Beginner's Guide to Bankruptcy
By: Adam Easton | Alejandro Ojeda | Eve Sahnow | Jessica Pierre | Kevin Quinn | Tawnya Marsh
Receiving your first bankruptcy notification can be an anxiety laden experience. Bankruptcy documents can be difficult to understand for those who do not deal with them on a daily basis. This simple guide is your companion to help you spot key issues when a customer files bankruptcy. It is written in an easy to understand style, without “legalese”. It is NOT intended to be an all-encompassing solution for dealing with troubled customers. This is meant to assist the entry level credit professional navigate and define the surface of the bankruptcy process. This will help you spot issues to raise with senior management.
Find out if the information is true and accurate or simply a rumor.
WARNING! Verification is extremely important as there are strict legal consequences for attempting to collect a debt if a bankruptcy has been filed.
WARNING! Verification is extremely important as there are strict legal consequences for attempting to collect a debt if a bankruptcy has been filed.
PACER – PUBLIC ACCESS TO COURT ELECTRONIC RECORDS
(This is the fastest and most reliable way to verify, so why go anywhere else?) Electronic access service that allows you to get case information directly from bankruptcy courts.
https://www.pacer.gov/ (Requires login and password)
Google search – Why not? Google knows all!
True? – Move to “Get your Ducks in a Row”
False? – See if you can determine where the basis of the rumor came from. (Talk to other vendors / trade groups)
Hmmm...Pay close attention to the filing date! This will dictate other rights such as potential preference issues (having to send money back) and reclamation (trying to get your stuff back).
Do we have orders pending or in transit?
Yes? – If you were paid up front, good for you! If not, you should consider cancelling or rerouting those shipments back to your warehouse. If already delivered, you may have a chance to reclaim your material. Reclamation will be discussed later.
No? – mark the account for non-shipment.
If you have a contract in place, you need to explore what your options are before you cancel. More about contracts in a bit, but you may want to seek legal counsel. Just sayin...
What does the account look like? People are going to ask a lot of questions so you need to be ready. Gather the proper documentation, to include two years of account records on:
- Delivery tickets (bills of lading, proof of delivery), credit application, guaranty and current statement. (This is the start of it but you will need all the info below retained for later consideration).
- Payment information - Check remittance copies, ACH/Wire receipts etc.
- Invoices (paid and unpaid) and a statement of account.
- P.O.'s which could be emails, voicemail, fax etc.
- How much do they owe you?
The Big Dogs! – This will include notification to salespeople, managers, CFO and others in your credit department (including other branches).
Your Peers! – Luckily NACM can help with this process. Visit NACM’s portal, they will verify (good thing somebody’s got your back) then send out notification to others in your industry group.
YOU WILL NOT BE AUTOMATICALLY NOTIFIED!
What is it? The automatic stay or “stay” bars you from ALL collection efforts. The automatic stay is put in place immediately after filing and there is no notification sent to anyone. The "automatic stay" protects the debtor and its property, stopping actions by creditors to collect on pre-petition debts (any amounts owed prior to the filing) or litigation. Think of it as a shield that is put into place between you and the debtor as soon as the bankruptcy petition is filed. The automatic stay applies to all chapters of bankruptcy
What does it mean to me? Collection Efforts HALT!!! The following can be considered collection efforts: demand letters, statements, phone calls, or invoices sent by emails or fax. As soon as you know about the bankruptcy, stop all efforts to collect any pre-petition amounts owed by the debtor or you will be in violation of the automatic stay (technically notice of the bankruptcy is not required for these efforts to constitute a stay violation).
Can the "STAY" be removed? - In some situations a creditor can ask the court to lift the “stay". Common reasons to do this would be: debtor is behind on home mortgage payments, automobile payments, failed to maintain insurance on home or vehicle or has a non-dischargeable debt such as alimony, child support, or other debt the debtor has agreed to reaffirm (you can't get rid of this one bucko!). If the stay is lifted, the creditor can proceed with certain actions that would otherwise be prohibited by the automatic stay.
Am I someone that can request a "lift" – Under certain circumstances, a creditor can ask the court to lift the stay. For example, if you have a lien on the debtor’s property and the debtor owes you more than the value of the property, you can ask the court to lift the stay. Otherwise, get in line. (meaning no).
How do I "Lift"? A motion is required to be filed with the court. Your next step is to pick up the phone and call your favorite attorney to file a motion (with the presiding court) explaining (in detail) why you are requesting the lift.
Exceptions to the Automatic Stay - If a debtor is filing the second bankruptcy within a year, the automatic stay applies only for 30 days unless extended by the court. If a debtor is filing a third time within a year, the automatic stay goes into effect only by the request of the debtor (if the third filing was in good faith).
Hmmm.. Courts take the automatic stay very seriously. There are consequences for failure to abide by these rules. So keeping your nose clean will keep you out of trouble. Violation of the automatic stay can lead to contempt of court.
Expiration of the stay
With respect to acts against property of the estate – the stay expires when property no longer belongs to the estate.
With respect to the debtor – the stay expires the earlier of when the case is closed or when the case is dismissed.
There are many exceptions and caveats to the automatic stay. If you have further questions regarding this you should seek legal counsel.
Exceptions to the Automatic Stay
What is it? Think of reclamation as a way to “reclaim” the goods that you sold on credit. Once the goods have been delivered or paid for, title has transferred. But, the Uniform Commercial Code (UCC) defines a process to get your goods back in the event of insolvency. The caveat is that successful reclamation requires cooperation with the debtor, who is already in bankruptcy and most likely unwilling to help.
What does it mean to me? Both the UCC and the Bankruptcy Code provide very clear direction on the reclamation process. What you can and cannot do is spelled out for you. Under the UCC, it is the seller’s right to demand that an insolvent (defined as easily as liabilities > assets) buyer return goods purchased on credit. A seller can reclaim goods delivered to a buyer if the seller satisfies the following conditions:
- The goods were shipped on credit
- The buyer was insolvent at the time it received the goods
- The seller demands return of the goods within 10 days of the buyer’s receipt of the goods
- The buyer is in possession of the goods when the seller made the reclamation demand.
Reclamation in bankruptcy: It is important to understand that reclamation rights continue under Section 546(c) of the Bankruptcy Code. Section 546(c) requires a written reclamation demand and expands the reclamation reach-back period to 45 days from the above mentioned 10 days. Note that reclamation rights are subject to any lien on the property sought to be reclaimed.
What do I do? Determine if you have sold them anything on credit in the last 45 days!!
If your answer is NO - get to the back of the line.
If your answer is Yes - Get out your favorite pen again, your "Reclamation Letter" should follow the guidelines below:
- State that it is a demand for reclamation
- Identify the goods subject to the reclamation and include copies of invoices and purchase orders.
- Demand an inventory of the goods on hand and make sure they segregate them until return transportation is arranged.
- Send letter through email, fax and certified carrier to include a signed return receipt.
- For a sample demand letter see the Manual of Credit and Commercial Laws from NACM.
What has to be on the other side for this to work?
- The buyer has to have your goods
- Goods have to be identifiable as yours
- Goods cannot be altered or processed (Must look as shipped)
- Goods are not subject to a lien
WARNING! Once a customer files bankruptcy, a reclamation demand must be sent within 20 days or reclamation rights are lost! Best practice is to send the demand as soon as possible because reclamation rights are only valid if the debtor still has the goods.
Demand Deadlines:The 45-day reach-back period is based on the physical receipt of good, for instance when the goods are delivered and signed for.
Hmmm...Computing 45 day reach-back: Begin counting backward starting the day before filing date. If your goods were received (title transferred) during this time, then they fall within your reclamation rights.
Early Case Considerations
“How do i put myself higher on the Totem Pole!”
First, answer this question:
ARE YOU A SUPPLIER OF GOODS OR SERVICES?
If the answer is “goods,” keep reading here.
If the answer is “services,” sorry! You will not have a priority administrative claim.
What is it – 503(b)(9) elevates all or a portion of the goods supplied to the debtor 20 days prior to the bankruptcy filing from a low priority general unsecured claim to a higher priority administrative claim. The goods must be sold in the ordinary course of business.
What does it mean for me – The 20-day portion of your claim has a much better chance of being paid in full. While secured creditors still retain priority over your 503(b)(9) claim, it’s still much better than being a general unsecured creditor. Unlike a reclamation claim, a 503(b)(9) claim is still available even if a secured creditor has a lien on the goods you shipped and if the debtor has already sold the goods.
What do I do – you must file a motion for allowance and payments of your 503(b)(9) claim. Always consult counsel for assistance with these filings.
Hmmm.. Check the local rules and any orders in the bankruptcy case that permit or require the filing of 503(b)(9) claims by proof of claim form rather than by motion
“The court may not know about you”
What is it? A debtor must provide a list of all known creditors when filing a petition for bankruptcy. You may or may not be a known creditor. It is important to verify that you have been listed as a creditor, your company is listed accurately and the amount owed is correct. If you are not listed as a creditor and do not have notice of the bankruptcy filing, it may preserve your right to continue collection action. (Talk to your legal counsel)
What do I do? You should obtain a schedule of creditors in the bankruptcy case. You can find the court filings through Pacer, or your attorney can get them.
“Proving they owe you money”
What is it? A proof of claim (aka POC) is your way of notifying the court that you’re owed pre-petition debt. The actual POC form is a written statement that notifies the bankruptcy court, the debtor, the trustee, and other interested parties that a creditor wishes to assert its right to receive a distribution (pay out) from the bankruptcy estate.
What does it mean to me? You need to decide if you’re going to file a POC. There will be a notice sent telling you to "file a proof of claim" and list a deadline (Bar Date) to get your claim filed or not to file a proof of claim. In most Chapter 7 and Chapter 13 bankruptcy cases where there are assets to distribute, creditors must file a proof of claim in order to get paid.
What do I do? File a claim because failure to do so will result in no distributions (if there are any).
What to attach - All supporting documentation to support the basis and amount of the claim, including any applicable contracts, invoices, purchase orders, account statements, and security interest (if secured), etc. DO NOT send originals! Take copies of the documents and keep a copy for yourself as well.
WARNING! Be aware of the deadline because late-filed claims may not be allowed.
If your claim is an Unsecured Debt - To see a sample proof of claim go to: http://www.uscourts.gov/forms/bankruptcy-forms/proof-claim-0
A creditor may file a proof of claim on its own, but some may wish to consult with legal counsel.
** Do I qualify as a critical vendor? – Ask yourself, will the debtor survive without you (or at least your goods and services)? If yes, Skip ahead to critical vendor discussion.
If your claim is a Secured Debt - If your debt is secured or you think you deserve "Priority" status, the proof of claim may be more complex and you might wish to consult legal counsel.
Understanding how to prepare and file a proof of claim is critically important for any creditor
WHERE DO I SEND THE CLAIM? – Typically you will send this to the clerk of the bankruptcy court where the filing is held, or in some cases, to a claims agent that may be appointed (which can be determined by looking at the case docket).
HOW DO I SEND CLAIM? – It is recommended that you submit your claim via reputable carrier (UPS/FEDEX) with tracking to ensure timely delivery.
WARNING! A claim is only considered timely if it is actually received by the claims bar date.
Don't file a claim- If you receive notice not to file a proof of claim, it has been determined that no assets have been discovered yet to make a distribution to creditors. If assets are discovered, you will receive a notice setting a deadline to file a proof of claim.
New Rule-Supporting documents must be attached. Exception: If supporting documents have been lost or destroyed (but must attach explanation of circumstances)
“Is is worth it for us to fight this?”
What does this mean to me? You need to weigh the amount of your claim with the anticipated legal fees if represented by counsel. Administrative and legal expenses can be costly, especially in complex chapter 11 cases.
What does it mean to me? You need to identify which chapter of bankruptcy you’re dealing with. The chapter will help determine the likelihood of any recovery (7, 11 or 13):
- Liquidation (chapter 7) - Filed by individuals or companies. Creditors must file a proof of claim in order to be eligible for a distribution.
- Reorganization (chapter 11) - Most common type of business filing. Intended as a reorganization. Can result in a plan or a sale of assets, among other results. The company remains in control of its assets and has all rights of a trustee. If the creditor is listed on debtor’s schedules in a chapter 11 bankruptcy and creditor agrees with amount listed by debtor as being owed, creditor does not need to file a proof of claim (unless the creditor’s claim (i) is listed on the schedules as disputed, unliquidated or contingent or (ii) is not listed on the schedules, in which case the creditor must file a proof of claim in order to be eligible for a distribution).
- Repayment (chapter 13) - Filed by individuals who retain assets and pay creditors over time under a structured plan
Hmmm.. Main difference between 7 & 13 - 7 = property of the estate is whatever debtor had at the time of the bankruptcy filing. 13 = property of the estate includes any property obtained by the debtor after bankruptcy filing until the time plan is confirmed.
What do I do? You need to determine if the debt is Secured or Unsecured. In other words, how is the debt classified by the court? Once you’ve classified your debt, make a final decision on how to proceed with filing your claim with the court.
Secured - Has the benefit of a security interest over some or all of the assets of the debtor. Was the security interest perfected over 90 days prior to Bankruptcy? You get paid first (even before the lawyers). File a claim.
Unsecured - Does not have the benefit of any security interest. Typically, but not always, is paid less than full value and pro rata with other unsecured creditors. See prior section on 503(b)(9) claims how your unsecured claim can be elevated to a priority administrative unsecured claim. Elevating all or a portion of a supplier’s claim from a low priority general unsecured claim to a higher priority administrative expense claim.
Can the debtor's business survive without you?
What is it? - Critical vendors are those that are essential to the bankrupt business’s survival in chapter 11. In other words, you’re supplying a product or service so important to the debtor’s business operation that without it, the debtor would fail to reorganize.
What does it mean to me? - If you supply a product or service that is so critical to the debtor’s operations that finding a replacement vendor would be overly burdensome on the debtor, the bankruptcy court may grant you critical vendor status. If you supply a product that is easily obtained from any other vendor, it is unlikely that the court will grant your critical vendor status. The benefit to becoming a critical vendor is that you can obtain payment in full of your prepetition claim. It also is a likely indicator that your relationship will survive a sale of the debtor’s assets and that your contract (if you have one) potentially will be assumed by the buyer. Often, however, as a quid pro quo for payment of your prepetition claim, you will be asked to extend the same credit terms as they had prior to the bankruptcy. This frequently is done through execution of a critical vendor contract which often provides that your critical vendor payment will be subject to clawback if you “misbehave” (i.e., revoke credit terms without justification). In addition, critical vendors rarely are given a preference waiver, so any payments you received in the 90 days prior to the debtor’s bankruptcy filing may still be subject to recovery by the debtor (subject to any preference defenses you may have – see discussion below on preference defenses).
How to get selected as a Critical Vendor:
To be considered a critical vendor, the debtor must file a motion with the bankruptcy court and prove to the judge that a creditor’s products are necessary to the survival of the business and difficult or impossible to get from other vendors. If the debtor is able to carry this burden then it will be authorized to pay its critical vendors in full.
In order to grant a supplier critical vendor status, courts look at several factors:
- Debtor needs particular products for the company to survive
- Vendor likely would stop selling the debtor absent payment of its prepetition claim.
- Whether payment to critical vendors (and therefore continued supply from those vendors) would increase the likelihood of a successful reorganization.
WARNING! Tread lightly when discussing critical vendor status because if you approach the debtor it can be deemed a violation of the automatic stay.
Are you as big of a deal as you think you are?
What is it? Are you one of the largest unsecured creditors? If so, you might consider becoming a member of the creditors committee. The unsecured creditors' committee is appointed by the U.S. trustee, in a chapter 11 case, and is made up of the largest unsecured creditors (usually 7 but sometimes fewer) of the debtors who are willing to serve. Committee members have a more active role than other creditors and have greater access to information and to the debtor’s representatives. The committee represents the interests of all unsecured creditors in a fiduciary capacity.
What do I do? A creditors committee must first be formed. The US trustee owns the process of forming the committee.
- The U.S. Trustee may appoint a committee as soon as possible after the bankruptcy case is filed if there is significant interest among unsecured creditors.
- The process begins with the US trustee sending a questionnaire to the largest unsecured creditors. Creditors interested in becoming a member of the committee complete and return the questionnaire to the U.S. trustee. From that point the U.S. trustee convenes an in person meeting of those creditors that are interested in serving. The trustee will select members of the committee from among those who submitted questionnaires and are present at the meeting (although sometimes this is done based on the questionnaires alone without an in person meeting).
What does it mean to me? The committee has official duties and responsibilities. There is a time commitment involved with being a committee member.
- Review the progress and status of the case and discuss the same with the debtor. Also, the debtor is required to file periodic financial reports with the Court and the Office of the United States Trustee. These reports should provide valuable information for the committee.
- Investigate the financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of the business.
- Participate in the formulation of a plan.
- Ask the Court to appoint an examiner in the case. An examiner is a professional (often a CPA) with the expertise to investigate the business and file a report drawing conclusions regarding the viability of the same, the competence of past or current management, possible fraud, etc.
- Request the appointment of a trustee. A trustee is an independent third party charged with the responsibility of controlling estate assets.
- Ask the Court to either dismiss the case or to convert it to one under Chapter 7 (liquidation). One cause for dismissal or conversion is unreasonable delay which is prejudicial to creditors.
The Bankruptcy Code provides further that the debtor must meet with the creditor's committee to transact such business as may be necessary and proper, and that the debtor shall furnish to the committee, upon request, information concerning the debtor's business and its administration. If in the performance of its duties, the committee would be aided by the services of an attorney,
Accountant or other professional, the Code provides a means for the appointment of such individuals as may be selected by the committee. The compensation of such individuals will be paid from assets of the debtor's estate, and will not be chargeable directly to individual committee members.
Think About It! - Considerations Throughout the Entire Case....
"You mean they are still in business?"
What is it? Some creditors may decide to sell to a debtor after they’ve filed chapter 11 bankruptcy. The debtor in bankruptcy, known as a Debtor in Possession (DIP), is now essentially creating new debt that is not part of the bankruptcy case.
Vendors need to manage their post-petition credit risk very closely. Due to the possibility that a debtor may have limited cash flow through the bankruptcy process, vendors may want to consider whether to continue doing business, and if so, under what terms. Steps in determining a debtor’s post-petition liquidity include searching PACER to determine whether the debtor has authority to use its lenders cash collateral or has obtained DIP financing. This information might help you as the creditor feel more comfortable with the debtors’ ability to pay you for post-petition shipments. In addition, if the debtor fails to pay you for any post-petition shipment you are entitled to a higher priority administrative claim for those shipments (although there is no guarantee administrative claims are paid in full). If you are not comfortable extending credit post-petition, you can impose COD or cash in advance terms or elect not to ship at all.
"What? I might have to pay money back to the bankruptcy estate?"
The answer to this is “yes” - Keep reading.
What is it? Preference and fraudulent transfer actions are some of the most common bankruptcy-related claims that creditors face. It may not seem fair, but it’s a reality of bankruptcy. The US Trustee will review all payments made to creditors going back 90 days from the date of filing. Any transfer (payment) made by the debtor to the creditor will be analyzed by the trustee. The intent of preference & fraudulent transfers analysis is to prevent a debtor from “preferentially” paying one creditor over another or “fraudulently” transferring assets to another party. The concept is rooted in fairness.
What does it mean to me? No creditor wants to receive a preference action. Nonetheless, you have to deal with it. You may receive a “demand letter” from the US trustee. The demand letter lists the payments that the trustee or debtor-in-possession identifies as having been made to you within the 90-day period. The demand is for immediate payment, usually less some small discount. When a creditor receives a preference demand letter, the creditor should always have experienced bankruptcy counsel review the case to determine whether the creditor has valid defenses (explained more below).
What do I do? You have to defend the preference action. The trustee or debtor-in-possession has the initial burden of proving that the elements of a preference exist. For starters, a prepayment is not a preference (even if the prepayment was received within the 90 days before bankruptcy). The Bankruptcy Code provides defenses to preference actions. The three most common are all “affirmative defenses,” meaning that the creditor has the ultimate burden of proof on these issues. The most common defenses used by creditors are explained below:
Creditors often are concerned about taking payments from their customers when the customer is known to be headed into bankruptcy. The reason is that the payment might be subject to clawback as a preference. Consider, however, that it often is better to have the money in-hand for several reasons:
- You have use of the money,
- The burden is then on the trustee to come after you to try to recover it as a preference, and
- You might have defenses to a later preference claim.
As it is often said, “possession is 9/10ths of the battle!” So, take the payment.
Ordinary Course of Business Defense – This defense is highly subjective, but the most common methodology is to look at the debtor’s payment history to evaluate its average time to pay your invoices for some period of time prior to the 90-day preference period. Did the timing stay consistent before and during the 90-day preference period? You may also use the average time for payment in the relevant industry to prove the ordinary course of business defense. What is the typical payment timing for other companies in the same industry? (Depending upon the court, the relevant industry might be the creditor’s or the debtor’s industry, if they are different.)
Contemporaneous exchange for new goods or services Defense - The creditor proves the “contemporaneous exchange” defense by showing that the creditor provided new goods or services contemporaneously with (i.e. at or near the same time) a payment that was of equal value to the goods or services provided and that the parties intended the transaction to be a “contemporaneous exchange.” For example, if the creditor delivers goods worth $100 on June 1 and is paid $100 for those goods on June 2, so long as the parties intended the $100 payment to be for the $100 in new goods and intended that the payment would occur “substantially contemporaneously” with delivery of the goods, then the contemporaneous exchange defense applies.
New Value Defense – This defense gives you credit for goods that you ship during the 90-day period after you have received an otherwise preferential payment. The value of any “new” goods or services shipped during the 90-day period after an otherwise preferential payment can be offset dollar-for-dollar against any prior preferential payments made by the debtor. In order to use this defense, most courts require that the later shipment remain unpaid, although some courts will count the later shipment as new value even if you have been paid for that shipment. Mechanically, using a simple example, this defense works as follows: you receive a $10,000 payment on Day 80 prior to the bankruptcy filing and ship $7,500 of new goods (for which you were not paid) on Day 70 prior to the bankruptcy filing. Under this scenario, assuming that the $10,000 payment meets all of the elements of a preference and would otherwise be avoidable by the trustee, you are entitled to offset the $7,500 shipment such that your net exposure is $2,500. This defense is much more objective than the ordinary course of business defense.
Don’t get comfortable! They have 2 years from the date of filing to file a preference lawsuit.
"Wait! We have a contract! What do I do now?"
AKA - Executory Contracts
This can be a complicated issue in any chapter 11 bankruptcy case, but don’t let the fancy words intimidate you. This area of bankruptcy is understood by only a small number of people with a specialized knowledge or interest. If you’re confused, that’s okay. We’ll walk through the basics, but it’s always wise to consult bankruptcy counsel if you are aware of any existing contracts that require performance by either you or the debtor.
What is it? - An executory contract is a contract that has not yet been fully performed, that is to say, fully executed. Put another way, it's a contract under which both sides still have important performance remaining, even if your customer is in bankruptcy.
What does it mean to me? If you are a party to a pre-petition contract (aka executory contract), debtors and bankruptcy trustees are authorized to “assume or reject” these contracts in bankruptcy.
Are you serious? Yes, property interests of the debtor filing for bankruptcy become property of the estate. An executory contract is property of the bankruptcy estate.
Why? The Bankruptcy Code allows debtors to shed (i.e., reject) burdensome contracts (e.g., those where the debtor is paying more than current fair market value) and to retain (i.e., assume) beneficial contracts.
How? Only with bankruptcy court approval can the debtor “assume or reject” an executory contract. As a party to an executory contract, the debtor is required to send you notice of a motion seeking authority to assume or reject your contract and you are given an opportunity to object, if appropriate. Bankruptcy courts defer to the debtor’s business judgment when deciding whether to permit assumption or rejection of an executory contract.
What does Assumption mean for me? A debtor may assume an executory contract by:
Obtaining an order from the bankruptcy court permitting assumption of such contract after notice and an opportunity for the non-debtor counterparty to be heard in the bankruptcy court
Confirming a plan of reorganization, which provides for assumption of the contract.
If your contract is assumed, you are entitled to a cure of all defaults (with limited exceptions). This means that if you are owed money under a contract for prepetition sales, if your contract is assumed, you will receive payment in full of your prepetition claim (as opposed to payment of some cents on the dollar).
What does Rejection mean for me? Rejection of an executory contract is essentially the debtor’s declaration that it will not perform its remaining obligations. Upon rejection, the debtor no longer can be compelled to perform.
What do I do?
If you receive a notice that the debtor is seeking to assume your contract, it should include what the debtor believes is the amount needed to cure any defaults. You should review this carefully to be sure that you agree with the amount. If you do not, you will want to retain bankruptcy counsel who can file an objection for you to assert the correct cure amount.
If you receive a notice that the debtor is seeking to reject your contract, first consider whether it is a leverage play by the debtor to try to get you to renegotiate the terms of your contract in exchange for continued business. If the contract is one you would prefer not to lose, you might wish to contact the debtor to see whether negotiations are possible. But know that it is ultimately the debtor’s right to reject your contract. If your contract is rejected, you are entitled to file a “rejection claim.” The order authorizing the rejection or a subsequent notice should tell you the deadline to file your rejection claim. A rejection claim is a claim based upon the debtor’s breach of your contract, which is what is deemed to have happened upon rejection. It is as though you are filing a lawsuit in state court against the debtor seeking damages for the debtor’s breach, but instead you are asserting those damages in the form of a rejection claim in the debtor’s bankruptcy case. The rejection claim is treated as a general unsecured claim.
WARNING! Beware the $0 cure. Often, in the context of a sale of the debtor’s assets, a notice will be sent to many contract counterparties at once stating that the contracts identified on an attached exhibit will be assumed and assigned to the buyer as part of the sale. In many cases, the exhibit is lengthy and the notice requires that any objections must be filed within a very short period of time. Be on the lookout for a $0 cure amount! If your contract is listed and the cure is erroneously listed as $0 but you do not object timely, you will not be entitled to any cure and will lose one of the greatest benefits of having your contract assumed.
Be cautious and monitor all filings and due dates. Deadlines are simply that... DEADLINES! Late or misfiled paperwork can cost you the ENTIRE amount of your claim.
Most proceedings take months and sometimes years to unwind. Use this time to read up on bankruptcy proceedings so next time, you will be ready.
Hmmm.. There are so many things here that should be considered. Too many to get into in this “highlights only” document. 90-day lookback, prepayment, practical considerations, key defenses, ordinary course of business, new value, contemporaneous exchange etc. etc.
NACM has many resources available; start with the latest edition of "Manual of Credit and Commercial Laws" by National Association of Credit Management(NACM). The information is fantastic and sample forms are even provided. A no brainer for sure. As sure as you are that you have all your ducks in a row, you are not an expert. The trickier the case and higher dollar amount at stake, the greater the likelihood you should obtain legal counsel.
Mark Dunham – Lieutenant Colonel Retired - US Navy & Air National Guard
The Meridian Group | 223 Fourth Ave, Suite 1700 Pittsburgh, Pennsylvania 15222-1713 | (412) 232-0113
The United States Department of Justice | “Information For Prospective Creditor Committee Members On Chapter 11 Cases”
Manual of Credit and Commercial Laws - 2014 Edition
Principles of Business Credit 7th Edition
3 A.M. Flashbacks
UCC Article 9 for Dummies
Graduate School of Credit and Financial Management
By: Christen Borman, Douglas Jacobson, Jovan Rosa, Rocky Thomas, Susan Thomas, and Melvin Ucelo
“Risk comes from not knowing what you’re doing”
As a credit manager in the world of business to business (B2B) commerce, it is your job to facilitate sales while managing the risk associated with the extension of credit and protecting your company’s investment in accounts receivable. Trade credit is essential to the accommodation of sales growth and, as we know, there is always some risk associated with the extension of credit. Unfortunately, as B2B creditors, we often don’t have the luxury of requiring collateral to extend credit. The prudent and risk free approach would be to require payment at the time of the transaction. However, the last we checked, our companies have sales growth, increased market share and profitability as their core goals. In a competitive environment, it is essential that we find ways to efficiently leverage the extension of credit to accommodate these goals.
The good news is that there are laws and regulations that provide protection for B2B creditors and give us legal remedies to help mitigate the risk that comes with the extension of trade credit. It is called the Uniform Commercial Code (UCC). The bad news is that most of us are not legal experts and it can be a daunting task to research and understand the UCC. We are hopeful that “UCC Article 9 for Dummies” will provide a quick guide to help the commercial creditor take advantage of the tools available to successfully secure their accounts receivable.
Legal codes and laws are not an easy subject to understand. The Uniform Commercial Code contains the legal framework that governs commercial business transactions. The articles of the UCC are a set of laws governing the sale of goods, leases, negotiable instruments, bank deposits, funds transfers, letter of credit, bulk transfers, bulk sales, warehouse receipts, bills of lading, investment securities and secured transactions. Within the code one of the most important articles is Article 9, Secured Transactions, which provides the governing rules for any transaction that combines a debt with a creditor’s interest in a debtor’s personal property. In 1998 revisions to Article 9 were completed and were approved by all fifty states by 2001. Article 9 provides a detailed instruction manual on steps to take to legally protect a debt by staking a claim in the debtor’s property.
The understanding and use of the basic elements of a secured transaction in Article 9 can be a daunting task. It requires a thorough understanding of the code and any new amendments. A creditor must be able to follow the process, comprehend the scheme and implement a solution that best fits the purpose of mitigating the risk. In most scenarios, the creditor can gain superior bargaining power by requiring the debtor to provide a security interest to the creditor as part of the transaction. This is done before granting a loan or providing something of value in order to maximize the likelihood of payment in the event that the debtor does not comply with the terms of the agreement. The creditor can exercise its rights created under Article 9. For this to be successful it is important to create an enforceable security interest “Attachment”, protect the security interest from claims of other parties to the collateral “Perfection”, and have the highest “Priority”.
As part of the process, it is always important that the choice of law and the parties’ jurisdiction is well defined in order to enforce rights with no delay. This usually is where the debtor is. Complications arise from the need to understand the common legal definitions used throughout article’s many sections, the fact that its rules have exceptions that a credit manager needs to understand, and that timing of actions and the specificity of documentation, if not followed, will endanger the legal protection the creditor seeks.
UCC Article 9 for Dummies is here to decode and help explain from a credit manager’s perspective, the more relevant aspects of the article and demystify the relevant aspects so we know what to do when it is required to secure a transaction. It’s meant to give a high level view of the code and to highlight the riskier areas. A credit manager should always seek advice from legal counsel regarding specific questions of law, especially if the monetary exposure is large.
The credit manager must ensure that all requirements of Article 9 are properly met and documented to obtain a legal claim in a debtor’s collateral if the debtor does not pay or satisfy its obligations. The credit manager must then take the steps necessary to insure that the legal claim established has priority over other creditors.
The illustration below attempts to capture the main areas of the code that a credit manager must be familiar with to protect his or her company’s financial exposure to a non-paying customer. Definitions of underlined terms are summarized in the glossary.
The main point of Article 9 is to be a secured creditor:
If a creditor is secured it has a claim in something of the buyer’s (the goods exchanged for future payment or other collateral). This gives the creditor:
- Right of repossession of goods extended in exchange for future payment if the payment is never made
- Elevated priority in the potential proceeds? Even if the buyer is filing bankruptcy
- It upholds defense to preference in the potential instance of a bankruptcy filing.
However, a creditor cannot be secured or have the claim in the asset until its interest is perfected.
What is a security interest?
A security interest is an interest in the asset of a buyer. This is important for creditors to leverage their position of being able to fully collect money extended to buyers.
A blanket interest securitization can be made and is often the case with banks that have an interest in all applicable assets of a buyer (except for some real property, aircraft, ships and motor vehicles). A Purchase Money Security Interest (“PMSI”) is applicable when the buyer takes possession of the goods from the creditor and it allows the creditor to seek a super-priority security interest, putting them above all other secured creditors in security ranking. PMSI filings are the only ones that require notification to other secured creditors of the filing since it gives that creditor super-priority interest.
What is collateral and why is it needed in a security interest?
The asset (collateral) in a security interest must be personal property but cannot be real property, aircraft, ships or motor vehicles.
Typical collateral involved in a security interest:
- Accounts receivable
- Stocks, bonds and negotiable instruments
Essentially, the collateral acts as the proceeds to which the security interest attaches. The common types of collateral in a security interest are blanket, consignment, or specifically listing the assets or a Purchase Money Security Interest.
It is imperative that a secured party handles collateral with care. The following case is an example of a creditor’s breach of this duty.
Collateral—Must handle with care!United States v. Baus The secured party neglected to take proper care of collateral consisting of debtor’s plant, machinery, equipment and inventory located in Puerto Rico by leaving it in an unsecured warehouse for two years. Theft and vandalism caused the sale of the remaining inventory to be delayed and led to an 88 percent decline in the value. The $100,000 of the debtor’s inventory netted just $12,131 after the expenses of the sale were taken out. The First Circuit found it “likely” that the government guarantor had breached its duties under Section 9-207
Who is responsible for taking care of the collateral?
Practical expenses incurred in ensuring the proper care of collateral are chargeable to the debtor and secured on the collateral. An example would be the cost of insurance. If the goods are accidentally lost or damaged any shortfall in the insurance rests on the debtor. Payment of taxes and other charges directly related to the preservation, custody, or operation of collateral also fall under this category.
Collateral in Action—Use it don’t lose it!
Collateral Description Errors causing failure to perfect
1st Source Bank vs. Wilson Bank & Trust (Tennessee)
The US Court of Appeals for the Sixth Circuit ruled that a creditor bank did not have a perfected security interest in the debtor’s accounts receivable because “the bank failed to include ‘accounts’ or ‘accounts receivable’ as part of the bank’s collateral in its UCC financing statement” even though those words were used in the security agreement.
Ref: source: Business Credit Magazine, May 2014 – “Mistakes in a UCC Financing Statement’s Collateral Description
Can Be Hazardous to a Perfected Security Interest!”
So now I have an interest in the collateral of my buyer - what do I do next?
File a security agreement!
The security agreement indicates the creditor’s right to file a security interest in the specifically named assets of the buyer, which acts as the collateral to uphold the agreement. In order for a creditor to have a valid security interest the agreement must be signed (authenticated) by both the creditor and the buyer, contain a description of the collateral, and make it clear that the security interest is intended.
Why are people telling me I need to be perfect in this process?
What is perfection in a security interest?
Perfection is when the creditor has filed their security agreement between them and the buyer. It is filed with the secretary of the state that the buyer is registered as a business entity in (or resides in if a sole proprietor). If the buyer is registered in multiple states, multiple security interests can be filed per state. If you don’t file your security agreement, you don’t have your security interest and you don’t have any secured rights in your buyer’s collateral. This would mean…You aren’t perfect!
Importance of Perfection!
Debtor Name Errors causing failure to perfect
1st Source Bank vs. Wilson Bank & Trust (Tennessee)
The creditor, CCF Leasing Company, filed a UCC-1 statement but listed the debtor as “Wing Fine Food”. Because a UCC search using the secretary of state’s search logic would not have produced the financing statement, the court found the filing to be fatally flawed and Wing Foods, Inc. was able to avoid the creditor’s security interest claim.
Ref: NCS Credit blog 11/12/2014
But I don’t have time to go to the Secretary of State!
Due to the detailed requirements of filing (including notification, most creditors prefer to use a qualified service, such as NACM’s MLBS.
Due to the detailed requirements of filing (including notification), most creditors prefer to use a qualified service. However, if you wanted to file a financing statement on your own, you must first make sure you have all the proper documents. You would then submit these documents to the central filing office in the state the debtor resides or its business is registered. This is commonly done electronically. Each state has its own rules for filing so further research must be done in order to ensure full compliance to that state’s requirements.
Required documents to file a financing statement:
UCC1-UCC Financing Statement – this is a Unified Commercial Code form prepared by the company granting credit. When it is filed appropriately it gives public notice that a creditor has a security interest in collateral belonging to the customer documented in the statement. The financing statement must be filed with the office of the appropriate government agency, generally the office of the Secretary of State of the buyer’s location.
Sample of UCC1 Template
How do I know my filing is complete?
Upon request at the filing office, you can obtain notification of acknowledgement when the filing is complete. A specific number is assigned to each UCC filing for identification and will be provided with the requested acknowledgement. This number is referred to as the file number. Furthermore, the date and time of the filing is critical given the hierarchy of security interests by date.
First in line, first in right—except for PMSI filings!
Therefore, the date and time will be recorded with each filing as well.
The filing office where the documents were submitted is the place that maintains the records of the financing statement and any attached documents. At least annually all states must review their filing-office rules to ensure compliance and effectiveness.
A creditor can search for records of financing statements by the debtor name or file number if they know it.
A filing can be refused for several reasons, like when it is not received properly (must be original document), the filing fee isn’t paid, an incomplete or invalid name for debtor or does not have attaching and complete financing statement. However, the filing office must communicate the refusal within two business days from receiving the record. Method of communication depends on the state requirements. Each state also has statutory requirements of holding public record documents that would dictate when they can destruct written records of financing statements.
What are the rules of priority and are there ways to obtain priority over existing creditors?
It is important for the creditor to know the rules of priority and determine the steps necessary to ensure that he is protected. Remember that the UCC -1 must be filed – your security agreement is worthless until the filing is complete. In most cases, if there is bank financing, they will usually have a perfected blanket UCC -1 that takes priority. This why it is important to do a thorough search of all prior filings to determine the effectiveness of your filing.
Rules of Priority:
- Determined by the time of filing or perfection – the first filed has the first right
- It includes both proceeds and the supporting obligations of the collateral
- Perfected interests can be subordinated (see PMSI) with the permission of prior secured parties
Can I secure future shipments that will take priority over existing security interests?
As indicated earlier, many times a bank or other secured lender will have a blanket UCC-1 that gives it priority interest in all inventory and proceeds of the debtor. However, there is way to secure goods and proceeds before they are shipped. This is done through a Purchase Money Security Interest (PMSI). A PMSI grants a security interest to the trade creditor sold on credit terms for the price of the goods sold.
A key advantage gained by a PMSI is that it gives the creditor access to co-mingled funds not specifically identifiable by the creditor or the courts.
Rules and requirements:
- Only covers goods and proceeds sold on credit terms moving forward – does not cover existing debt.
- The debtor must agree and sign off
- Must describe in detail the goods or inventory that is covered
- Always do a UCC search to determine existing secured parties
- The secured party (most often a bank) must be notified and grant a priority for the good s or proceeds of the creditor prior to the debt being incurred. This is called a subordination. It is usually not granted unless the secured party determines that it is in their best interest and provides the potential for additional income and profits.
- Must be filed and recorded once completed and signed.
- The PMSI is perfected once the debtor takes possession of the inventory
- You must send official notification to the holder of the prior security interest prior to debtor taking possession
Sample Purchase Money Security Interest
How do I enforce my security interest once it is in place?
A security interest attaches to collateral and becomes enforceable if:
- value has been given
- the debtor has rights in it and/or the authority to transfer rights to a secured party.
AND if any of a number of conditions are met, one being:
- an authenticated security agreement giving a description of the collateral is completed
What happens if my customer (debtor) defaults?
Secured Creditors in Action!
Assuming that you have filed all of the necessary paperwork and perfected your security interest, there may come a time when a customer defaults on the agreement. At that point there are several options available to you to enforce your lien against the collateral.
Three things you can do:
- Foreclose on the collateral
- Claim a judgment against your customer
- Enforce a claim against your customer in court
As a creditor you may deduct reasonable attorney fees and collection expenses incurred during the repossession of your collateral.
As a creditor you can sell, lease, license, or otherwise dispose of any or all of the collateral covered by the security agreement as long as it is reasonable to both parties. If you are going to dispose of the collateral, you must send notification to the customer and any secondary lien holder unless they waive their right to the disposition of the collateral. In most cases a 10-day notice is sufficient.
All proceeds that are received over and above any debt owed must be returned to the customer or to a subordinate security interest holder. The customer would still be liable for any deficiency amount that is owed after the collateral is seized.
Upon default you may require your customer to assemble the collateral and make it available to you at a place of your choosing and is convenient for both you and your customer.
Notice of disposition should include a description of the collateral to be sold, leased, or licensed, the method of disposition, charges associated with the sale or disposition, and time and place of the disposition.
We will sell (lease or license) the following collateral privately sometime after this date. You are entitled to an accounting of the unpaid indebtedness secured by the property that we intend to sell (lease or license) for the amount of $_______. You may request an accounting by call us at (telephone #).
For a consumer goods transaction:
Name and address of creditor and date
Example: Notice of our plan to sell property
Name and address of debtor
Identification of collateral
We have your collateral and because you broke promises in our agreement we will sell (description of collateral) at a private sale sometime after (date). The money that we get from the sale (after paying our costs) will reduce the amount that you owe. If we get less money than you owe, you will still be responsible for the difference. If we get more money than you owe, you will get the excess unless there is a secondary lien holder. You can get the property back at any time before we sell it by paying us the full amount you owe, including our expenses. For a balance owed please call us at (telephone #). We are also notifying other individuals who may have an interest in this collateral or who owe money under your agreement. (List names of other possible lien holders if any).
Acceptance of collateral in full or partial satisfaction of the obligation can be done only at the debtor’s consent within 20 days of notification. This does not require you as a creditor to dispose of the collateral (Does not apply to consumer transactions)
In consumer transactions collateral must be disposed of within 90 days after taking possession or within a longer period to which the customer and secondary lien holders have agreed to.
The customer or a secondary lien holder has the right to redeem the collateral for full payment of the obligation at any time prior to disposition.
Default—Mistakes can be costly!
Sports Authority Bankruptcy and Implication on UCC Consignment deals:
Sports Authority initially filed Chapter 11 bankruptcy to reorganize its structure and become a much smaller retailer of sports merchandise and clothing. However, in the midst of the initial bankruptcy proceedings the creditors became aware that Sports Authority was listing inventory as an asset when the inventory was in fact part of consignment deals and therefore not assets of Sports Authority but still assets of suppliers (creditors). This critical issue forced Sports Authority into Chapter 7 bankruptcy because it had been overstating its assets and blurring the true financial disarray it was in.
During the bankruptcy the court ordered Sports Authority to start liquidating its assets which caused an argument over the proceeds of the sale of consignment items. Should the proceeds go lenders with secured interests in Sports Authority or go directly back to the suppliers with the consignment agreements that claimed they still owned the items up for sale in the liquidation?
Alas, the crux of the issue acknowledged that had the suppliers protected their consignment agreements by perfecting a security interest and notifying lenders to not use the consignment goods as collateral in their security interests of Sports Authority. This is a critical part of UCC Article 9 and important for all creditors to be aware of in their dealings of consignment issues.
The purpose of Article 9
For creditors to gain a security interest in personal property (assets) of a customer which may elevate their position in collections
Security agreement = security interest
Must have identification of parties, granting clause and collateral (asset) description
No UCC-1 = Not perfected = Not a secured creditor
To become a secured creditor à perfect security interest by filing a UCC-1 with the proper filing clerk
With a perfected interest a secured creditor has:
- Right of repossession of the asset
- Elevated priority in bankruptcy
- Defense to preference in bankruptcy
Mistakes are costly
Always review your work for accuracy. Utilize a third party for additional verification to confirm all steps are complete.
Attachment – when a security agreement is executed and the debtor acquires right in the assets subject to the security interest (collateral). The creditor’s security interest becomes enforceable.
Collateral – property subject to a security interest. Laws vary regarding various types of collateral and the legal jurisdiction. Typical personal property involved in a security interest includes inventory, fixtures, equipment, vehicles, accounts receivable, and stocks/bonds/ negotiable instruments. It cannot be real property.
Control – Control of collateral does not mean the same thing as possession of collateral. See UCC Article 9 parts 1 and 2.
Lien – official claim an asset for payment of a debt or an amount owed by a buyer. It is usually a formal document signed by the credit provider and sometimes by the buyer who agrees to the amount due.
Perfection – a legal process by which a secured creditor can protect itself against claims of other third parties who wish to have their debts satisfied out of the same debtor collateral
Possession – with respect to collateral, possession is the control a person intentionally exercises toward that collateral. To possess collateral, a person must have an intention to possess it. A person may be in possession of an asset but that does not imply ownership.
Priority – where your perfected claim falls with respect to other creditors; what is the legal order of collateral disposition
Security Agreement – the debtor agrees to specific points that govern the lien, e.g. collateral and the nature of the debt obligation
Security Interest – an interest in in a customer’s personal assets to secure the repayment of its debt
Purchase Money Security Interest – a specific type of security interest that enables an entity that provides financing for the acquisition of goods or equipment to obtain priority ranking ahead of other secured creditors.
UCC 1 Financing Statement – a UCC form prepared by company granting credit. When it is filed appropriately it gives public notice that a creditor has a security interest in collateral belonging to the customer documented in the statement.
The Basics of Financial Statement Analysis:
From a Credit Professional’s Perspective
By: Charles Edwards, CCE | Vivian Hoang, CCE | Brendon Misik, CCE | Kenny Wine, CCE | John Zummo, CCE
This is a condensed guide to assist credit professionals that are new to requesting and analyzing financial statements or those that are coming to credit from various other departments (accounts receivable, accounts payable, clerical, sales, etc…) and don't have as much (or any) experience working with financial statements. More experienced credit professionals may also be able to utilize the information contained in this guide to enhance and sharpen their financial statement analysis skills. Many companies do not require financial statements and many more didn't require them prior to 2008; however, the number of companies that have added the collection and analysis of financials to their credit file reviews have grown significantly, especially after the recent economic downturn. Many of these companies have now included the collection of financials into their corporate credit policies. It is now more important than ever to not only collect financials, but also be able to analyze them properly and be able to explain your analysis as part of your credit decision. For that reason, it is very important to have at least a basic working knowledge of financial statement analysis and understanding of the key ratios and ideas that go into a sound credit decision. This is what this guide hopes to achieve for the new entrant into credit management.
This guide will walk through the basic ratios to analyze leverage, liquidity, efficiency, profitability, and debt coverage of a company. There will also be an overview on the four basic financial statements (balance sheet, income statement, statement of shareholders’ equity, and statement of cash flows). In addition, the quality differences in financial statements that a credit professional would receive will also be discussed. These will include internally prepared (using QuickBooks or other software), tax returns, compiled, reviewed, audited with a qualified opinion, and audited with an unqualified opinion. The basic financial ratios will show a comparison of two fictitious companies, ABC Corporation and XYZ Corporation. ABC Corp. will be an example of a financially strong company, while the financial statements of XYZ Corp. will be an example of relatively weak financials. The purpose for this would be to allow you, the reader, to follow along with the authors to show performance, and some compare and contrast narrative on what to look for (financially) between these two types of business entities from a credit perspective. Each section will have some “core” financial statement analysis credit metrics, how the calculations are completed, some caveats to watch out for, and “what they mean” from a credit management perspective.
Additional information will be provided on where the reader could go for more subject information to further fine-tune their financial analysis skill set. There will be a short explanation on NACM's credit class offerings followed by a short description of the various NACM-credit designations as well as some suggested financial websites to check out for additional information. We end this paper with a glossary of financial terms and ratios for easy reference, and an appendix with complete financial statement exhibits on both ABC Corp. and XYZ Corp.
Before even beginning the process of analyzing a financial statement, it is important to understand the different types of financial statements, how they are prepared, and how reliable the information contained in them may be. The cover letter of a financial statement should tell you how the financial statement was prepared; depending on the type, we are able to better understand to what level the information was vetted for our reliance on the information provided. The types of financial statements that you are likely to see, in order of least costly and least reliable, are: internal, compiled, reviewed, and audited financial statements. Below is a more thorough explanation of these types of statements.
Internal financial statements are prepared by members of the business without the support or assurance of any outside sources, such as a CPA firm. These types of statements may also be referred to as management prepared or “in-house” financial statements. Internal financial statements would likely not come with a cover letter or notes. This type of financial information is often generated from in-house accounting software such as Quick-Books or Sage, and is only as reliable as the information being entered by the user. For many smaller companies, this may be the only type of financial statement available. Other types of financials include a cost/fee paid to the preparer and may not be pursued if it has not been specifically requested by a lender or investor. There is no assurance that information generated on internal financial statements is accurate. That is not to say this information cannot be useful, but it would require an assessment of the character and expertise of the source in order to better assess how reliable information delivered in this format may be.
Compiled financial statements will involve the assistance of an accounting professional or CPA, but their services are merely to verify that the data is presented in a format consistent with professionally prepared financial statements. The costs are much less than a review or audit, as there will have been little, if any, attempts to verify the underlying financial information. As such, the reliability of the information would rest heavily on the character and expertise of the individual and business producing the information in much the same way as with an in-house financial statement.
Reviewed financial statements are becoming more and more common with small to mid-sized companies in the U.S. A financial statement review is not as thorough or reliable as an audit, but the cost for a review would be less, and thus a review may be more appealing to the entity covering the cost of preparing the financial statements than would a more costly audit. Reviewed financial statements are prepared by a certified public accountant (CPA) and an effort is made to verify much of the information. The scope of a review will vary by firm or circumstance. A thorough review may include many of the same verification activities that would exist in an audit. A review would likely include ratio analysis, investigations of inconsistencies of major journal entries, a review of records, follow up questions from previous reviews, and a review of accounting & other business practices. A review would not require the accountant to gain any significant assurance of internal controls, assess fraud risk, or other types of audit procedures. A review would also not require a CPA firm to express an opinion on the validity of the financial statements, which removes the firm from any accountability in the event of fraud or miss-represented information.
Audited financial statements are the most reliable form of financial statements. An audited financial statement would require the CPA firm preparing the statement to express an opinion on the reliability of the information contained in the statements. There are three types of opinions that may be expressed: unqualified opinion, qualified opinion, and an adverse opinion.
- In an unqualified opinion, the firm conducting the audit represents that the information is presented fairly, in all material respects, and correctly represents the financial position of the business being audited. This is the language you want to see in the cover letter of your audited financial statements.
- A qualified opinion will have identified a specific area in which the firm conducting the audit was not able to confirm that the information expressed was in compliance with either company policies and controls, or the accounting policies governing the audit. This may not mean the information is inaccurate or cannot be relied upon, but you should seek to understand the circumstances and details of a qualified opinion to determine if the qualification would significantly alter the assessment of the financial information and your credit analysis. The terms “except” or “subject to” used in the cover letter after the auditing firm represents that the information is presented fairly, are generally reference points as to why the opinion is qualified.
- An adverse opinion would mean that information was not able to be verified and may indicate fraud or other issues. This could also represent that the accountant or firm conducting the audit was not able to verify that the subject of the audit has the financial wherewithal to be considered a going concern and continue to operate its business. An adverse opinion is rare, and any reliance on financial information carrying an adverse opinion may not be advisable. A credit professional should discuss this opinion with the auditing firm as well as with the customer in order to gather further information before deciding on the next steps to take in their credit analysis and decision.
Tax returns are another format in which you may see financial information provided from a prospective or active customer. It is important to understand that the rules, laws, and formats governing tax returns are different than those governing an audited financial statement produced for investors and creditors. It is difficult to define the general reliability of a tax return, as they are produced in a variety of ways depending on the return. Tax returns may be prepared by an individual and may pose many of the same reliability concerns that you’d expect from an internal financial statement. There is, however, some additional level of assurance knowing that a tax return is subject to an audit by the IRS, so presenting inaccurate information may come with the risk of perpetrating tax fraud. Tax returns may even be prepared by a licensed CPA and come with much of the same levels of assurance that we’d expect from reviewed financial statements.
Once you know what type of financial statements you are dealing with, you will now have to go through these different statements to begin your analysis. There are four basic financial statements that are commonly prepared by profit-making organizations: balance sheet, income statement, statement of shareholders’ equity, and statement of cash flows. These statements should all be prepared in accordance with GAAP (Generally Accepted Accounting Principles); however, GAAP is not a law and is only required by publicly traded companies. These financial statements, when combined, give the reader a good idea of the financial strength and condition of a company. Between these four financial statements, the reader can see where the cash and other assets of a company are now, where they came from, and where they went. If prepared properly, these statements should assist with a credit professional’s ability to make a sound credit decision. An overview of these four financial statements is provided below.
Balance Sheet: The balance sheet shows the value (according to GAAP) of the assets of a company at a particular point in time and how these assets were funded. Assets can be funded with either debt (liabilities) or equity. This creates the basic accounting equation of assets (A) = liabilities (L) + shareholders’ equity (E). Assets are generally listed based on how quickly they can be converted into cash. Liabilities are generally listed based on their due dates. Certain ratios that will be discussed in this guide will allow the reader to understand the leverage and liquidity of a company’s balance sheet in order to determine the company’s ability to meet short and long term financial obligations. Understanding the balance sheet can also give the reader an idea of the company’s ability to raise funds in the form of debt or equity in order to buy additional assets or to pay back other debt obligations.
Income Statement: The income statement shows the revenues and expenses that a company generates over a particular period (i.e. month, quarter, year, or year-to-date). These line items are generally calculated using the accrual accounting method that conforms to GAAP. Accrual accounting follows a matching principle and records transactions at the point of sale. Basically, accrual accounting calculates the receipts instead of the actual cash. In accrual accounting, the transaction is made at the time of the sale, even if it was sold on a credit account and the cash isn’t collected for a few weeks or months. The other method of accounting is the cash basis. This method is used less frequently and only calculates transactions (revenues and expenses) when cash actually exchanges hands.
The top line of the income statement is the revenues (or sales) generated from the sale of goods and/or services under normal operations. The next line is generally the direct costs involved in making those sales. The net figure of these two gives the gross profits and gross margins, which will be discussed later when we get into profitability ratios. Other operating expenses such as selling, general, and administrative expenses are then deducted from gross profits to get to operating income, which will again be discussed in more detail later. Depreciation and amortization expenses are also deducted. These expenses are non-cash expenses used to spread out the cost of large and long-term assets over the periods they are used. After other non-operating income and all expenses, including taxes, have been taken into account, the bottom line shows the net income (or loss) of a company. Again, the net income (or loss) is not necessarily the cash that a company generated, but the difference between the sales receipts and the expense receipts for a particular period of time.
Statement of Shareholders’ Equity: This statement ties both the balance sheet and the income statement together. The statement of shareholders’ equity starts with the net income (or loss) from the income statement. From there, distributions/dividends or capital injections can be made to reconcile to the equity section of the balance sheet. The amount of net income left over after distributions/dividends is retained in the business and increases the retained earnings account in the equity section on the balance sheet. All of the changes in the equity section of the balance sheet are detailed in the statement of shareholders’ equity. Other equity sales and purchases, such as stock repurchases, are also detailed on the statement of shareholders’ equity and reconcile to the other equity accounts on the balance sheet. Many non-publically traded companies have simple equity accounts and do not create or provide a statement of shareholders’ equity. Typically, the difference in retained earnings from one period to the next is equal to the net income of the company. If the amount is less, than the difference is typically the amount of distributions/dividends that were taken; however, this should be verified with the company for accuracy. The dates on the current balance sheet and the prior period balance sheet should match up to the date range of the income statement in order for these calculations to work.
Statement of Cash Flows: While the income statement can tell a reader whether a company made a profit based on receipts, a statement of cash flows can tell a reader whether or not the company generated cash from these receipts. Many financial statement users are vitally interested in the actual cash received since sales receipts alone cannot pay creditors, which makes this statement very important. The statement of cash flows uses the amounts from the income statement as well as the period-over-period changes from the balance sheet to outline the trail of the inflows and outflows of cash. Under the indirect method of preparing the statement of cash flows, the statement uses the accrual method figures from the income statement and adjusts them up or down depending on the changes in the balance sheet accounts from the prior period. Using the direct method of preparing the statement of cash flows, the accountant shows the items that affect cash flow, such as cash collected from customers, interest received, cash paid to suppliers, etc. The statement of cash flows gives the reader the true picture of the sources of cash (starting with net income/loss using the indirect method) and the uses of that cash. This statement is broken out into three activities: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. This way an analyst can easily dissect the cash flows of a business and be able to look at operating cash flows separately from the other activities. This statement ultimately reconciles the difference between the cash on hand at the beginning of a balance sheet period to the end period balance of cash on hand.
Examples of these four basic financial statements have been included as exhibits in the appendix for two fictitious companies: ABC Corporation and XYZ Corporation. ABC Corp. is an example of a financially strong company and XYZ Corp. is an example of a weaker company that would pose heightened credit risk requiring additional steps and information that would be needed in order to potentially approve them for credit. The financial statements in the appendix are used to work through the five categories of ratios that will be discussed in detail. The five categories of ratios are as follows: leverage, liquidity, efficiency, profitability, and debt coverage ratios. The individual ratios in these five categories will be further discussed to educate a credit professional on the basics of credit analysis. It should be noted that financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis. In addition, there is no one definitive set of key financial ratios, there is no uniform definition for all ratios, and there is no standard that should be met for each ratio.
Notes: In addition to the four basic financial statements, there are also notes to the financial statements that are found after these four basic financial statements on audited financial statements and many reviewed financial statements. Although the appendix of this guide does not include an example of notes to the financial statements, this is a very important section of the financial statements that should also be analyzed by a credit professional. Notes help to further explain the numbers that are in the four basic financial statements such as inventory valuation methods, depreciation methods, and debt repayment terms, to name a few. The notes also help to analyze the strength of a company by including additional information that can’t be found in the numbers such as bank information (line of credit commitment amounts, maturity dates, and covenant information), subsequent events, and contingent liabilities, as well as other important items. These important disclosures should be read carefully by the credit professional as they may end up making or breaking a credit decision.
There are many equations and ratios in financial statement analysis, but there is only one known as the accounting equation. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders. The reason the balance sheet is called a balance sheet can be demonstrated with this very simple yet often poorly understood equation.
Assets = Liabilities + Equity
This equation represents the left side of the balance sheet (assets), which is equal to the right side of the balance sheet (liabilities + equity). The fact that the totals on the left and right side of the balance sheet should match is why it is called a “balance” sheet. Each side is a picture of the company and their assets, capital, and debt structure. The left side (assets) shows everything a company owns, and the right side (liabilities + equity) shows how those assets are financed. It is important to understand the left side of the balance sheet and how assets are broken down into long-term and short-term assets. An asset is categorized as long-term or short-term based on the projected period of time it will take before that asset is converted into cash (liquidated). Changes in what percentage of assets are long-term and less likely or more difficult to be converted into cash (less liquid) and what percentage are short-term and easier to convert into cash (more liquid) can have dramatic implications on a company’s ability to pay its bills and meet other operating commitments. Understanding the asset structure and liquidity of an organization is very important and will be covered further in another chapter. For the purposes of this section, we are going to focus on the right side of the balance sheet and how a company’s assets are financed.
As stated above, the right side of the balance sheet, or the accounting equation (liabilities + equity), show how a company’s assets are financed. It is worth noting that liabilities=debt, and equity=net worth. Don’t be confused to hear or see these terms used interchangeably; they are the same. No matter how large or small a company is, every asset is financed with capital from debt or equity. Imagine all of a company’s assets boiled down to a single dollar which represents every asset within the company. That dollar can be broken down into what % is financed by creditors (liabilities) and what percent is financed by contributions from owners/investors (equity). The higher the % of assets financed by creditors/liabilities, the higher the leverage of the company. This is a very important concept to understand as a creditor because as leverage increases and more of the company’s assets are financed by debt, the higher the burden of risk becomes for the creditors. The percentage of assets financed by debt can be measured with a variety of different metrics, some of which will be discussed below. The standard for those leverage metrics will vary widely by industry, so it is helpful to have an idea of what metrics would look like for a typical company in a given industry. Throughout this guide we will be referencing excerpts from two very different example companies (ABC Corp. and XYZ Corp.). Both of these companies’ financial statements can be found in the appendix to this paper. Below are calculations and analysis of three common leverage ratios:
1) Debt to Equity ratio: Total Liabilities divided by Total Equity.
Total debt to equity can be a very helpful tool when trying to understand how leveraged a company may be. The higher the debt to equity ratio, the more leveraged a company is. Stated another way, a high debt to equity ratio means more of the company’s assets are financed through debt, and the higher the burden of risk for creditors. If a company’s debt to equity were equal to 2, then for every $1 in equity the company has $2 in debt. If the debt to equity ratio is less than 1, the company has more equity than debt. For example a debt to equity ratio of .50 would mean that for every $1 in equity the company has $.50 in debt. If the debt to equity ratio is negative, the company has negative net worth and is insolvent. Insolvency likely represents a much higher risk for creditors due to a much higher likelihood the company will default on future debt or other obligations.
Example ABC Corp: $12,449 = 0.64
Example XYZ Corp: $129,733 = 17.7
In the examples above, the total debt to equity for ABC Corp. shows for every dollar in equity there is $0.64 in debt. We know that because the debt to equity is below 1.0, meaning that ABC Corp has more equity than debt. XYZ Corp. on the other hand shows that there is $17.70 in debt for every $1 in equity. XYZ Corp. is much more leveraged than ABC Corp., which would likely mean an increased risk for creditors.
2) Debt to Tangible Net Worth: Total Liabilities divided by Tangible Net Worth.
Tangible Net Worth is the Total Equity minus the total of Intangible Assets.
(Equity - Intangible Assets)
The total debt to tangible net worth is essentially the same ratio as the debt to equity calculation in example 1 above but with the removal of intangible assets from equity. Intangible assets are usually not able to be liquidated (converted into cash), and thus they are rarely able to assist a company in meeting its debt obligations. It is thus very important to understand how a company’s intangible assets may be shaping their leverage and debt to equity ratio.
Example ABC Corp: $12,449 = 0.78
$(19,512 - 3,531) =
Example XYZ Corp: $129,773 = -135.0
In the case of ABC Corp. above, the removal of intangible assets has a minimal effect on the leverage, going from a total debt to equity of 0.64 to a total debt to tangible net worth of 0.78. This does not represent a large change, and would likely not dramatically change our perception of the company or the risk of extending them credit. However, in the case of XYZ Corp., the removal of intangible assets caused tangible net worth to become negative. This means that without relying on the value of these intangible assets, the company owes more to its creditors than the value of all of its tangible assets combined. This indicates a very high risk position for creditors of XYZ Corp., and it would be reasonable to expect a higher probability of bankruptcy and/or default on the debt.
3) Assets to Equity (Leverage Ratio): Total Assets divided by Total Equity
The total asset to equity ratio, also known as the leverage ratio, shows the total assets of a company compared to equity. Stated another way, if a company has a high leverage ratio or their leverage ratio is growing, they are more leveraged and a higher percentage of their assets are being financed through borrowing from creditors as opposed to being financed by investment from owners.
Example ABC Corp: $31,961 = 1.64
Example XYZ Corp: $137,061 = 18.7
In the examples above, ABC Corp. has a leverage ratio of 1.64, so for every $1 in equity the company has $0.64 in debt/liabilities. You can tell from their leverage ratio, that the majority of the assets of the company are equity financed, and thus they have lower leverage and would likely represent less risk for a creditor. Conversely, XYZ Corp. has a leverage ratio of 18.7, so for every $1 in equity there is $17.70 in debt/liabilities. Clearly, XYZ Corp. is much more leveraged than ABC Corp., and that would make them a much higher credit risk. If the leverage ratio equals 1, then the company has no debt, and everything they own is owned outright by the company’s owners. If the leverage ratio goes below 1 and is negative, that means a company has negative net worth. Having a negative leverage ratio would result in a higher probability of bankruptcy and thus a higher credit risk.
You will notice that the leverage ratio is higher than the total debt to equity ratio by exactly 1. This will always be the case due to the accounting equation (assets = liabilities + equity). Based on the accounting equation, the leverage ratio can be used interchangeably with the total debt to equity ratio to get to the same conclusion on the leverage and related risk of a company. Both ratios are shown since credit departments prefer to stay consistent, and some use the leverage ratio while others use the total debt to equity ratio. In addition, the leverage ratio can be used in more advanced financial analysis when using the DuPont analysis for calculating the return on equity of a business (discussed in more advanced readings).
It is important to understand how leverage and changes to leverage affect a company’s financial strength and help us predict their ability to repay debt. As a rule of thumb, higher debt means higher leverage and higher leverage means increased risk to creditors.
What is liquidity? And why is it so important for the credit professional to understand it? Specifically, liquidity is the ability of an enterprise to generate sufficient cash amounts (from the conversion of their raw material purchases, product development, product sales, and cash collection - also known as the ‘Cash Conversion Cycle’) to meet their own firm’s required cash needs in order to properly operate their day-to-day business. Generally speaking, a trade creditor (like the company you work for), has very short customer credit terms (i.e. Net-7, 10, 15, or 30) with their debtors (or customers); hence, a customers’ liquidity position, or solvency readings, becomes very important to quantify (and gauge) from a credit management standpoint.
If your firm’s standard credit terms are Net-30, then you’d expect your customers to pay you in 30 to 35 days. Calculating the more common ‘liquidity metrics’ (which we’ll do below) will give you (the credit professional) more confidence in your customer’s ability to pay your firm on a timely basis, after you have released your firm’s products to them. There are three ‘key’ liquidity ratios (of which all of their components are found on a standard balance sheet) as shown below:
- Current Ratio
- Quick Ratio
- Net Working Capital
These three ratios are explained in detail below and looked at between two different companies: ABC Corporation and XYZ Corporation:
Current Ratio: Total current assets divided by the total current liabilities:
Total Current Assets
Total Current Liabilities
The current ratio (shown above) is probably the most widely used of all the liquidity ratios. (Note: This ratio is simply a measure of how many times your customer’s total current assets (which generally consists of: cash, accounts receivable (AR), pre-paid assets, inventory, etc.) can ‘cover’ their total current liabilities (which generally consists of: accounts payable, debt due within one year, notes payable, accrued liabilities, etc.). Since this is a ratio we are working with, the outcome your calculation produces is something compared to the number ‘1.’ So, in the below example, and shown on any GAAP balance sheet, you’ll be able to discern how many times your customer’s total current assets can cover (i.e. 1x, 1.5x, 2x, etc.) their total current liabilities, which, of course, would include your firm’s invoices to this customer.
Obviously, the higher the final calculated ratio, the better the chance of your company getting paid, and hopefully within your assigned customer credit terms. Generally speaking, you’ll want to see a current ratio result of over 1.5 to 2.0 times, which would indicate a healthy result; but, this result should be compared to your company’s related industry average for their peers as well. Below are calculations and analysis of liquidity ratios using our example companies, ABC Corp. and XYZ Corp:
ABC Corp: Current Ratio= $18,576 = 2.41 ( also expressed as 2.41x or 2.41:1)
XYZ Corp: Current Ratio=$109,337 = 0.95(also expressed as 0.95x or 0.95:1)
The current ratio (CR) result for ABC Corp. of 2.41:1 suggests that there is $2.41 of current assets for every $1.00 of current liabilities, which is usually a good sign. As a comparison, however, XYZ Corp.’s CR of less than 1, at 0.95:1, suggests this firm has only $0.95 to cover $1.00 of their current liabilities. This could portend a potential problem. However, it would have to be further looked into because some industries have very low CR results and have no problem paying their vendors.
Quick Ratio: Total current assets minus the inventory amount, all divided by the total current liabilities:
Total Current Assets - Inventory
Total Current Liabilities
The second key liquidity ratio (shown above) is the quick ratio (QR). The QR is calculated the same as the CR, but you would subtract the customers’ inventory amount shown in the total current asset section of the balance sheet. This ratio is also called the acid test ratio. We subtract the inventory balance (and some finance professionals also subtract the ‘prepaid assets’ amount, too) because inventory is the ‘least’ liquid (i.e. it could take the longest to be converted into actual cash) of all the total current asset components. Here’s a quick example of this ratio for these two different companies:
ABC Corp: Quick Ratio = $18,576 - $6,833 = 1.52:1
XYZ Corp: Quick Ratio = $109,337 - $63,723 = 0.40:1
You’ll note that the above result for the ABC Corp. (1.52:1) is a smaller ratio than the current ratio result shown above (2.41:1) because we have subtracted for the Inventory amount and hence made the numerator a smaller number. The above result would suggest that this customer (ABC Corp.) should be able to service their short-term debt (total current liabilities) without first having to sell-off their inventory to raise additional liquidity (cash) to pay their short-term obligations. We would read this result as this customer has $1.52 in ‘quick’ assets, for every $1.00 in total current liabilities (which would, again, include your firm’s invoices to this customer). Then if we look at XYZ Corp.’s quick ratio result of only 0.40:1, this would imply that XYZ Corp. only has $0.40 for each $1.00 of their current liabilities. This could pose a problem for XYZ Corp. should they have a problem converting their inventories into salable products. Again, as with all ratios, the quick ratio should be monitored for period-over-period trends (both positive and negative) and also compared to your firm’s industry norms as well.
Net Working Capital: Total current assets minus total current liabilities
Total Current Assets - Total Current Liabilities
The third liquidity calculation (and remember, there are other liquidity ratios used in actual practice) is the net working capital calculation, shown above. This calculation is used to designate the amount by which current assets exceed (or are less than) current liabilities. Simply put:
ABC Corp: Net Working Capital = $18,576 - $7,719 = $10,857
XYZ Corp: Net Working Capital = $109,337 - $114,983 = ($5,646) or -$5,646
The net working capital amount actually quantifies a liquidity (or solvency amount) in dollar terms. Unlike the above two methods which are ratios (some result compared to the number 1), this amount actually shows the credit professional the ‘actual’ dollars available to finance trade creditors. Some firms like to reduce the amounts they have ‘tied up’ in their net working capital amounts to help reduce their carrying (interest) costs with their lenders; however, this can make them less credit worthy.
As shown above, ABC Corp. has a ‘positive’ working capital position of $10,857k. This would imply a favorable result. However, some further research the credit professional would need to do to believe this would be to understand their customer’s monthly payment requirements for items such as: interest costs, A/P requirements, long & short term principal payments, and other monthly operating expenses required to keep their company doors open. In contrast, XYZ Corp. has a ‘negative’ working capital position of ($5,646k). This could imply a problem with this firm meeting their day-to-day operating costs. The credit professional would need to delve more into this customer’s monthly cash requirements to see if this customer would be a potential credit risk and not be able to pay your firm’s invoices by your assigned credit terms.
Also, if a firm is getting paid very quickly from their customers (like in 1 or 2 days, like a retailer or firms in the petroleum industry whom have very brief customer sales terms), and then their vendors give them much longer sales terms (like Net-15 or Net-30), this could skew a firm’s net working capital result that’s being reported. Again, this gets back to knowing your firm’s industry credit practices and becoming more informed of overall credit management principles in general.
Efficiency metrics measure how effectively the company utilizes its assets and how well it manages its liabilities. Top performing companies turnover assets quickly and efficiently, that is to say they have a high “run rate.” Some key areas of efficiency, especially to the business credit professional, are those associated with short-term assets and liabilities. These ratios are able to tell us a lot about how efficiently and effectively a company is managing its short-term operations and working capital investments.
Keys to comparison:
- Industry: the ratio will vary from one industry to another.
- Year-to-year: trending analysis is very important. Performance of this year needs to compare with previous years’ performance to analyze the abnormalities. Seasonality of a business can potentially skew the efficiency ratios of a company when analyzed month-to-month or quarter-to-quarter.
Accounts Receivable Turnover: Sales divided by accounts receivable:
Accounts receivable turnover measures the effectiveness of a company’s sales terms and collection policy. The sooner that accounts receivable can be collected, the sooner cash is available for use. A lower turnover number may suggest the company is too lenient on credit terms or having difficulty to collect. A higher turnover number is better because it has a low days sales outstanding (DSO). Rising DSOs could increase uncollectible receivables that lead to bad debts. If a company has bad debts that have not yet been written off, then this would negatively impact nearly every other ratio that is discussed in this paper. In addition, the quality of the company’s sales might have to be questioned going forward.
To calculate this ratio, we need to get information of the sales (or revenue) from the customer’s income statement and accounts (or trade) receivable from the balance sheet under the current assets category.
ABC Corp: Accounts Receivables Turnover= $61,768 = 12.65 times per year
XYZ Corp: Accounts Receivables Turnover=$151,305 = 4.88 times per year
Days Sales Outstanding (DSO): 365 days divided by accounts receivable turnover:
Accounts Receivable Turnover
Days sales outstanding (DSO) measures the average number of days it takes a company to convert its accounts receivable into cash. Lesser days are better because it takes less time to collect the customer’s accounts receivable.
ABC Corp: 365/12.65 = 29 days
XYZ Corp: 365/4.88 = 75 days
The accounts receivable turnover result for ABC Corp. suggests that ABC Corp. collected all of their accounts receivable balance 12.65 times per year, on average. It also means ABC Corp. took 29 days on average to collect their accounts receivable. The accounts receivable turnover result for XYZ Corp. suggests that XYZ Corp. collected all of their accounts receivable balance 4.88 times per year, on average. It also means XYZ Corp. took 75 days on average to collect their accounts receivable. In this calculation, we can see there is either something in XYZ’s credit policy that is causing them longer to collect, or they have potential bad debts that might need to be written off. XYZ Corp.’s cash is all tied up in receivables.
Inventory Turnover Ratio: Cost of goods sold divided by inventory:
Cost of Goods Sold
The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a year. A higher inventory turnover ratio is better because it has a low days inventory outstanding (DIO). A low inventory turnover ratio may indicate overbuying, falling sales, unaccounted for shrinkage, or excessive carryover of obsolete inventory. If a company has shrinkage or obsolete inventory that has not been accounted for, these amounts may have to be written off (expensed), which would negatively impact nearly every other ratio that is discussed in this paper. In addition, the quality of the company’s inventory management, and even possibly sales, might have to be questioned going forward.
To calculate this ratio, we need to get information of the cost of goods sold from the income statement and inventories from the balance sheet under the current assets category.
ABC Corp: Inventory Turnover = $42,277 = 6.19 times per year
XYZ Corp: Inventory Turnover =$126,523 = 1.99 times per year
Days Inventory Outstanding (DIO): 365 days divided by inventory turnover.
Days inventory outstanding (DIO) measures how many days on average it takes to sell a company’s inventory. A lower DIO is better because it takes less time to sell inventory.
ABC Corp: 365/6.19 = 59 days
XYZ Corp: 365/1.99 = 184 days
The inventory turnover ratio result for ABC Corp. suggests that ABC Corp. sold and replaced their total inventory balance 6.19 times per year, on average. It means ABC Corp. has about 59 days’ worth of inventory on hand to support average sales. The inventory turnover ratio result for XYZ Corp. suggests that XYZ Corp. sold and replaced their total inventory balance 1.99 times per year, on average. It means XYZ Corp. has about 184 days’ worth of inventory on hand to support average sales. In comparison, ABC Corp. performed better than XYZ Corp. when turning their inventory into cash. XYZ Corp. might be carrying an excessive amount of inventory or might be overbuying materials/products for future sales needs. This should be analyzed further to see if there is obsolete inventory or shrinkage that has not been accounted for and needs to be written off (expensed).
Accounts Payable Turnover: Cost of goods sold divided by accounts payable
Cost of Goods Sold
Accounts payable turnover measures how a company manages paying its own bills. A higher turnover means there is possibility that the company doesn’t have favorable terms from its suppliers. A lower number of accounts payable turnover helps to stretch the working capital and free cash flow with longer days payable outstanding (DPO). As a creditor, a higher turnover is preferred because it is a prediction of how the company will pay their vendors.
To calculate this ratio, we need to get information of the cost of goods sold from the income statement and accounts payable from the balance sheet under the current liabilities category.
ABC Corp: Accounts Payable Turnover = $42,277 = 11.95 times per year
XYZ Corp: Accounts Payable Turnover = $126,523 = 2.75 times per year
Days Payable Outstanding (DPO): 365 days divided by accounts payable turnover
Accounts Payable Turnover
Days payable outstanding measures how many days that the company took to pay its vendors. From a credit professional’s perspective, if the number of days is high, it is a potential sign of a company struggling with cash flow and a prediction of a company’s payment schedule to their vendors.
ABC Corp: 365/11.95 = 31 days
XYZ Corp: 365/2.75 = 133 days
The accounts payable turnover result for ABC Corp. suggests that ABC Corp. paid all of their accounts payable balance 11.95 times per year, on average. It also means ABC Corp. took 31 days on average to pay its vendors. The account payable Turnover result for XYZ Corp. suggests that XYZ Corp. paid all of their accounts payable balance 2.75 times per year, on average. It also means XYZ Corp. took 133 days on average to pay its vendors.
In this calculation, we could see XYZ Corp. might be having some problems with its cash flow and they are stretching payables to compensate. They could also just have extended terms with their vendors, but this is worth looking into further especially for potential new customers where payment trends with your company have not yet been established.
Cash Conversion Cycle:
Days sales outstanding + days inventory outstanding – days payable outstanding
DIO + DSO – DPO
“Cash is King!”
This formula measures (in days) the amount of time it takes a company to convert its investments into cash, or how long it takes a company to collect cash from sales of its inventory. When understanding the cash conversion cycle, it is helpful to remember that any dollars in inventory and accounts receivable are investments in working capital that have not yet been converted into cash. Conversely any amount in accounts payable is working capital being financed by trade creditors and is allowing the company to delay spending their cash. Any investments in inventory or receivables are essentially cash that a company has not collected yet and will decrease the overall cash available to the company to finance operations.
From the calculation above, ABC Corp. took 57 days and XYZ Corp. took 126 days to turn their investments into cash. We could see that XYZ Corp. is having problems generating cash. This explains why they took longer to pay their vendors.
Note: This measurement is not as effective for service companies such as consulting businesses, technology companies, and insurance companies that have little to no inventory and might even have very quick accounts receivable turnover.
In this next section we will discuss profitability ratios. Wikipedia, Investopedia, and Bloomberg, all tell us that profitability ratios are basically metrics used to assess a business’ ability to generate earnings as compared to its expense and cover cost over a specific period. Profitability is also sometimes analyzed through earnings performance ratios. No matter what you refer to them as, they always have to do with the return on something (i.e. sales, assets, etc.). In this section we will explore three primary profitability ratios:
- Net Profit Margin
- Gross Profit Margin
- Operating Profit Margin
These ratios by themselves may yield some insight and will definitely be helpful in analyzing whether to extend credit to a customer or to determine their long term viability. You will want to use these ratios in conjunction with the other ratios discussed in this paper to get a better picture of a customer’s financial position and whether or not you want to give them open credit terms. The Securities and Exchange Commission (SEC) requires all publicly traded companies to file quarterly and yearly financials (i.e. 8k and 10k). These reports will be based on the approved GAAP requirements. For those publicly traded companies that you are doing business with, this can really help in your validation and trending models because there will be multiple months and years on file. For private companies, you will want to ask for three years, three quarter-ends, or three month-ends of data to determine a trend. The best comparison is when you can compare year-over-year to see how they are doing and compare with other like companies in the same industry. In the previous sections, we discussed how benchmarking against like companies within the same year can be helpful to analyze a company’s financial strength. This should give each credit professional the ability to analyze the current statement in a meaning full way by reviewing a trend to determine what you think will happen in the future. All of the information you need for this section can be found on the income statement. The ratios below will help you to determine the health of a company or how much credit risk your company’s policy will allow.
One of the most common profitability ratios is the net profit margin. This is also sometimes referred to as the bottom line margin. Here the number is expressed as a percentage and should be above zero. This is kind of a no brainer as a company should be profitable to stay in business. This is one of the most frequently used ratios. The net profit of a business will tell you what’s left over after all expenses/costs are taken out of sales. Historical net profit margins provide the analyst with the ability to determine if the customer is trending up or down. Are they making as much money as their competitors? Did the profit margin increase from the prior periods or did it decrease?
Net Profit Margin: Net income after tax divided by net sales:
Net Income after Tax
ABC Corp: Net Profit margin = $4,213 = 0.0682 (also expressed as 6.82%)
XYZ Corp: Net Profit margin = $123 = 0.00081 (also expressed as .08%)
While both companies have a positive net profit margin, it’s obvious that ABC Corp. is doing better than XYZ Corp. Assuming that both companies are from the same industry, we could make an assumption that ABC Corp. is controlling its expenses much better than XYZ Corp. If these companies are not from the same industry, it still won’t matter for XYZ Corp. because they are just barely breaking even. One other thing to be considered is the type of industry of the company you are evaluating. You should have a good understanding of what the margins should be in the industry you are evaluating. For example, the service industry typically has 15% to 30% margins. If either company, ABC Corp. or XYZ Corp., were in the service industry, we would say both were not doing as well as related companies in their industry.
Gross Profit Margin: Gross profit divided by net sales
Gross profit margin can be a great asset to any credit professional. If a company is able to increase their gross profit margin month after month or quarter after quarter, this typically means the company is increasing their sales prices and/or they are able to lower their direct input costs. A good example of this is where a company can increase sales at existing prices, but takes advantage of economies of scale to buy materials/products in bulk at lower costs. In the chart below, we see from year-to-year the gross profit dollars increased from $13,303 to $19,491. In the second chart below, we expressed the same numbers as a percentage to give you a better perspective to how these companies manage their cost of goods sold. ABC Corp. not only increases its gross profit dollars, but as you can see from the second chart, the percentage of gross margin increased 5% from 2013 to 2014.
In this second example (below) we can see where XYZ Corp. made an additional $2.7M in gross profit; however, the gross margin actually dropped 3%. This is a good example where the numbers alone don’t necessarily tell you the whole story.
Now you will need to determine if this is good or bad. ABC Corp. is growing their margins while XYZ Corp.’s margin is getting compressed. Here you would want to do more analysis and ask some follow up questions for XYZ Corp. For example, expenses outpaced sales as a percentage, why? You may be able to figure this out if you have a detailed page breaking out cost of goods sold.
The last ratio on profitably will be operating profit margins. This ratio is primarily used to measure a company’s pricing strategy and operating efficiency. The operating profit margin measures the part of the company’s revenue remaining after paying production cost, such as wages, raw materials, etc.
Operating Profit Margin: Operating income divided by net sales
ABC Corp: Operating Profit margin = $6,824 = 0.1104 (also expressed as 11%)
XYZ Corp: Operating Profit margin = $3,855 = 0.0254 (also expressed as 2.5%)
When determining your operating income and net sales make sure you don’t include things outside of the operating portion of the financial statement, for example one-time expense for a settlement, or some sort of other nonrecurring income/expense. The higher the operating profit margin, the better cost controls a company has. When a company is well established and been in business for a number of years, fixed cost should go down and thereby the operating profit margin go up. Here you want to see a trend where the operating profit margin is increasing every quarter and year. So it’s important to not just do the calculation on the current financials but look at previous months, quarters, and/or years.
A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds. If a company you are selling to is no longer in good standing with their bank due to the inability to meet covenants or the inability to pay their loans, then the company will either have to seek funding from their vendors by stretching their bills, or file for bankruptcy. Either way it is very important for you, as a vendor, to understand this relationship and analyze a company’s ability to pay their debt obligations. A profitable business does not necessarily mean that there is enough income or cash flow to support its debt payments. If you are analyzing a company that is profitable, how can you determine the strength of their profits? One million dollars ($1M) in net income or even operating cash flow sounds great, but what does it really mean for the company? This amount might be sufficient for a company with total debt of $1M, but it may not be good at all for a company with total debt of $100M depending on the structure of required payments. In order to fully analyze the strength of a company’s income and cash flow, it has to be compared against the required debt payments that the company needs to make. To fully analyze this relationship of income and cash flow compared to debt service, 3 basic ratios have been outlined below:
- Times Interest Earned Ratio
- Debt Service Coverage Ratio
- Cash Flow from Operations Debt Service Coverage Ratio
These three ratios are further defined in detail below. In addition, we will walk through differences in these ratios when analyzing the financials of ABC Corporation and XYZ Corporation.
Times Interest Earned Ratio: The times interest earned ratio is expressed as the operating income of the company divided by the interest expense of that company:
The operating income of a company can be found as a subtotal on the company’s income statement after all operating expenses have been taken into account. Other income/expenses can often fluctuate and include one-time items, but the operating income/profit represents the income from core (normal) operations. Interest expense can be found as a line item on the income statement. This is the amount of interest that was due and payable in the particular period that the income statement covers. These amounts for ABC Corp. and XYZ Corp. are shown below and highlighted in yellow:
ABC Corp: Times Interest Earned Ratio = $6,824 = 29.93 (also expressed as 29.93x or 29.93:1)
XYZ Corp: Times Interest Earned Ratio = $3,855 = 1.17 (also expressed as 1.17x or 1.17:1)
If the ratio is over 1, this means that the normal operations of the business are profitable enough to pay the interest payments on the company’s debt. An average company will have a cushion, perhaps a ratio of 1.50:1.00 (1.50x) or higher. This helps to apply additional funds towards principal/debt reductions or to help during periods when operations are not as strong. As shown above with ABC Corp. and XYZ Corp., both companies have a ratio over 1 and can both support interest only payments; however, ABC Corp. has a sizable cushion over 1, whereas XYZ Corp. has a much smaller cushion over 1. When subtracting interest expense from operating income, XYZ Corp. only has $547k to cover other cash needs such as taxes, distributions/dividends, principal debt payments, capital expenditures, etc.
Covering required interest payments should be maintained at a minimum. In addition to this, many companies have liabilities that require principal payments to reduce the balance on the debt over a set period of time. For instance, equipment depreciates and loses value over time, so a business will need to make principal payments on this debt to avoid having its loan value exceed the value of its asset. The next two ratios help to analyze the full ability of a company to service its required debt payments.
Debt Service Coverage Ratio: The debt service coverage ratio is expressed as the earnings/income (E) of a company before (B) the sum of interest expense (I), depreciation (D), amortization (A), and any other non-cash items (together represented as EBIDA), divided by the sum of current portion of long-term debt (CPLTD), current portion of capital
Net Income + Interest Expense + Depreciation + Amortization
CPLTD + Current Portion of Capital Leases + Interest Expense
Although EBITDA is not a financial measure recognized in GAAP, it is commonly used in finance and by banks to assess the performance of a company. The “T” in EBITDA stands for taxes. The reason why taxes have not been added back to the ratio calculation above is because taxes are equally, if not more important as paying back bank loans. Federal and state tax liens can prevent a company from obtaining funding and negatively impact their cash flow. Depreciation and amortization expenses are added back to net income since these are non-cash expenses and can be used to help service debt. These expenses can be found as a line item on the income statement or on the statement of cash flows. Since interest expense is one of the primary debt payments as shown in the previous ratio, we would also add back interest expense to the numerator. The current portions of both long-term debt and capital leases can be found under current liabilities on the balance sheet. These represent the amount of principal payments that are due within the next year. Loans/leases can be refinanced, paid off early, or issued throughout the course of a year so these amounts are simply good estimates. The figures needed for this ratio calculation for ABC Corp. and XYZ Corp. (not including interest expense as shown earlier) are shown below and highlighted in yellow:
ABC Corp: Debt Service Coverage Ratio = $4,213 + $228 + $1,029 = 6.24x
$649 + $228
XYZ Corp: Debt Service Coverage Ratio = $123 + $3,308 + $3,671 = 0.77x
$5,950 + $3,308
Just like the last ratio, if this ratio is over 1, than this means that the company has the ability to make their required debt payments. An average company will have a cushion of 1.25x or higher to help during slow periods or when floating interest rate debt is on the rise. As shown above with ABC Corp. and XYZ Corp., the financial performance of these two companies is further differentiated as we move from the times interest earned ratio to the debt service coverage ratio. ABC Corp. still maintains a very strong ratio, whereas XYZ Corp.’s ratio is less than 1 and cannot afford to make the large required principal payments of $5,950k that come due next year if they maintain the same EBIDA.
Operating profit and EBIDA in most cases is based on the accrual method of accounting, meaning that revenues and expenses are entered when invoices are issued, not when they are paid. Just because a sale was made does not mean that the company has collected the receivable and has the cash on hand in order to pay the interest [and principal] that is due. Debt cannot be paid with A/R; only cash can service debt payments. For this reason, we then use cash flow from operations in the numerator instead of EBIDA.
Cash Flow from Operations Debt Service Coverage Ratio: This ratio is the same as the one above, but uses the cash flow from operations instead of EBIDA in the numerator:
Cash Flow from Operations*
CPLTD + Current Portion of Capital Leases + Interest Expense
*Interest expense should be added back if using the indirect method.
The cash flow from operations can be found as a subtotal on the statement of cash flows. This is the cash flow that has been generated from the operating activities of a company and includes changes in certain balance sheet accounts such as A/R, inventory, and A/P to show the actual cash inflows and outflows of a business. This is slightly different than the operating profit and EBIDA of a company that shows the inflows and outflows of receipts, but does not tell you if they were paid or not. Since most companies use the indirect method starting with net income [and depreciation/amortization] at the top, interest expense will need to be added back just as it was with the last two ratios. The cash flow from operations needed to calculate this ratio for both ABC Corp. and XYZ Corp. have been shown below and highlighted in yellow:
ABC Corp: Cash Flow from Operations Debt Service Coverage Ratio = $4,758 + $228 = 5.69x
$649 + $228
XYZ Corp: Cash Flow from Operations Debt Service Coverage Ratio = $87 + $3,308 = 0.37x
$5,950 + $3,308
Again, if the ratio is over 1, then the company generated enough cash to afford its required debt payments; however, a cushion of at least 1.25x is recommended for average companies. Since this ratio includes changes in balance sheet accounts that are only taken at a single point in time, it is not necessarily bad if a company’s ratio is under 1 for a single period. When this occurs, it is important to go back and analyze the efficiency ratios that were discussed previously. As shown previously with the debt service coverage ratio, ABC Corp. continues to show a strong ratio, whereas XYZ Corp.’s ratio continued to decline showing a probable decline in efficiency ratios as previously discussed.
A more advanced debt coverage analysis will include other items, such as additional one-time income/expense items, discretionary expenses, expenses on related party assets, capital expenditures, distributions/dividends, subordinated debt, related party debt, receivables from a related party, balloon payments, and mitigating factors to name a few.
This paper has endeavored to explain some initial ‘starter’ information on the content and how to analyze what’s shown on the four GAAP required financial statements: balance sheet, income statement, statement of shareholders’ equity, and statement of cash flows. This paper has also broadly discussed the various types of audit opinions coupled with some beginning financial statement analysis. Clearly, in our professional field of credit management, an opening guide for new credit professionals to this profession would never be able to adequately cover all that a more seasoned credit professional would (and will) encounter in ‘real’ practice. In fact, most of what we learn, and need to know, is based on just plain work experience and the school of hard knocks. But, this guide has attempted to provide some ‘food for thought’ for a new entrant into the field of credit. However, there’s so much more to learn, and cover.
For those of you who want to take credit management to the ‘next step,’ the balance of this paper will aim to cover the following questions and resources: how could I further advance myself in the field of credit management? Are there any credit designations I could earn to further my knowledge in this field? What’s involved in earning those designations? What other resources are available out there that are commonly used for benchmarking and learning other tools in credit management? Well, let’s examine the first question very briefly on how to advance our career (and knowledge) in the field of commercial credit.
In your credit work, you will no doubt hear about one of a credit professional’s main credit associations called the National Association of Credit Management (NACM). NACM has more than 15,000 members located throughout the United States. NACM affiliated associations offer valuable credit services in formal credit training in the form of: classroom credit classes, online credit classes, webinars, monthly publications, seminars, and annual credit conferences, just to name a few. At your local NACM affiliate, you should be able to get your formal credit training (no matter what your background) and also meet other fellow credit professionals working toward similar goals and objectives.
At most NACM affiliates, they have the resources (courses) that will allow you to complete the more commonly held credit designations of:
- Certified Credit and Risk Analyst (CCRA)
- Credit Business Associate (CBA)
- Credit Business Fellow (CBF)
- Certified Credit Executive (CCE)
For credit professionals aiming to expand their knowledge in the international credit management arena, the following designations are also available:
- Certified International Credit Professional (CICP)
- International Certified Credit Executive (ICCE)
The first three designations require the completion of 10 to 15-week classes in: Credit Principles, Financial Statement Analysis, and Accounting. As you progress to the highest designation of CCE, you will review material in such courses as Credit Law, Business Law, and Advanced Financial Statement Analysis. Each credential requires the passing of a formal exam to demonstrate your mastery of the course material which you’ll have had to pass with a letter grade of ‘C,’ or higher. The international designations are completed mostly on the internet, but are just as rigorous (and comprehensive) in their material and test taking as the ones just discussed.
Earning a credit credential demonstrates that you’re very serious in both advancing your knowledge in the field of credit along with utilizing this information in your day-to-day credit work for your company. This information benefits both you as a credit professional and should also help you to protect one of your firm’s largest assets on their balance sheet: accounts receivable.
Along with credit credentialing, our field has some additional resources that have been around a long time which can also assist in one’s knowledge growth in our profession. For various credit departments ‘benchmarking’ tools and further learning of many different types of credit metrics (and calculations) there is the Credit Research Foundation (CRF) (www.crfonline.org). This is a paid member service, but they do offer a lot of complementary benchmarking reports on many different companies and industries. We already mentioned NACM(www.nacm.org) as an excellent resource for a full suite of credit related services along with their local affiliates. For ‘open’ credit positions in both finance and credit, there’s Robert Half International (RFI) (www.roberthalffinance.org). RFI also offers a complementary ‘annual’ salary survey for those employed in the accounting and finance positions.
A very common resource (among several others) for customer credit reports is Dun & Bradstreet (D&B) (www.dnb.com). D&B reports are run on a subscription type basis, and generally contain the following key credit information: full name of business entity, date business started, company hierarchy, and if there’s been any suits, liens, and/or judgments filed against a company, along with a Paydex score which shows how well (or slow) this company pays their vendors (potentially your company).
A helpful public website for general news on publicly-traded companies (and business news of the day) is Yahoo Finance (http://finance.yahoo.com). This popular website allows one to get the latest news developments on large companies along with investor opinions, financial statement data, and related competition information on companies. Google Finance and other search engines offer similar information as well.
Again, these are just a few credit resources which barely scratch the surface of what’s available to a credit professional and their credit department. But this is a start.
Finally, the authors of this paper wish you the best of luck in your new credit career and we hope you have enjoyed this paper and got as much out of it as we enjoyed writing it. We strongly encourage you to get involved in this very dynamic (and honorable) profession called commercial credit. We are confident that you will find it challenging, personally and professionally fulfilling, and hopefully very rewarding.
We all wish you the best of luck!
Graduate School of Credit and Financial Management – Class of 2016
Charles Edwards, CCE
Vivian Hoang, CCE
Brendon Misik, CCE
Kenny Wine, CCE
John Zummo, CCE
Glossary of Financial Terms and Ratios
Debt to Equity ratio: Total Liabilities divided by Total Equity.
Debt to Tangible Net Worth: Total Liabilities divided by Tangible Net Worth. Tangible Net Worth is the Total Equity minus the total of Intangible Assets.
Assets to Equity (Leverage Ratio): Total Assets divided by Total Equity.
Current Ratio (CR): Total current assets divided by the total current liabilities: should be greater than 1.5.
Quick Ratio (QR): Total current assets minus the inventory amount, all divided by the total current liabilities (also known as the acid test ratio): generally lower than the CR, but should still be above 1 depending on the industry.
Net Working Capital: Total current assets minus total current liabilities: should to be greater than $0.
Accounts Receivable Turnover: Sales divided by accounts receivable.
Days Sales Outstanding (DSO): 365 days divided by accounts receivable turnover.
Inventory Turnover Ratio: Cost of goods sold divided by inventory.
Days Inventory Outstanding (DIO): 365 days divided by inventory turnover.
Accounts Payable Turnover:Cost of goods sold divided by accounts payable.
Days Payable Outstanding (DPO):365 days divided by accounts payable turnover.
Cash Conversion Cycle:Days sales outstanding + days inventory outstanding – days payable outstanding.
Net Profit Margin: Net income after tax divided by net sales: should be greater than 0% and be in line with other like companies in the same industry.
Gross Profit Margin: Gross profit divided by net sales: should be sufficiently greater than 0% and needs to be compared to previous years to assure an upward trend.
Operating Profit Margin: Operating income divided by net sales: should be greater than 0% and should show improvement year-over-year.
Times Interest Earned Ratio: Operating income divided by interest expense: should be over 1 to pay interest expense on debt, and usually has a cushion of 1.5:1 or higher.
Debt Service Coverage Ratio: Earnings/income (E) of a company before (B) the sum of interest expense (I), depreciation (D), amortization (A), and any other non-cash items (together represented as EBIDA), divided by the sum of current portion of long-term debt (CPLTD), current portion of capital leases, and interest expense: should be over 1 to cover required debt payments with healthy companies reporting 1.25:1 or higher.
Cash Flow from Operations Debt Service Coverage Ratio: Cash Flow from Operations (add back interest expense if using the indirect method) divided by the sum of current portion of long-term debt (CPLTD), current portion of capital leases, and interest expense: should be over 1 to cover required debt payments with healthy companies reporting 1.25:1 or higher.
- Gahala, C. L. (2013). Credit management: Principles and practices (4th ed. revised). Columbia, MD: National Association of Credit Management.
- Fraser, L. M., & Ormiston, A. (2010). Understanding financial statements (9th ed.). Upper Saddle River, NJ: Prentice Hall.
- Dean, J. F. (2004). The art & science of financial risk analysis (2nd ed.). Columbia, MD: National Association of Credit Management.
- Supervision and Regulation Division of the Federal Reserve Bank of Atlanta. Director’s guide to credit. Atlanta, GA. Federal Reserve Bank of Atlanta. Print.
- U.S. Securities and Exchange Commission. (2007). Beginners’ guide to financial statements. Retrieved from http://www.sec.gov/investor/pubs/begfinstmtguide.htm
- Jurinski, J. J. (1994). Credit and collections. Barron’s educational series, Hauppauge. New York, NY. Barron’s Business Library.
- Ittelson, T. (1998). Ratio analysis, financial statements, step by step guide to understanding and creating financial reports. Franklin Lakes, NJ: Career Press, Inc.
- Investopedia. (2015). Operating margin. www.investopedia.com
- Accounting Tools. (2015). What is a financial statement review? www.accountingtools.com
- DiCicco Gulman & Company, LLP. (2011). Reviewed financial statements vs. audited. www.dgccpa.com
Appendix: Exhibit 1 - ABC Corporation Consolidated Financial Statements
Appendix: Exhibit 2 - XYZ Corporation Consolidated Financial Statements
By: Sherri Belanger, John Markham, Dwight Collings, Fabiana Fabbrini, Carmen Centeno, Brandy Sailers-Dow
- An action or activity that requires a delicate balance between different situations or requirements. (Google)
- An attempt to cope with several often conflicting factors or situations at the same time (Merriam Webster)
- Don't avoid extremes, and don't choose any one extreme. Remain available to both the polarities - that is the art, the secret of balancing. (Rajneesh)
- So be sure when you step, Step with care and great tact. And remember that life's A Great Balancing Act. And will you succeed? Yes! You will, indeed! (98 and ¾ percent guaranteed). (Dr. Seuss)
Conducting collections is a delicate balancing act. Credit professionals must steadily navigate through a whirlwind of choppy payment behavior and a fluctuating economic climate while nurturing positive customer relations and keeping their company’s business philosophy intact. In the end, their greatest strengths (their anchors in this storm) are the strategies they cultivate through trial and error. Quite literally – through experience. As a collector evolves, so should their framework of techniques.
From the very moment a credit application is obtained, the groundwork for the collection process begins. As in any significant relationship, periods of success and challenge are expected. The venture begins with cooperation, negotiation, and the excitement that each party will contribute to a shared goal of prosperity and satisfaction. The risks of entering the commitment, of course, are heavily weighed. Throughout the relationship, there are reminders about promises made and the importance of maintaining high standards. Add to this the emotional element of internal/external stressors on this professional bond, and the collection process becomes a sensitive component that can make or break a business relationship. A credit professional must develop their collection techniques if the alliance is not only to survive, but to thrive long-term. Again, a delicate balancing act.
The ultimate goal in collections is to maximize cash flow by facilitating sales and to minimize risk. To do this, credit professionals must continuously improve their collection performance, influence, and attitude. The collection-related strategies below are presented in the following collaborative piece:
- Credit Application
- Debtor Identification
- Managing Emotions
- Timeline for Collection Activities
- Bad Debt Accounting & Collection
- Effectively working with Sales
- Dunning Explained
- Global Connection
The credit application is the central piece of documentation in a credit file as a whole and is an ongoing “contract”. Essentially it is an agreement between a creditor and a debtor and it defines the terms and conditions of selling to a customer on open credit. In this section we will discuss what makes up the credit application, how credit professionals utilize it for decisions and as a collection tool, and the high level aspects of utilizing a credit application for legal purposes.
Depending on the type of trading relationship between parties, the components and details of a credit application vary widely. Some of the standard components in most applications include applicant information, references, terms and conditions and personal guaranty. The applicant information verifies the business name or sole proprietor information, the names of the principals/owners, billing information, length of time in business, type of business, state of incorporation, and other information that can be useful in identifying the company requesting credit. References are usually a request for bank and supplier payment history and can be helpful in determining credit worthiness. Customer financials are a good way to dig deeper on a customer’s credit worthiness. In some instances, however, it may be impractical to obtain reliable financial information from the customer. In these cases, credit decisions must be based on more qualitative factors such as character, management competence, and market position.
The terms and conditions portion of the application explains the details of the credit relationship which, after signed, becomes an agreement between the creditor and the debtor. This includes the terms of sale (ie Net 30), any fees associated with past-due payments (interest or legal fees), whether the creditor has the right to enact a security agreement (blanket or PMSI), and what circumstances trigger default. Lastly, some applications may include a personal guaranty. This is a separate agreement which, when selling to a corporation or limited liability company, means that an individual (usually an officer of the company) will personally guarantee payment in the event of default.
Other essentials that are useful in making a good decision include validating the customer’s legal entity, reviewing the customer’s business model and strategy, reviewing any prior experience with the customer (or businesses with similar ownership) and, if possible, planning a customer visit. A customer visit can be a good start to building a solid relationship with larger customers and provide an opportunity for the credit professional to see firsthand both the risk and potential of a company. All of these components enable a credit professional to make a better, more informed decision.
High level Legal Aspects:
A complete credit application will specify the ‘where’, ‘how’, and ‘when’ a legal action can be taken. Essential documentation for a legal case may be obtained while performing regular monitoring of the accounts receivable and documenting collection efforts. Actively working the aging ensures that customers are notified on time when their payments are due, leading to earlier detection of payment issues.
One thing to keep in mind before using legal action to collect a debt is the cost associated with an attorney and court filing. In many cases, establishing a payment plan or promissory note with defined terms can be a much more cost effective solution. During the collection process, negotiating with the debtor and being open to different paths of resolution can be the key to recovering delinquent past due invoices without going to court.
A customer may declare bankruptcy if they cannot meet their obligations and in some cases, they may still be operating their business during the process. If a creditor is made aware, by any means (report/ certified letter or customer/legal advice), that a customer has filed for bankruptcy, the law protects the customer and all collection efforts on the past due debt must stop. This is called an automatic stay and trying to collect on the antecedent debt, even sending a statement of account, is prohibited by law unless there is an exception through the courts. Credit professionals should be aware of the state and local laws regarding commercial debt collection.
The credit and collections team hopes to avoid having a customer declare bankruptcy or having to write off bad debts. By taking the time to develop a robust credit application process and performing due diligence, credit professionals can realize the ultimate goal- minimizing risk to the organization while growing sales. Building a successful trade relationship requires a good foundation and strong framework, starting with the credit application and followed by effective account management. For a sample credit application, please go to:
Whether a credit professional has worked in collections for a short time or for many years, the collector eventually comes to understand that the very nature of collection work oftentimes places them into situations where they must respond to upset, confrontational customers. Voices are raised, conversations get heated, and blood pressures rise. The customer, frustrated with their issue, sends a scathing email or calls at the height of their stressful moment to express their dissatisfaction for the company.
Fair? No. Understandable? Probably. Unresolvable? It depends. An opportunity to build a stronger relationship? Most definitely yes.
Collectors are often seen as people who pursue and pummel debtors to succumb to their will. As villainous as that may sound, it’s how they are generally perceived. A collector’s greatest power, however, lies not in the ability to provoke - It lies in the capacity to exert positive influence and in the talent for conflict resolution. If a credit professional enters a collection call with a negative attitude, they are only begging for a similar response. Yet, if they approached a customer with a positive, helpful attitude, it puts the client in a position where they see they will benefit from mutual cooperation. When it comes to resolving payment conflicts, attitude is key.
Ever heard someone say, “He has a high IQ, yet he lacks emotional intelligence?” What does it mean to have a high or low emotional intelligence (EQ)? Highly effective collectors usually display a high level of emotional intelligence whether they realize it or not.
Having a high IQ means that one’s logic, abstract reasoning, learning ability, and memory capacity are top-notch. However, a high IQ does not guarantee an individual is good at making judgments in real-life situations. (Shane Frederick, “Why a High IQ Doesn’t Mean You’re Smart,” som.yale.edu 11.01.09)
On the other hand, a high EQ can help a person analyze a difficult situation, determine the best course of action, and use it to their advantage, regardless of their IQ. Having both a high IQ and a high EQ makes one a power-user of influence. Without a good dose of EQ, however, the IQ can only go so far in social, work, and relationship scenarios. It behooves collectors to sharpen their EQ so they can be highly effective in their field, as they are at the precipice of customer-company relationships.
The good news is that although IQs are permanent, EQs can be improved upon with awareness and practice. EQ is comprised of four proficiencies:
(Travis Bradberry, “About Emotional Intelligence,” TalentSmart.com 2017)
The key to improving one’s EQ is to identify where one’s emotions come from, then analyze why and how one typically reacts. EQ steadily increases as one connects their inner self-awareness with their outer social-awareness. This is not to say that all emotions must be stifled. Rather, they should be used as a compass to navigate how one should react in certain situations.
For example, a credit professional may have to call a debtor whose name they are all too familiar with. Perhaps the customer is known for her argumentativeness and sharp tone on the phone. Anticipating the call, the collector is filled with reluctance and negativity. Emotions are apparent as the collector tries to control the conversation immediately, not letting the customer get a word in edgewise. He cuts her off as she tries to make a point so that the customer does not gain control of the discussion, trying to avoid an earful of negativity. The collector cuts the call short and tells the client he’ll email the details before quickly bidding her farewell.
The credit professional may have ended the conversation, but he did nothing to improve the situation. His feelings about her have not changed, and he has actually given her more reason to protest. And he is now farther away from a solid payment plan.
Using one’s emotional intelligence means (1) anticipating one’s own feelings and how one would normally react, (2) stepping back to assess if that reaction would be productive or prohibitive, and then (3) formulating a better way of solving the situation so that both customer and collector feel respected and satisfied. Sometimes it simply means making that important call after lunch when one has had time to nourish one’s body and regain energy. Sometimes it means opening the phone-call with a bright and cheery greeting. (Collectors don’t always have to be the voice of doom.) Perhaps it means being an active listener and letting the client vent as much as she wants before offering a calm and reasonable solution. Maybe it means talking to someone who is not emotionally invested in the issue and getting an outside perspective first. Sometimes it just means reminding one’s self to take a few deep breaths and not take things personally.
Go to the following link to take an EQ Test: http://www.ihhp.com/free-eq-quiz/
Let go of the ego
Collectors differ in personality and approach, however their persistence, drive, and ability to pursue payment under challenging circumstances are what make them successful at what they do. Doing otherwise would not only undermine their objectives, but would also ensure that their longevity as collectors would be short-term.
Credit professionals all strive in their own way to keep their companies thriving and afloat by ensuring timely payment for goods and services. It is pleasant to work with customers who are conscientious and who pay on time. Still, one’s true professional worth shines through when one is able to resolve payment conflicts in the face of blatant reluctance or lingering hardship. These types of encounters are not for the passive or the easily flustered. They require a high level of self-confidence and tenacity. Yet, these attributes, if not managed properly, can often add fuel to the fire. Aside from working within the laws developed in recent years to prohibit overzealous collection activity, it is important for collectors to be mindful of how their rapport with customers can either set the tone for calm resolution or ignite fiery resistance.
The ego is an important asset. It helps individuals accomplish their goals by giving them the courage to believe in themselves. A healthy ego propels one to go after what one wants with confidence. But too much ego (often accompanied by a thin skin) can often alienate customers. Ask anyone who works for the Sales Department of a company how important the relationship is between a company and its customers. One will hear tales of how the fussiest client was won over by a few simple accommodations and a soft touch. Or, how a long-time loyal customer closed their huge account because of how they felt they were spoken to by a single customer service representative.
Even when a credit professional knows they are right and the customer is not so right, arguing with an air of condescension only makes matters worse. It may feel natural (almost instinctive) to fight back and protect ones ego from customer attack, but no one ever wins in this scenario.
“There is a fine line between being egotistical and being confident... Ego says “I can do no wrong”, whereas confidence says “I can get this right.” Confidence says “I’m valuable” while ego says “I’m invaluable.”... As long as that confidence stays inside, you will follow that individual to the end. The moment that confidence comes out (and inevitably starts to grow with every assertion), other people lose faith and stop believing.” (Jayne Coles, “How Important is Ego in Your Career?” www.linkedin.com 10.14.15)
Collectors are often judged by the amount of money (and how fast) they collect. Timing is everything in the collections’ world. Amassing the most payments is one of the most gratifying parts of collection work. However, one mustn’t forget that the numbers are achieved only so long as relationships with clients are maintained and nurtured. This is an ongoing process that should never be taken for granted. As a collector, tone and word choice are vital to keep that relationship going.
In most cases, companies want their staff to accumulate the most funds possible, but not at the expense of losing future business prospects.
“Be sure to keep in mind what your words are actually saying to the consumer. Will the results be positive for everyone or will the consumer walk away with a negative feeling and result? You have the power to affect that choice.” (Bill Lindala “Stay Calm and Collect It,” p. 20. 2016)
Tone is definitely a skill to be practiced, whether it is in an email, letter, phone call, or face-to-face interaction. Tone should be professional, gracious, and should always display a willingness to help. Take, for example, the following questions:
- When can we expect payment?
- I’d like to help you resolve your balance. How can I assist you?
The first question, although valid, elicits defensiveness. The second question builds confidence and shows a readiness to help. Customers who feel a creditor is on their side are not only more willing to resolve balances, but also are more forthcoming with financial information that can help the creditor assess their current economic condition. This is knowledge which one can’t afford to dismiss, especially when it can help one assess and predict financial behavior. Not only does one gain payment info, one also gains valuable insight. Customers who are put off by a negative “us vs. them” tone aren’t as willing to provide such information.
Tone makes a huge difference in how people react to credit professionals. Harnessing one’s tone to gently influence customers to provide much-needed information not only benefits one’s companies, but also increases one’s ability to better direct customers in the long-run.
Collectors constantly compete with other vendors for the attention and consideration of debtors. Collection calls are fertile ground for emotionally-charged dialogue. The common tactic may be to command payment behavior with an assertiveness and alarm far above other creditors in the industry. Yet, a gentler, more mindful approach may actually induce cooperation from the customer that goes far beyond a single pay-out. A credit professional can make their case (and call) stand out by managing the discourse in a variety of ways:
- Using empathy - a key indicator of emotional intelligence
- Showing others that you understand their feelings
- Checking with them that you understand the problem
- Being clear about the endgame - solutions that satisfy both needs
- Gaining attention
- Collaborative language and problem-solving
- Providing the basis for positive future work
- (Dr. David Walton, “Emotional Intelligence - A Practical Guide,” p. 128. 2012)
Working effectively with sales is very important to the overall success of the credit department. The challenge, however, is to keep the relationship positive since the sales and finance team can sometimes be viewed as having conflicting priorities and the dynamic can be complex. It is generally clearly understood that the sales department is concerned with generating business for the company, however credit professionals also have an important role to play in securing new business and protecting existing business. By working with new customers to determine the best payment terms available to them, the credit department is facilitating sales and fostering a relationship that is able to survive difficulties and hopefully thrive over time. Working with marginal accounts, especially those with difficult cash flow issues, allows the creditor to preserve existing business and may lead to a stronger relationship with the debtor once the issues are behind them, potentially leading to an increase in future sales. Although the dynamic between sales and credit can sometimes be seen as contentious or having conflicting priorities, the truth is that they share a common goal- strong sales. After all, it’s not a sale until the product is paid for. Sales is a valuable resource; they are the eyes on the ground, they are key to business intelligence, and they can be a sounding board in difficult situations. It is important to develop a positive working relationship with sales team.
The fact is that many credit departments are located in a company building and have little to no face to face interaction with customers. Unfortunately this puts the credit department at a disadvantage; a walk through a customer’s store may reveal shelves full of inventory, perhaps covered in dust, or a store that sees very few customers during the day. These may be warning signs of trouble and they are impossible for a creditor to observe without visiting the customer’s location. Sales can be a creditor’s ‘boots on the ground’ and can relay potential areas of concerns thereby helping the credit department to better understand the challenges that a customer is facing. Conversely, the sales team can also confirm increases in business, expansion of facilities, and opportunities for growth. By engaging with sales, a credit department is able to gain valuable insight into a customer’s operations, enabling them to make better decisions.
In addition to providing valuable quantitative information, the sales team generally has a closer relationship with the customer than the credit department and can provide insight into the customer relationship. This insight can prove useful when needing to convey a difficult message to the customer. If it becomes necessary to reduce payment terms or require prepayments going forward, sales should be made aware of the change and offered an opportunity to participate in conveying the message. The credit team should be careful not to depend too heavily on the sales team to deliver bad news, since the relationship between the customer and salesperson is a valuable asset. At a minimum, a sales person should be aware of changes in a customer’s terms or issues that could upset the relationship so that they are not caught unaware. These small considerations will help to ensure that the sales team and the credit team maintain a good working relationship.
Working with marginal accounts can be challenging for both sides of the sale but it can also provide unique opportunities for the sales and credit teams to partner together. Marginal accounts are usually considered to have less favorable references or financial information that would cause concern over extending open credit. Often sales is not aware of the existence or details of negative information and the credit team is tasked with balancing the desire to make a sale with the need to manage risk. Communicating concerns to the sales team, especially regarding financial information, should be done as tactfully and professionally as possible. Instead of declining the sale altogether, the credit team looks for a way to facilitate sales. Instead of framing the credit decision as ‘yes’ or ‘no’, the credit team may instead consider ‘how’. An account that may warrant prepayment today could very well warrant terms in the future and the credit department should take extra care in delivering a message that will keep the lines of communication and the road to increased future sales open.
Good communication and respect are the cornerstone of any good relationship and the sales-credit dynamic is no different. A good credit professional seeks to engage sales in good times and bad, knowing that the results will pay dividends for not only their individual departments, but the company as a whole.
Behind every debtor is a unique story waiting to be unraveled. It is a credit professional’s responsibility to read each debtor prudently so suitable credit decisions can be made. The first question to be answered is why the customer has fallen behind in their payments. There are many reasons why a customer could be in arrears and each scenario may need to be handled differently. In instances where delinquency is an unusual event for the debtor, and they are forthcoming with reasonable information and can provide a solid plan for future payment, it may be possible to come to a quick and easy agreement. However, it is the debtors who choose to withhold critical information, promote falsehoods, or are, perhaps, naïve to the state of their business health, who creditors must approach cautiously and probingly. Signs that credit professionals must look for in order to prevent loss and prepare for any negative impact on the company are:
|Loss of income||Over-commitment||Debts left by former partners|
|Natural disaster||Theft/fraud||Disruptions in the industry|
|Working the system||Withholding payment||Disorganized AP|
Although collectors must treat all types of debtors professionally and respectfully, the strategy and approach can differ for each scenario. Before determining what course of action to take, a collector must find out which category the debtor currently falls. Does the debtor show a willingness to pay down the debt, but is unable to do so for the next several weeks due to cleaning up after a major storm? Is the debtor more than able to pay, but is unwilling due to delayed issuance of credits for returned product on the creditor’s part? Does the debtor show no signs of being able or willing to pay – possibly, missing in action? Once a credit professional determines the debtor’s status, it is easier to come up with an enforcement plan.
The green shaded area in the illustration below signifies there are no obvious reasons for alarm. Business as usual. The orange shaded areas do indicate a cause for alarm; however, there remains optimism that issues can be resolved with continued communication and a little nurturing offered from both sides. The red shaded area is a signal that it may be time for the creditor to cut their losses and to initiate the referral process.
(Brendan Le Grange “Collections Strategies – The Unable to Pay / Unwilling to Pay Matrix,” https://blegrange.wordpress.com 3.24.09)
It is important to note the fine line between offering flexibility in good faith and allowing one’s self to be taken advantage of. It is important to gather as much information about your customer as possible to determine the risks of seeing the business relationship through difficult times. It is often useful to reach out to one’s sales people in the field as well, as they can be a credit professional’s best eyes and ears. Once information is provided, and the financial condition and payment attitude has been assessed, a creditor should implement the following strategies:
|Willing and able?||Continue to nurture a close, mutually beneficial relationship.|
|Willing but unable?||Establish debtor’s payment limitations. Listen closely. Is delinquency a temporary instance or downward trend? Payment plan can be offered if sensible to do so. Important to uphold relationship while customer resolves. Flexibility should be shown, but not in excess.|
|Not willing but able?||It is critical to act immediately and to use leverage appropriately.|
|Not willing and unable?||All options exhausted. Expedite referral to in house special collections or outside collection agency for further handling.|
“Knowing when to work with the debtor and when to draw a line in the sand is paramount. Asking probative questions and listening for the answer will assist in determining ability and willingness.” (http://EzineArticles.com/expert/Patrick_H_Hale/430046)
Some customers try to keep collectors in the dark regarding their financial distress. It is important to be aware of any warning signs before matters become too big to control. Credit professionals can locate signs of insolvency and non-liquidity in a customer long before the at-risk behavior begins to have a detrimental effect on the creditor. This information can be found in business newspapers, trade association reports, and other publicly available documentation. However, it is very important to know the authenticity of your sources before coming to any conclusions.
Some warning signs that serve as red flags to the credit professional:
- The debtor has stopped discounting bills
- There is a general slowdown in payments to vendors
- Lawsuits are being instituted against the debtor
- Tax liens or vendor liens are being filed against the debtor
- The debtor is constantly shifting from one source of supply to another
- The debtor is in default with its lending institution(s)
- The financial condition of the company is deteriorating
(NACM, “Principles of Business Credit,” p.424, 2013.)
Every company should have a comprehensive credit and collections policy which includes guidelines related to aging receivables. Management and the Credit departments generally have targets related to Days Sales Outstanding (DSO), aging tolerances, and bad debt which should be considered when creating a timeline for an organization’s collection activities. The National Association of Credit Management (NACM) provides a wealth of information for organizations that are seeking to create or update policies that reflect best practices in credit and collections.
Following a comprehensive credit policy, collection success begins with good information. Invoices must contain accurate data regarding the customer’s account and charges to the debtor; missing or incorrect information will greatly hinder even the best collector’s efforts. Invoice disputes should be corrected as quickly as possible and it is advisable to consider a policy which requires invoice discrepancies to be communicated to the organization within a certain number of days. Resolving invoice disputes becomes increasingly more difficult as an invoice ages. Accurate contact information is also critical to the successful collection of invoices. It can be disappointing to direct one’s efforts to an incorrect contact who does not respond, delaying collection time and wasting resources.
While some companies choose to begin collections before invoices are due, others choose to collect when the account is past due. Sending regular statements can help a debtor stay on top of their payables and may reduce manual work down the road. While the details of a collection policy may differ between organizations, the timeline for collections generally begins gently and escalates based on the risk to the receivable.
Initial contacts with a debtor should contain a friendly request for payment. There are a number of reasons that payment may have been legitimately delayed- an unresolved invoice dispute, a keying error in the payables system, a business event, a life event (in smaller companies), a quality issue with the invoiced item, or even a misunderstanding. It may be beneficial to include in the friendly reminder an offer of assistance, such as “If there is anything that may be preventing the invoice from being paid, please let us know immediately so that we may be of assistance.” When an initial contact for payment is not successful, it is important that collection efforts be consistent and increasing in urgency. Early requests for payment may also consider the payment history of the debtor; if payments are chronically late and there is little communication to indicate that delays are due to isolated issues, it may be advisable to influence payment behavior using a tighter collection timeline or leveraging resources.
Timely collections is essential to managing a healthy receivables portfolio. The value of a receivable declines over time because the likelihood of collection decreases the longer that a receivable is outstanding. An aging schedule predicts the collectability of receivables based on their aging bucket, expressed as a percent, and assigns a value to the receivable. For example, if a customer owes $10,000 for an invoice that just came due, that receivable is valued internally at 100% because the likelihood of collection is high. As the receivable ages and the likelihood of collection is reduced, the value of the receivable is also reduced. If a company has valued receivables over 90 days at 50%, that invoice is now worth $5,000. That is not to say that the debtor only owes $5,000 because the debtor still owes the entire $10,000- rather, that is the internal value that the creditor has placed on the receivable as an asset. Not only does the likelihood of collection decline over time, but the resources that a collector has used in trying to collect the debt represent a cost to the organization.
If initial contacts have proved unsuccessful in securing payment and it has been determined that the payment delay is due to either an unwillingness or an inability to pay, the creditor should increase the frequency and tone of the contacts to reflect the urgency of their request. Some companies use dunning letters or a dunning strategy that mirrors their collection policy. The schedule that a company uses is unique to their business and considers their market, capacity to leverage, level of risk, and the overall relationship with their customers. A greater explanation of the dunning process is explained in the next section.
Generally after a certain number of unsuccessful attempts to collect, the creditor will send out a final demand. A final demand is the last step before collections and may be a precursor to, or a substitute for, a third party agency’s 10 day letter. It is important to know what the third party collection agency offers in terms of support services, how much the third party agency charges for collections, and what type of tone the agency takes in collecting on your behalf. They become the face of the creditor they are representing and therefore should present themselves in a manner the creditor would approve of.
Once an account has been referred to a third party agency, a creditor’s credit and collection policy dictate whether it is going to be reserved for bad debt. Reserving for a receivable is not the actual action of writing it off, but it recognizes it is a receivable at risk of being written off. Some companies choose to write off bad debt once a receivable hits a certain age or once a third party collection agency has deemed it to be uncollectable. Accounting for bad debt is explained in a later section.
Dunning is not a word that is often heard outside of credit and collections but it is a process that we do often, even if we don’t know it. The word ‘dunning’ can be either a transitive verb (dunning a customer, the dunning process) or a noun (the dunning letter itself). ‘Dun’, according to Merriam-Webster, is a word from circa 1626 that means “to make persistent demands upon for payment.”
Dunning letters are, very simply stated, a standardized letter used to communicate with a customer regarding an overdue account that typically escalates in either frequency or tone until the balance is resolved. A company’s dunning process is the schedule which dictates when letters are sent out as the account balance ages. Dunning letters generally should contain the balance details, including the total amount due and the invoice detail, as well as a request for payment and contact details in case there are any questions.
Dunning letters and the process for sending them to overdue accounts is decided by the organization that sends them, according to an escalation schedule that the Accounts Receivable or Credit Department feels is appropriate. There is no set or ‘right’ schedule for dunning a customer; however it is important the entire collection process comply with all applicable laws. It is advisable that every credit and collections professional be knowledgeable about the laws that apply to their collection efforts.
Many ERP systems offer the ability to automatically send out dunning letters based upon customizable parameters that are set up in the system. This reduces the amount of manual work that an Accounts Receivable Specialist has to do to send out letters; however there is the risk that a customer may receive a dunning letter for an invoice that is a known issue or is being disputed. For this reason, it is important to be aware of the customizable features and built in logic for automated dunning processes.
A manual dunning process involves making requests for payment at regular intervals using phone, email, or regular post. Dunning language traditionally begins with a reminder for payment either before the invoice is due, on the due date, or shortly after the due date. A common school of thought is that payment reminders that are timed shortly before the due date prompt more on-time payments. Some companies prefer to wait until the invoice is due or until a grace period has expired before sending the first request for payment. This is a strategy that should be thoughtfully considered and discussed, followed by consistent implementation.
Initially, dunning letters should be a friendly reminder of a past due balance. If early dunning attempts are unsuccessful, there is usually an escalation in frequency and/or tone as collection efforts progress. It is important not to threaten or harass debtors in a way that could create a liability or damage a company’s reputation as a creditor, regardless of the action (or lack thereof) of a debtor. Maintaining professionalism throughout the collection process facilitates constructive discussion and is reflective of the integrity of the creditor.
Failure on the part of the debtor to respond to dunning attempts signals trouble for the creditor. If the contact information is correct and there is proof that the debtor has received the dunning notices without responding, additional intervention is needed. An organization’s credit and collection policy should contain a roadmap for escalating collection activities, potentially with a referral to a third party collection agency. It is important to keep accurate records of all collection efforts.
Every credit professional will engage in some form of negotiation in the course of their duties whether it be with customers, sales people, finance team members, or management. Negotiation is much like credit, both a science and an art, and reaching an agreement that satisfies the parties involved takes skill and talent. While many people engage in negotiations in their daily lives, for example buying and selling cars or property, credit professionals are constantly called upon to reach agreements that meet the needs of multiple parties and must do so in a way that will promote growth.
Successful negotiations start with a couple of key techniques. It is important to understand that one’s mood, tone, physical and mental position, and preparedness will have a direct impact on the outcome. Being fully prepared is not strictly limited to facts; rather it is the sum of many parts which include projecting the appropriate attitude and presence that will make others want to reach an agreement. Hunger, fatigue, distraction, discomfort, and nerves can all play a role in derailing even the best laid plan. Making sure the environment is conducive to success is a good first step.
Alternative plans are another key aspect of reaching an agreement. Usually a negotiation involves two or more parties whose agendas do not fully align and compromise or persuasion is necessary for a successful outcome. Each party has their own version of the best possible outcome but as a negotiation progresses and the individual parties adjust their definition of success, the well prepared negotiator has alternative outcomes in mind that also meet their needs. They are prepared with not only the best possible outcome, but they have identified the worst case scenario and have alternate proposals to suggest.
It is important to remember that a negotiation is not simply about imposing one's own agenda on others. Listening to the other parties is critical to understanding their position and by validating their concerns, a good negotiator is able to overcome resistance and gain support for a positive outcome. Anticipating objections and having answers prepared in advance can help to remove roadblocks in the process and will demonstrate that the credit professional understands the issues.
During negotiations there may be times of quiet or a lack of activity, as parties consider new information or are asked to revise their position. This quiet can be a tool that prompts the other party to offer a solution or to offer more information than they would have otherwise, had they not felt compelled to fill the silence. Embracing the silence not only projects confidence, it can result in the other parties making a move they were not fully prepared for. Incremental victories such as these may add up to overall success as long as the negotiator acts intentionally and with thought to the overall process. Remember too that agreements can sometimes take time to solidify. If discussions break down, knowing when to take a break and regroup may make a significant difference in the outcome.
For credit professionals, the most frequent area of negotiation involves customers who are unable to make scheduled payments. The customer may be asking for a payment extension or they may be asking for a payment plan, to space out payments on a large balance. It is important to first understand what is driving these types of requests; is this isolated incident or is the situation expected to continue short to long term? Has the customer made similar requests in the past and does this demonstrate a pattern of cash flow issues? Are there issues in the market that are impacting the customer's ability to pay? Are the reasons for the delay caused by factors under or outside of the customer's control? These are key questions the credit professional will need answered in order to make a decision.
Another area that can require negotiation is in regards to payment terms. A credit professional may do a credit review and grant terms that the customer or the salesperson feels is too restrictive. It may be reasonable to reconsider if additional information is made available, such as financial statements or references that were not considered in the original review. The credit professional may need to explain their decision and should therefore be prepared for such a discussion, especially since sales and credit must present a united front. Requests to change trading terms does not only happen with new accounts; established customers may also request a review of their account. Changes to terms should be met with a healthy dose of skepticism but also with an understanding of what is driving the request, asking similar questions as requests for payment extensions. If the customer is dealing with a temporary setback, it may be appropriate to help them work out a payment plan or other solution that will allow trading to resume under normal conditions in the near future. A request for a permanent change in terms will usually require additional analysis including the increase in the overall balance and risk, the impact to DSO, and compliance with the credit policy as well as anti-trust laws. A change in terms is unlikely to resolve serious financial issues and the credit professional should use caution when negotiating with customers in these situations. It is possible to help financially distressed companies through times of trouble, but having open communication and good follow up is essential.
Depending on the level of involvement with managing customer financial accounts, credit professionals may also be involved in resolving disputes related to pricing, shipping, or charge backs. Disputes can impact timely payment and in order to effectively resolve the issue, it is important to understand all of the facts before proposing a solution. Pricing issues can cause invoices to be held for payment and often times it may require assistance from an internal sales person or the customer's purchasing agent. There may have been special pricing that wasn't communicated at the time of order entry or there may have been a recent price change that has not been updated on the customer's side. The original purchase order is generally the best place to start, since it may have annotations or other purchasing information that will help resolution. If the solution is not simple or if the misunderstanding is not easily cleared up, it may be necessary to involve additional stakeholders in order to reach a solution. Before responding to a pricing issue, it is important to have as much information as possible.
Short shipments or incorrectly shipped orders will usually require a proof of delivery (POD), a packing slip, or a bill of lading. While these types of issues are common, resolution is not always easy. Comparing a packing slip to the customer's receiving log may be enough to resolve the issue but sometimes there are more complex factors involved. Requesting the debtor pay the invoice until the dispute is resolved is one option or the creditor may request payment for the items not in dispute while the issue is investigated further. Splitting the disputed amount or crediting back disputed items are additional possibilities, depending on the circumstances. It is up to the credit professional to be aware of the facts surrounding disputes in order to navigate to an equitable solution, understanding that sometimes compromise is the best way to preserve a valuable relationship.
The best advice for good negotiations and successful dispute resolution is to be to prepared, know the facts, and construct outcomes which, to the extent possible, are positive for all involved. Keep in mind:
- Before beginning any negotiation, make sure you are in a good state of mind. Having a calm disposition and expecting a positive resolution will help you to effectively engage the customer.
- Gather as many of the facts as possible and engage stakeholders as necessary. Reaching an amicable solution that addresses the real issue requires attention to detail and being open to outside perspectives.
- Have multiple possible outcomes available whenever possible and anticipate potential objections.
- Never give up. A credit professional who quits in the face of adversity will lose the battle. It may not be the right time to reach an agreement, but another opportunity might present itself that will allow for a successful resolution.
Bad Debt is defined by Merriam-Webster’s Dictionary as a, “loan that will not be repaid.”For such a simple definition, companies have found many different ways to interpret and account for their own bad debt. In some businesses, the bad debt is accounted for once an account hits a certain aging bucket (90, 120, 150 days past due), and in others an account won’t be written off to bad debt unless the customer is unresponsive or the debt has been discharged in a bankruptcy. The industry of a company, whether the company is publicly held or privately held, and the philosophy of management on bad debt will all dictate how and when bad debt is classified.
From a functional side, the accounting for bad debt can vary greatly from company to company. One way it can be accounted for is through monthly accrual on financials then at year-end the amounts get “trued up’” to mirror the actual bad debt being recorded. Another process used by companies is to write-off actual bad debt identified on a monthly basis. There are other variations on how to accrue and account for the bad debt on a monthly, quarterly, and annual basis.
In 2002 the Sarbanes-Oxley Act was passed, which refocused the need to truly identify bad debt correctly in publicly held companies and to create internal controls to ensure it was not understated in financial statements. Truly to follow the standard set forth by Sarbanes-Oxley, a company must show a consistent process for identifying and treating bad debt expenses which mirrors what they believe to be uncollectable. As a result many publicly held companies have become more conservative in how they account for bad debt expense.
The goal of any credit professional is to minimize bad debt expense. The problem with a complete focus on minimizing bad debt expense is it leads to a risk aversion mentality which will limit the opportunity to sell on a credit basis. The goal should be to balance risk to maximize profitability through sound credit management. Many companies today are driven on sales growth, which in many cases means finding the correct balance between risk of loss or bad debt, and the return from taking on a “risky” customer. Some businesses even have “risk- based pricing” to account for the varying levels of risk to take on a customer.
Bad Debt Collection (Recovery)
Given that bad debt is defined as a “loan that will not be repaid,” it might seem like a contradiction in terms to discuss the collection of bad debt. Really, this speaks to the relentless nature of credit managers in the pursuit of collecting what has already been deemed uncollectable. The means and approach for collection does not necessarily change once an account is written off to bad debt expense, but if collected it will have a 100% profit hit as a reversal of the previous bad debt entry.
Even before a customer becomes a bad debt, there are many items that may signal that an account is struggling to repay a debt. The customer may not be returning calls, has a voicemail that is full, or in conversations states a struggle related to cash flow. Some of the adverse actions in the early stages by a credit manager could be a dunning letter, turning over to a collection agency, having an attorney file suit, or if a customer has filed bankruptcy filing your proof of claim or right of reclamation claim. When an account is struggling sometimes the best solution is coming up with a promissory note for a longer term paydown, or getting further security against another asset like a piece of property.
Once these avenues have been pursued without any results and the customer is still in business, a legal course of action can make sense if it is deemed cost effective. Filing suit to gain a judgment gives the creditor the ability to file a lien against property owned by the debtor or garnish a bank account. Even if these do not equate to payment in the near term, the judgment remains valid for a number of years (varying by state). The lien against a property can become valuable even years down the line if at that point the debtor wants to sell the property.
As companies expand into the international marketplace, it can be easy to underestimate the challenges that come with selling beyond a company’s own borders and into unknown territories. While some challenges may be obvious, such as importation or foreign exchange rates, some challenges may be related to something more subtle- the ambiguous matter of culture. Globalization of business has outpaced the ability of many organizations to manage the accompanying cultural shifts. The focus of international credit and collections is usually concentrated on overcoming legal, political, technological, and economic barriers, while cultural barriers are often unacknowledged or discounted. The cultural diversity found in today’s global economy requires that those engaged in international credit and collection efforts be aware of the global influences on a business relationship.
Before examining the different nuances of global business, it is important to remember a couple of key points. First, the political and legal climate in both the country of the creditor and the country of the debtor will have a direct impact on trade. It is imperative that international trade obey the laws of the countries involved, especially laws regulating importation and taxation. Second, accurate information throughout the order to cash process is critical to the successful import, export, and payment of goods. It should not be assumed that the technological standard of one nation is the same as another. Having clear and comprehensive order to cash processes can alleviate and help to avoid some of the issues surrounding international trade. Before expanding into international markets, a creditor should make sure that invoicing is accurate, containing the correct legal billing name, billing address, payment terms, Value Added Tax (VAT) information (if applicable), shipping address, invoice date, due date, article codes, prices, discounts, and origin information (if required). Correcting errors on international invoices can cause delivery and importation delays or in extreme cases, issues at customs that could impact future trade. It may also be advisable to email invoices; especially those that have far to travel via post or that may be destined for an area with weak infrastructure. Creditors should familiarize themselves with all of the legal requirements for dealing with countries into which they would like to expand. Finally, having someone who can provide language support for international customers is an invaluable tool for a creditor. Collecting or negotiating in one’s own language can be daunting enough without the added stressor of poor communication.
Although these suggestions are intended to help build a strong foundation upon which to expand or enhance trade with other countries, it is important to remember that all communication must be based in mutual respect and consideration. Cultural missteps can be forgiven and overlooked when parties work together but failing to value or appreciate a customer transcends questions of culture or custom.
EMEA - (Europe, Middle East, Africa)
The EMEA Region is a very short acronym for a very large area of the world that includes Europe, the Middle East, and Africa. Due to the vast cultural and even subcultural differences of these regions, it would be unwise to make broad generalizations in regards to cultural influence or business practice. Instead it is advisable to seek out resources and agents within the respective countries that specialize in trade and collections regulations. Lawyers in-country are not only qualified to represent creditors in court, they are also valuable resources for drawing up contracts and advising on business decisions before litigation becomes an issue. Legal counsel can be expensive however, and resources such as the Finance, Credit, & International Business Association (FCIB), Export.Gov, and local sales associates can be helpful sources of information.
South of Europe - Mediterranean countries
Many of the businesses in Mediterranean countries are family run and multi-generational. For this reason it is advisable to exercise care in maintaining the relationship to preserve trade. It is not uncommon to spend time socializing and exchanging personal information over a meal whilst discussing business. These types of customers may prefer a more personal style of account management, especially when dealing with difficult situations such as negotiating payment plans. In Italy, Spain, and Portugal, although the EU Directive on payments and terms is very clear and standards are required under the Directive and EU law, many of the companies in these areas have traditionally expected longer terms. Managing these expectations can be difficult and the desire to retain longer terms remains. It is important to note that the EU Directive only applies to trade between EU countries; therefore a US exporter selling to a country in the EU would not be bound by the Directive. At the time of this writing Greece continues to be under capital control, meaning that payments issued to foreign companies need to go through an approval process at the bank; this process can be long and bureaucratic.
Eastern Europe (Bulgaria, Czech Republic, Croatia, Hungary, Romania, Poland, Slovak Republic)
In Eastern European countries, customers are accustomed to working on a prepayment basis or being insured by third party companies for extended credit. Amicable and confidential approaches to resolving disputes are usually looked upon most favorably, especially if it is possible to conduct business in person. A professional demeanor combined with a personal element, such as a site visit, typically adds value to the management of these accounts. Business culture generally resists the payment of interest fees for late payments, despite the EU Directive which defines not only the maximum rate for interest but also the minimum fee for a late payment (presently €40). It is again important to note that the EU Directive applies only to trade between countries in the European Union. For US companies selling into Eastern Europe, the EU Directive does not apply.
Central Europe is comprised of some of the world’s most highly developed economies. As such, it might be easy to assume that credit comes with lower risk and that invoices will be paid timely, however creditors should still exercise caution and perform due diligence throughout the order to cash process. According to a report published by Market Invoice entitled “The State of Late Payment 2016”, the countries of Central Europe pay at or before the due date on approximately 40% of invoices. According to Businessculture.org, businesses in this region generally appreciate punctuality, conservatism, and adherence to agreements. Belgium is known for being slightly less formal and generally conflict averse.
The Nordic countries of Northern Europe generally have a high standard of living, value egalitarianism, and expect punctuality, according to Businessculture.org. Denmark and Sweden trade heavily with Germany and the Netherlands, all countries which belong to the European Union (Europa.eu). Notably, Norway and Iceland are not a member of the EU and because of this, trading with EU countries requires additional customs documentation. Norway is, however, presently a member of the European Economic Area and part of the European Free Trade Association. According to the Market Invoice report, “The State of Late Payment 2016”, companies in this region generally pay close to terms.
UK & Ireland
With the vote on the Brexit and the exit from the EU in 2019, new challenges will arise due to changes in the trading regulations with the UK, including new customs laws and taxes. One important consideration for the UK and Ireland is that the trading currencies are different for each- the UK trades in GBP and Ireland trades in EUR. Another notable difference is that, according to Market Invoice’s “The State of Late Payment 2016” report, Ireland generally pays on time while the UK averages approximately 6 days late. The UK is still very traditional and prefers to do business in person; spending time winning over a customer may pay dividends later on. A beer and light conversation about football (American soccer) can create an opportunity for a more informal business discussion, though it should be noted that people can be very passionate about the teams they support.
In Russia and most of the CIS countries (Commonwealth of Independent States), business discussions are frequently done at lunch or dinner where socializing and entertaining has a large impact on dealings between companies. Due to the sometimes informal nature of this approach, it is very important to have contracts that contain clear and concise details including payment terms, credit limits, bank information, and product access. Agreed changes to contracts should be formally amended or entirely rewritten to avoid any misunderstanding. Default in payment could result in damage to the debtor’s business reputation; for this reason, customers experiencing issues will often suggest a payment plan to the collector and abide by it. Companies in these areas are accustomed to having to prepay for orders due in large part to the difficulty in finding trade or financial information. When customers are eligible for open terms, they may still pay in advance- especially if there is a favorable exchange rate. It should be noted that Belarus presently has some currency controls in place that limit prepayments. Companies will frequently use one name for import trading (English) and another for doing business within their country (Cyrillic). Customs can be very bureaucratic and it can take a long time to clear shipments if there are discrepancies in the documents.
Countries in the Middle East such as the UAE, Kuwait, and Saudi Arabia are used to working with Letters of Credits (LC’s), typically documentary LC’s. Standby LC’s are generally not used and documentary LC’s typically forbid interest charges. Documentary LC’s are paid according to the terms defined in the LC.
Standby LC’s are generally workable in Turkey; however the fluctuation of the local currency can have a large impact on payments. There have been occasions when the exchange rate has been very low for extended amounts of time and the customer may wait until the last minute to purchase currency, usually USD or EUR. The Turkish business culture is generally very traditional and formal, preferring scheduled meetings and favoring punctuality, according to Businessculture.org.
The majority of trade is done using documentary LC’s, which can be time-consuming and sometimes confusing. Collections on accounts with open terms can be difficult, and delays are not unusual. Payment promises may not materialize and legal issues are based on common law. Active involvement in amicable debt collection, following proven principles of negotiations, and conforming to local terms are key features to successfully collecting in India. By keeping in close contact with the debtor, credit professionals are able to distinguish between genuine cash flow problems versus stalling tactics and non-payment. Field visits and face-to-face meetings with the debtors can be very helpful in the collection process.
South African Law has Roman Dutch origins and the debt collection process is well entrenched within the system. However, due to the fact that South Africa remains a developing country, corruption and fraud remain rife and a weak currency greatly affects the debtor’s ability and/or willingness to pay. Delivery time and customs are also some aspects a collection professional should consider.
North Africa (aka Maghreb: Tunisia, Algeria, Morocco, Libya)
Debt collection can be difficult in Maghreb countries. Many debtors try to avoid payment with a range of delaying tactics, which collection professionals have to deal with. The legal system can be inefficient, much to the detriment of creditors. Due to the events of the Arab Spring in 2011, collection opportunities have become even more difficult. In Tunisia, political unrest has led to destruction, vandalism and the burning of assets and commercial premises, which has forced many companies out of business. When trading with Tunisian or Algerian companies, it is highly recommended to obtain bills of exchange covering the whole debt prior to delivering the goods thus avoiding future discussions and allowing creditors to file a Payment Order in case of non-payment. Algeria has tried to limit imports and has restricted trading terms to LC’s or CAD. Documentary LC’s that are controlled by the bank are held to very strict standards and even small discrepancies will cause payment to be withheld. Customs regulations are also very strict and combined with the bank’s restrictions, it can be very difficult to trade in this country.
As with many Latin American countries, business dealings rely heavily on interpersonal relationships. The attention paid to developing relationships and making contacts could easily be viewed as an investment in the success of the business partnership. Pagarés, literally translated as “will pay”, are promissory notes which include very specific language and, if properly executed, may help facilitate trade. Court systems in Mexico shares more in common with other Latin American countries and Europe than it does with the US, relying heavily on civil law which is a mix of Ancient Roman, Canonic, and Medieval Merchant law. Due to the complexity and differences between US and Mexican legal systems, it is advisable to consult a lawyer experienced with Mexican law when pursuing a legal course of action.
South & Central America
Like Mexico, South and Central America rely heavily on interpersonal relationships. Countries in this area vary in regards to the general level of formality; however respect for the individual and increasing incrementally to senior leadership is especially important. Collections in SCA can become more complicated in countries where Customs and the Central Bank are heavily involved in trade. It is critical that collection efforts in these countries be done with an understanding of the trading environment including the political, financial, and interpersonal factors that influence the creditor/debtor relationship.
According to WorldFinance.com, China does not officially allow ‘collections’ due to a law from the 19th century that allows only legal entities such as the police or court system to collect debt. Despite this, many companies do provide debt collection services by billing their services as risk management or credit consulting. Since honor is an integral part of Asian culture, payments are generally received timely and insolvency is frowned upon (Worldfinance.com). Payments in Indonesia are the most likely to encounter delays. Common payment methods are bank transfers and drafts.
Differences in the time zone should be acknowledged and planned for, especially in regards to communication and making ship/hold decisions. Payments are mostly issued by bank transfer and, according to the Market Invoice report “The State of Late Payment 2016”, payments averaged 26.4 days late. Generally speaking, collection efforts can mirror those that someone would use in the US but it would be good practice for the collector to be acquainted with the challenges of exporting into this area. Sea freight is preferred by many customers since air shipments can be very expensive, however it can add a considerable amount of time onto delivery of the product.
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