Covid-19: Identifying the warnings signs of business insolvency

Thanks to a massive injection of state-funded liquidity into global markets, late payments and insolvencies aren’t something many companies have had to deal with recently, unlike normal years. But as our first article on Insolvency risk and understanding the Covid-19 domino effect points out, this situation is set for a dramatic change.

With governments expected to begin phasing out state support this year, the challenge now facing CEOs and CFOs is how to spot high-risk customers and suppliers before the inevitable wave of insolvencies hit.

The risks associated with customer insolvency are clear-cut: without adequate protection, not only do you face potentially devastating financial loss if you sell on credit terms but there is also the potential for protracted (and costly) legal proceedings. Meanwhile, the risks related to supplier insolvency may seem less direct, but they can be just as negative – ranging from lost down payments and deposits to interrupted production and service delivery, which can also lead to business insolvency.

Identifying insolvency risks in a supply chain is critical, but what exactly do high-risk, Covid-sensitive customer and supplier companies look like and are they easy to spot? 

According to Marine Bochot, Head of Group Credit Underwriting at Allianz Trade, identifying Covid-sensitive customers can be complex as it often involves piecing together a jigsaw of factors, which combine to heighten the risk of business insolvency.

Marine explains that one of the key factors that increases insolvency domino effect risk is the sector in which a customer operates. “For example, businesses in the hospitality, non-food retail, air industry and automotive sectors now represent a higher risk of insolvency,” she says. “That’s because borders have been closed, traffic has been minimal, mobility has been stopped, people haven’t been able to meet or move, and they either haven’t been able to consume or they consume differently – for example online.”

“In fact, all businesses in sectors that rely on physical exchange and physical interaction have experienced the need to quickly and dramatically evolve their operational models and cost structure. Companies that lack this flexibility and agility are particularly vulnerable to business insolvency and then potentially to the domino effect.”

The passenger airline industry is a prime example of this. The airlines with the agility and flexibility to convert or reinforce part of their traffic from passenger to cargo have performed much better during the pandemic. 

Our recent report Vaccine Economics reinforces this focus on sector vulnerability. It points out that the business insolvency domino effect is expected to start impacting companies during HQ2 2021, with the majority of sectors failing to return to pre-crisis levels of turnover and profitability until early 2022. Meanwhile, air transport (equipment and services) and non-food retail are clear outliers, unlikely to recover until 2023 at the earliest, making companies in these sectors more vulnerable to the domino effect and a greater risk as customers. Other factors increasing company vulnerability include heavy reliance on cross-border trade and an under-investment in digital transformation.

Businesses with significantly weakened balance sheets and poor cash flows are another red flag for CFOs and their credit managers. This risk category includes supply chain customers already struggling with high debt or those saddled with high-interest costs and high fixed cost structure. It also covers businesses with thin operating margins and those experiencing difficulty meeting their financial obligations.

Marine says: “The companies most at risk within this group are those that were not quick enough to secure state guaranteed loans. Vulnerable companies without state support have generally been confronted with bankers who are shy to offer loans on medium credit profile risks. This puts them in an even tougher position.”

When it comes to hunting for financial distress and insolvency warning signs among customers, you should ask the following questions about the companies you do business with. These points form a sliding scale which increases in severity. Generally speaking, the more questions answered with ‘yes’, the greater a company’s risk level.

• Is your customer taking longer to settle invoices?
• Have they asked to renegotiate contracts?
• Is there a trend toward late deliveries… or even disputes?
• Are funders refusing to support your customer during renewal facilities?
• Have they attempted to switch to alternative funding sources?
• Are their stocks performing badly? Are they being shorted?
• Have the credit default swaps (CDS) prices increased?
• Has your customer recently lost a major client/supplier? 
• Are they attracting negative press coverage?
• Have any C-suite members resigned unexpectedly?
• Is your customer unable to pay employee salaries/social charges?
• Have they appointed restructuring advisors?

Marine maintains that in the current economic environment visibility and awareness of risk is paramount. She says: “The situation is complex, so you need to have 360-degree visibility of what’s happening around you and your partners.

Achieving such a granular level of insight is not easy, especially for embattled SMEs who may find their resources stretched to the limit during tough economic times. Nevertheless, with the business insolvency domino effect expected to impact from the second half of 2021, it is critical that all companies are fully aware of the environment in which they operate. 

Marine concludes: “If you have trade credit insurance, remain in close contact with your insurer. More than information providers, they have skin in the game, so it is in their interests to give you the right levels of understanding to effectively manage the risk within your supply chains and recover potential bad debts. If you don’t have trade credit insurance, I highly recommend you get coverage right away. If you are determined not to get insurance, you should at least buy a risk grade as in most cases it incorporates the probability of default of your customer.”

It would be a simplification to think a trade credit insurance begins and ends with premiums and pay-outs. The industry focus is increasingly on predictive prevention. In other words, an effective trade credit insurer will do everything within their power to identify high-risk trading partners and break the chain of potential insolvencies before it can start. For example, our risk assessments are based on data from our proprietary intelligence network which analyses daily changes in corporate solvency representing 92% of global GDP.

When companies are faced with a chain reaction of insolvencies throughout global supply chains, data of this granularity will continue to provide the confidence to trade, and be paid, no matter what.

The third article in our Covid-19 Insolvency Domino Effect series focuses on the proactive steps businesses should take toprotect their businesses from supply chain risk. This includes the best strategies to de-risk your operations and the partnerships you can forge to achieve new levels of risk awareness.