

Summary of benefits of credit risk insurance

Before actually going to the market for quotes, you would be best served by clearly identifying what your interest in credit insurance is and how you think it will benefit your company. As a custom tailored financial tool, there are many practical benefits to having this type of coverage in place. That said, there are also some common misconceptions about what this type of coverage can be used for.

At the most basic level, credit risk insurance is designed to protect you from unexpected losses due to the insolvency or past due default on the part of your insured customers. The limited number of underwriters who specialize in this unique coverage will in most cases, conduct credit evaluations on the accounts you wish to insure and approve them for specific credit limits based on your requests and the results of their research. Given this active credit evaluation on the part of the insurer, credit insurance should not be approached as a tool you can use to grant credit to companies that don’t merit it. Likewise, it should not be sought when you have an imminent loss that you are looking to shelter.

Credit risk insurance is a proactive management tool that best helps you in the following specific areas:

Catastrophic loss protection: Across most industries and companies of all sizes, it is generally true that the top 20% of accounts represent about 80% of the company’s revenue. In some cases, the concentration of credit exposure among a few or even one key customer is even greater. Just one sudden, unexpected loss could have a devastating impact on the business. If you consider that your receivables are a concentration of all of your cost and your profit, and that, in many cases, you create them based on nothing more than a customer’s promise to pay; you can see that there is a tremendous amount of risk facing your business. Even with customers you believe are “good as gold”, the risk of unexpected default persists. Credit insurance is a great tool to remove this catastrophic risk from your balance sheet and cap your company’s exposure.

Safe sales expansion: It is not uncommon for customers to request more credit than you are comfortable giving them, or to have new customers you aren’t familiar with seek meaningful amounts of credit from you. While you may invest in a professional credit practice to review these requests and manage the exposures, if you are limiting sales as a result of concern over the risk, credit insurance is an ideal answer. Many companies use credit insurance to be able to expand on existing credit limits without having to put themselves at additional risk. It is also helpful in covering open credit sales to new accounts where you might have limited information and sales history. It is worth pointing out that using your credit insurance policy to support additional sales you would not have made otherwise will not only allow you to recapture the premium, it will help you drop additional profit to your bottom line.

Credit decision support: As mentioned earlier, in just about every case, the underwriters on your credit insurance policy are going to actively research, approve and monitor the accounts you wish to insure. Having an industry specific financial analyst doing this work for you as part of your credit risk insurance program adds a lot of expertise to your credit practice, or provides you, to a certain degree, with an outsourced credit department. This allows you to focus your internal resources more on cash flow management and collections work. If you consider the cost of amassing the information resources, many by costly subscription only, and hiring the additional expert financial analysts, this decision support alone is worth the typical annual premium. Most companies operate on the general rule that as long as the customer is paying timely credit management efforts can be focused elsewhere. Unfortunately, payment history is not a valid predictor of default. Many companies are current on their bills at the time they file for bankruptcy protection or are forced into default. Having the carrier watching your covered accounts and helping you evaluate credit limits on new risks is a great advantage to the program.

Borrowing enhancement: If the company borrows against its receivables, credit risk insurance can provide additional protection to the lender so they may be able to enhance the borrowing arrangements. They do this by increasing the percentage they will advance against insured accounts, and/or roping more accounts into the borrowing base- large concentrations, slow payers, export customers, etc. This allows you to maximize the amount of working capital available from the same pool of receivables. If you’re in a high growth mode and find yourself in need of more working capital, credit insurance is a great way to resolve the problem. Exporting on open credit: With more companies sourcing customers outside their own borders, the risk of granting credit terms has to be balanced against maintaining competitive terms against other sellers. Export credit risk insurance is one tool you can use to offer competitive open credit terms without the additional risk.

Before you talk to a specialist in this field, you should take a look at your business- the customer base, credit practices, risk appetites, etc. and think about how you want the policy to go to work for you and where it can bring value. With this accomplished, you’ll be better prepared to have a productive dialog with a specialist who can help you find the ideal solution.

(248) 646-9400 – http://www.gccrisk.com

How to Buy Credit Risk Insurance I

Credit Analysis Tips for Parent-Subsidiary Relationships

This article belongs to our sister company, Profitguard. 

Credit professionals are often tasked with evaluating the credit risk of a subsidiary entity whereby very little entity level financial data is available, but the parent company does report financial data. The strict by the book technical approach is to treat the subsidiary as a separate entity and approve credit on its own merits. However, this is not usually practical in the real world. One often has to review the parent to ultimately make a decision.

The same way a strong parent company can support a lesser subsidiary’s creditworthiness, a weaker parent will constrain the creditworthiness of an otherwise financially healthy subsidiary. Thus, it is important to gauge the financial strength of the parent and its level of support for it’s subsidiary.

If the parent company is public, one of the first places a credit professional should check is the company’s SEC Filings. A U.S. public company’s 10K (annual report) or foreign company’s 20F (annual report) will most likely disclose information regarding its support to it’s subsidiaries. A public company may also report debt information on its website under Investor Relations. If the parent company is private, you will have to sift through the notes sections on the company’s annual report or ask management to provide additional details.

Determining the level of support a subsidiary receives from its parent company is not a perfect science. There are, however, some key factors to consider when evaluating the parent-subsidiary relationship and associated credit risk. Factors to consider include, is the subsidiary a guarantor or borrower on the parent’s lending agreement? Could the subsidiary trigger a cross-default or cross-acceleration provision in the event the subsidiary defaults? What is the parent company’s economic incentive in the subsidiary? Economic incentive is a key factor and some components include the strategic importance of the subsidiary, whether or not the entities share a common name, and the amount of investment in the subsidiary.

In the event a weak subsidiary is tied to a strong parent company’s credit agreement, it is likely the parent will support the subsidiary in times of financial stress in order to avoid any default issues on its credit agreement. In the case where a financially strong subsidiary is tied to a weak parent, the subsidiary is at risk of being pulled into any financial troubles experienced by the parent company.

In a real world example, we point out U.S. Steel Canada’s bankruptcy in 2014.  U.S. Steel allowed its Canadian subsidiary to file for protection from creditors under the Companies Creditors Arrangement Act in September 2014.  Just months before this filing, U.S. Steel amended its Credit Agreement to designate U.S. Steel Canada, and each subsidiary of U.S. Steel Canada, as an excluded subsidiary and to waive any event of default that may occur.  This should have been a red flag for credit professionals as U.S. Steel tried to insulate itself from its weak subsidiary.

A weak parent has both the ability and incentive to extract assets from a healthy subsidiary and burden it with liabilities during times of financial stress, which may result in both entities filing for bankruptcy. One of the key factors in reviewing a situation like this is to determine if the subsidiary is insulated or “ring-fenced” from the parent. If the subsidiary is truly separate, with its own financing, and has legal protections in its structure, you could consider the credit risk as stand alone. Legal protections would typically prevent excessive dividend upstreaming, intercompany loans, or any non-arm’s length transactions.

Hopefully these tips provide more clarity on parent-subsidiary relationships.


(248) 646-9400 // http://www.gccrisk.com

Credit Analysis Tips for Parent-Subsidiary Relationships

Suppliers Can Wait

We thought this article might be of interest as it discusses the push for extended payment terms and explores corporate liquidity levels. It was originally published by our sister company, ProfitGuard, and we hope it can be educational for you.

Company liquidity levels continue to rise in the United States. Cash on hand for the 1,000 largest U.S. companies rose by 17%, or $154 billion, in 2017.  Much of that increase can be explained by exploding debt levels and the effects of U.S. tax reform.

Despite sitting on huge piles of cash, many U.S. companies are still pushing hard to be working capital efficient.  The cash conversion cycle (“CCC”) is a measure of working capital efficiency.  The CCC essentially shows how effectively a company is converting resources to cash.  It consists of the length of time it takes companies to get receivables in the door (days sales outstanding), the length of time inventory is on the books before its sold (days inventory outstanding), and the length of time a company takes to pay its suppliers (days payable outstanding).  Ideally, companies want to have a lower cash conversion cycle.  In 2017, the 1,000 companies in the scorecard reduced their CCC to 36.5 days, the fifth straight year of improvement.

As it turns out, looking deeper into shorter cash conversion cycles reveals that companies are not necessarily getting better at collecting on receivables and managing inventory.  Instead, for the third year in a row, it was the ability and willingness to lengthen payment terms (increasing DPO) that primarily pushed CCCs lower. Unfortunately, this manipulation of the cash conversion cycle is a trend that is not losing any momentum. DPO reached its highest level in ten years, or 57.4 days.  Translation: Many organizations are taking almost two months to pay their suppliers.

As more companies look to extend payment terms, it is important to understand the additional credit risk, and how to minimize that risk, when a customer requests extended payment terms from you. Longer credit terms mean your business will have to wait longer for the cash inflows from the collection of accounts receivable. In the meantime, your business may experience a cash flow shortage. This will require you to cover this gap with borrowings from a lender or tie up cash. While the borrowing cost may seem insignificant at first, in the long term it could affect your working capital and your ability to grow your business.

You have a couple of options to consider that could help offset the additional risk from a customer extending its payment terms. First, it is rational to charge that customer a risk premium to cover your increased credit exposure and cost of capital. Another option could be to reduce your DSO on other accounts to cover the difference. It also might make sense to stop selling that customer if it is not viable from a cash management perspective.

Credit professionals should never just accept a customer extending payment terms without first completing a full review to understand all the risks involved and how it affects the business.

Sources: ProfitGuard, CFO Magazine, and The Balance

Suppliers Can Wait

Fox Capital Managment

Below is a condensed version of an article from Fox Capital Management regarding the developing risk of corporate debt defaults.  With a significant amount of maturities coming due in 2019 and 2020, we thought this perspective would be of interest.

Today, we here at Fox Capital believe a bubble highly vulnerable to collapse lies in the corporate debt market and the passive investment vehicles accompanying it.  While C&I lending from the traditional banking system has been healthy since the last crisis ended, the corporate bond market has absolutely exploded, tripling in size from the peak of the prior cycle in 2007.  As a direct result of the Fed’s zero interest rate policy, investors of all kinds were forced out on the risk curve, scrambling for yields attractive enough to meet their own obligations. Pension funds, endowments, insurance companies and retail investors (through ETF’s and bond funds) gorged on corporate debt for extra yield in a ZIRP world.  Many of these yield-starved “shadow lenders” were new to the corporate debt market, and US companies were happy to tap this additional source of cheap money to lever up for stock buybacks, M&A and dividends given the immediate gratification of such financial engineering (higher stock prices).

Assets in the corporate bond ETF market have grown by over 10X since the last crisis.  With no yield available in Treasuries, investors blindly piled into corporate bond ETF’s with the largest growth in Investment Grade funds (for example the LQD).  Now, however, the Fed’s hiking cycle has made Treasury yields far more attractive, and the yield premium of corporate bonds (especially Investment Grade bonds) is beginning to look less appealing.  This could create a reversal of capital flows back toward Treasuries, and indeed we are seeing early signs of that with Investment Grade bond ETF outflows accelerating already.

In addition to the impact a sustained reversal of flows could have on corporate bond pricing, corporate bond fundamentals are currently on a very precarious perch with US corporate leverage at all-time highs on many metrics.  Further, the average interest rate for corporate America is set to increase next year for the first time since 2009, and nearly 50% of all corporate debt outstanding matures during the next 5 years, with the biggest y/y jump occurring in 2019.  Most troubling is the fact that while the ratio of corporate debt to GDP has never been higher, corporate default rates have never been lower.  This irrational phenomenon is a result of the Fed’s extended period of zero interest rate policy, though with a tightening cycle now under way, this historic divergence cannot last.  These facts are largely ignored now that the economy is strong and corporate earnings growth and margins are at decade highs, but any small reversal of these “peak” fundamental metrics could introduce heightened volatility to the bond market quite quickly.

 

Parallels to 2008:

No financial crisis is ever the same as the prior one, as policy makers diligently prepare to fight the last war again with effective new measures.  This backward-looking preparation unfortunately leaves them vulnerable to new challenges forming ahead.  Many bulls argue that the banking system is far more robust and that consumer and mortgage debt is healthier than during the 2008 crisis, and they are correct.  What they do not understand is that the bubble has now shifted to a new location, like water finding its own level.  It will not be a consumer debt and banking crisis this time.  It will more likely be a corporate credit and passive investment vehicle crisis, resulting in a bear market for stocks and bonds and a new cyclical economic recession.

The biggest similarity to the 2008 bubble (aside from its primary enabler – the Fed) is that investors are far too ignorant and complacent about the debt products they own.  Today, it is the large amount of BBB-rated debt hiding in investment grade corporate bond mutual funds, and especially ETF’s, that is analogous to all those garbage mortgages hiding in AAA-rated debt product “innovations” during the housing crisis.

While BBB-rated corporate debt is considered “investment grade,” it sits on the lowest rung of the ladder.  When BBB debt gets downgraded just one notch by ratings agencies to BB, it becomes a “fallen angel” and is reclassified from Investment Grade to High Yield (also known as junk).  This is important because many investors, such as pension funds and certain bond funds, are unable to own debt rated below investment grade by charter, so should a wave of BBB downgrades occur, forced selling would be a natural consequence.  It is also fair to assume that much of the investing public, especially ETF investors, could feel misled by the “investment grade” status of products they have acquired, and in turn would liquidate positions, especially with risk-free Treasuries now offering similar yields.

Exacerbating this particular risk is the fact that the BBB segment of the investment grade bond market has grown by 4X over the last 10 years, far outpacing overall market growth.  At the peak of the last cycle in 2007, the total investment grade market was $1.7 trillion, and BBB-rated debt accounted for under 25% of the total.  Since then, the investment grade market has ballooned to over $5 trillion, with BBB-rated debt accounting for over 50% of the total. In fact, when examining the entire corporate debt market, including Investment Grade, High Yield and Leveraged Loans, BBB-rated debt is the single largest component of the entire $7.5 trillion market.  Again, should a wave of BBB downgrades to junk occur, it would now have a far more destabilizing effect given BBB-rated debt’s outsized portion of the market.  The knock-on effect to the High Yield market would also be catastrophic, since even a small slice of the BBB market would swamp the much smaller and illiquid junk bond market with supply.  While corporate health in terms of growth and earnings presently seems very sound, such a downgrade cycle could happen at any time due to the tenuous fundamental state of the credit market, especially with interest rates now on the rise.

Finally, unlike during last cycle, we expect that the ratings agencies will be far more proactive with downgrades when merited given how much scrutiny and criticism they faced ten years ago for failing to meet their responsibilities in the mortgage market.  Several senior credit officers at both Moody’s and S&P have recently gone on record predicting a particularly large wave of downgrades and defaults in the corporate debt market when the next economic downturn occurs.  We suspect these agencies will err on the side of caution in an effort to rebuild credibility, lowering the bar for a wave of ratings adjustments.  As discussed above, it is the mountain of BBB-rated debt that has the biggest implications for a potential downward spiral.

 

(248) 646-9400 http://www.gccrisk.com

 

Source: Fox Capital Management 

Fox Capital Managment

Collection from Slow Payers- The Art of Persuasion

While it’s not unusual to encounter slow paying customers, it’s important to be watchful for a slow pay situation that typically foreshadows real payment ability problems.

Having established collections processes will help assure that the routine, “non-credit risk” payment issues are addressed in a timely manner.  It’s also important to have that next set of steps to pursue if a payment problem develops.  Incurring collections fees or filing a claim under your credit insurance policy comes with certain costs that you may be able to avoid if you employ some interim steps to assure you’ve first exhausted your best attempts to get paid.

At GCC, we provide a cost-free demand letter service to our clients.  This very effective tool has been used by countless clients over the years, helping them avoid unnecessary collections costs and claims filings.  A demand letter from a third party allows you to take the role of problem solver and let that third party be the “bad cop”.

Most recently, a client was having difficulty collecting a $188k balance that had aged out to 6 months old.  We prepared a demand letter advising our client that upon review of their current aging, we found the amount was significantly past due and per the terms of their credit insurance policy, they would be required to file the account with the carrier for collection action and by doing so, negatively impacting their customer’s credit profile.  The client shared the letter with their customer and received an almost immediate response indicating that full payment was on the way.

While this approach does not work in every case, we’ve found that if the customer has the funds, these demand letters are very effective at getting you paid.  We’d invite you to talk with your agent or client service representative to discuss this approach if the need ever arises.  We’re always happy to help.

(248) 646-9400  www.gccrisk.com 

Collection from Slow Payers- The Art of Persuasion

Rising Interest Rates Pose Threat to Credit

Benchmark interest rates have steadily risen after a decade of slow economic recovery and are expected to continue to rise.  Some economists anticipate four rate increases from the Fed for all of 2018.  Debt is becoming more expensive, which will certainly put more pressure on companies who are heavily reliant on debt to capitalize their businesses. Short-term Treasury yields are rising rapidly and long-term yields, while slower to rise, are seeing increases as well.

Interest expense is an important consideration when evaluating credit risk.  As a result of higher borrowing costs, companies, especially smaller-sized enterprises who aren’t generating enough cash flow to cover their debts, are at increased risk of defaulting on their payments and may eventually fall into bankruptcy.

So, how does this effect corporate credit? In the face of a robust economic climate and rising interest expense, companies find cash flow strained and working capital constrained. Higher borrowings put more pressure on the company’s liquidity. The effect of these financial issues then travels down the supply chain in the form of slower payments to vendors and in some cases unexpected insolvencies. If customers do not have sufficient cash flow to cover their expenses, they begin defaulting on payments to their suppliers. Suppliers then have difficulties absorbing these defaults while still trying to cover their operating expenses, and the risk travels down the line creating a domino effect of slow payments and defaults.

Credit insurance provides protection against past due defaults and insolvencies so you can continue uninterrupted after losses occur. The policy replaces the lost revenue protecting your critical working capital and cash flow. Many credit insurance users also find that it allows you to lower your bad debt reserves with the certainty that comes with the carrier’s assurance of payment. With credit insurance, you will be able to take excess bad debt reserves back into income, allowing you to provision less and giving your earnings a onetime boost.

In short, in times like these, credit insurance will not only help protect your working capital and bottom line, it can also be used to gain financial efficiencies that help free up capital within the business that may otherwise be tied up in bad debt reserves.  Feel free to talk to us today to learn more.

(248) 646-9400 http://www.gccrisk.com

Sources: USA Today, CBS News, Global Commercial Credit

 

Rising Interest Rates Pose Threat to Credit