Bad Debt Is Lurking in Your Accounts Receivables, but Where Is It?
Tips on Segmenting Your AR and Identifying Concentration Risk
The typical course of action on managing bad debt loss is to identify, then focus credit and collection activities on individual customers who are financially weak. These customers pose the highest risk of bad debt loss.
This is a classic approach and when executed properly, it can enable a company to satisfactorily manage their credit risk. It should also facilitate maximizing revenue from customers with a higher degree of credit risk. Because it focuses effort where needed, it can be quite efficient as well as effective.
There is another bad debt threat to your Accounts Receivable (AR) asset, however that could prove devastating. It involves concentration risk, which simply refers to a vulnerability associated with a group of customers with similar characteristics.
When a customer segment shares a common vulnerability to external financial shocks that can damage their financial strength, the risk can remain hidden if your risk monitoring is focused on identifying individual accounts that could be problematic. If a segment of customers owing you significant amounts of money is negatively affected by an external development or event, it may result in a large reduction in cash flow and higher bad debt losses.
A key threat stemming from concentration risk is that relatively quickly it can materialize and result in diminished cash flow and higher bad debt loss. This is often the case when there are economic upheavals or natural disasters.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
Customer Segments and Credit Risk
Customer segments can be defined in many ways. Common factors include industry, geography, sales volume, company revenue, and so on — virtually anything that can be used to differentiate segments of customers. Vulnerability to inflation and impact of high interest rates are two additional factors related to the financial strength of you customers.
Industry — a prime example of industry impact was the restaurant industry during the Covid pandemic. Many restaurants suffered as their revenue fell way below their break-even point and they suffered losses from perishable food that spoiled. An entire industry became a poor credit risk virtually overnight.
Geography — this risk associated with customers segmented by proximity to each is often caused by a natural disaster. While the news coverage of the disaster ends within a few days, the rebuilding of individual customers and the general area can endure for years. Consider a manufacturing customer whose factory is destroyed, or more likely, several manufacturing customers whose factories are destroyed. Their ability to pay you could be diminished for a potentially long time; in some cases, their survival may be in jeopardy. Local economic conditions can also be a factor here, especially when the regions economy is subject to a “boom or bust” environment. For example, oil producing areas often have large swings in economic activity that affects all businesses.
Sales Volume — it is always interesting to rank your customers by the amount they purchase from your company. Using Pareto’s Theorem, also known as the 80/20 rule, you may be surprised at the level of risk concentrated among the 20 percent of customers that account for 80 percent of your sales. We’ve also worked with companies where there was a concentration of risk in the middle segment (the top half of the 80 percent of customers contributing just 20% of sales). You never know where risk may show up, because risk is seldom distributed evenly.
Company Revenue — It should come as no surprise that large, mid-sized and small companies tend to be affected by different degrees to economic events as well as a wide variety of disasters. For example, large firms are much more resilient in the face of a cyber attack than smaller firms.
Vulnerability to Inflation – Most companies are negatively impacted by inflation as their costs increase. All try to mitigate the impact by increasing their prices. Customers in a very competitive industry will probably not be able to increase prices to fully offset their cost increases, so their profit margins and cash flow will decrease. This includes companies supplying large retailers (WalMart, Target, Home Depot, etc.). who will almost certainly not be able to recover the full impact of cost increases.
Vulnerability to Higher Interest Rates – Highly leveraged companies with variable interest rates will see (and have already seen) their interest expense increase substantially. For highly leveraged companies, this will reduce their financial strength. For example, the home-building industry can expect to see a decrease in revenue, profit, and cash flow and will become a higher risk customer segment as interest rates rise. There is currently a lot of press about “Zombie Companies” that also fall into this category. These are firms with interest rate coverage for the trailing twelve months (TTM) of 1 or less and high short term debt to total debt, making refinancing very difficult when their current loans expire.
Your company may have significant exposure to other customer segments. Identify those segments so you can keep an eye on them and the external threats that may arise.
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