Here Are the Distress Signals Private Firms Flash When They Are in Trouble
Rising Business Failures and a Challenging Economy Demand Additional Vigilance
According to data from the Administrative Office of the U.S. Courts, commercial bankruptcy filings increased 40.3% in the 12-months ending June 30, 2024. Since then the U.S. has gone through a tumultuous change in presidential administrations resulting in enormous government layoffs and economic instability driven by a novel approach to tariffs. In response, the stock market is 18 percent off its 52-week highs—a strong harbinger of recession in the coming months.
Even before all this turmoil, the business outlook was concerning, in large part due to lingering inflation. Here’s a warning to trade creditor’s from a major commercial credit bureau (from CreditSafe’s Cost of Late Payments report).
“The record-high bankruptcy filings in 2024, despite a relatively stable economic environment, suggest systemic vulnerabilities in the business landscape. For 2025, we can expect elevated bankruptcy trends to persist, especially if underlying structural challenges, such as debt overhangs and sector-specific weaknesses, are not addressed. Key industries like retail, real estate, and small-to-mid-sized enterprises, which are typically more sensitive to economic shifts, could bedisproportionately affected. A prolonged period of slow economic growth or stagnant productivity would exacerbate these pressures, particularly in sectors heavily reliant on discretionary consumer spending orexposed to supply chain volatility.” — Steve Carpenter, COO for North America at CreditSafe
Guess what? Discretionary consumer spending is under assault and supply chain volatility is rising. If you are extending credit to other businesses, it’s high time you began watching your customers closely for late payments and other signs of distress.
The Imperative to Keep Past Due Balances in Check
A key objective of Accounts Receivable (AR) management is minimizing past due AR to ensure cash in-flows and minimize bad debt losses. Delinquent payments from customers create cash flow shortages, a need to borrow funds and pay interest (at increasing interest rates), and a significant work requirement to accelerate the late payments. When you do eventually get paid, you recover the cost you expended in fulfilling the customer order albeit less the cost of collections and borrowing.
On the one hand, high levels of delinquency can substantially hurt your cash flow and your organization. Moderate levels, though, are not likely impactful enough to cause your firm to fail, but still can severely impact profits. On the other hand, a customer bankruptcy or other default typically causes the loss of most if not all the AR owed by the customer.
Customer defaults can be devastating, especially if they cause a substantial bad debt loss. This is money you expended on the customer’s behalf, which now cannot be recovered except through many multiples of new sales, depending on your profitability percentage, to make up for the loss. A large volume of bad debts can render your firm insolvent. At lower levels, bad debt losses may still require you to:
Borrow funds at very high interest rates with restrictive loan covenants, give up some or all control of your firm, etc.
Cut costs dramatically, damaging your firm’s ability to serve customers — this is especially true when you must lay off key workers, who may be difficult to re-hire if and when your business recovers.
If you are selling public companies, a single bankruptcy can have a huge impact on your firm. Fortunately, you usually have time to prepare because public firms are required to share their financial information, making it relatively easy for you to identify customers that are foundering. We discuss this in a previous article: Big Company Red Flags You Can’t Afford to Miss.
Private firms, however, are much less likely to share financial information (you should still require them to provide financial statements if the credit you will be extending to them is substantial). Without financial insights, it is much harder to identify financially distressed customers. Not being able to look at their books means you have to look for external factors.
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17 Warning Signs a Customer May Be a Default Risk
With private and smaller firms, cash flow is the lifeblood of the business. Access to other capital is often limited and expensive. The following red flags, many of which point to cash flow issues, are indicators that a customer is failing and headed toward defaulting on the debts owed your firm:
Each payment later than the previous—indicates constricted cash flow
Changes in payment patterns—e.g., instead of averaging 7 days beyond terms, some payments may be 20 or 30 or more days past due some months, while at other times they will pay close to the due date—this is an indication they are having cash flow problems
Deterioration in payments to other suppliers—visible in a new credit bureau report or from re-checking their vendor references
Changes in order size and frequency—the customer may be looking for credit from multiple sources, especially if they are constantly bumping up against your credit limit
Requests for an increased credit limit—re-check their other vendor credit references and a credit bureau report to see if their credit utilization is high: a lack of credit availability could be causing cash flow problems
Requests for extended payment terms—see above
An increase in credit reference requests—the customer may need to obtain credit from new vendors because they are behind in paying their current vendors
A noticeable increase in requests for invoice copies or other documentation—they may be stalling for more time
An increasing volume of partial payments and payment deductions—may indicate cash flow problems
An increase in disputed invoices & unwillingness to pay short—more indications of cash flow problems
Repeated broken promises to pay—they may be having trouble collecting from their customers and, therefore, are having trouble managing cash flow, or they are otherwise stalling for time
Bounced (NSF) checks and other payment defaults—a clear indicator of cash flow problems
Inability to contact them (no phone contact and no email replies)—have sales confirm they are still in business, and if so, deliver your message
When they admit to having cash flow problems—re-check their other vendor credit references to compare notes and gauge the extent of the problem
Your sales team’s observations from on-site customer visits (depleted stock, low level of activity)
New Derogatory Information (Suits, Liens, or Judgements)—visible in a new credit bureau report or via a credit bureau change monitoring service
Deterioration in risk rating/score—from credit bureau report or monitoring service
Minimizing Bad Debt Loss Exposure
Once you have identified that a customer presents an elevated risk, there isn’t much you can do to secure the existing receivable except to collect it. With new sales, however, there are some risk mitigation tools you can use, such as security agreements, guarantees, and credit insurance (for more details, check out Customer Stops Paying — Now What?). As for your overall strategy for these priority accounts, it should include
Start Collection Activities (calls and emails) when your at-risk customers’ invoices are only a few days past due, with weekly follow up at a minimum. If the customer is not responsive, don’t hesitate to place the account with a collection agency. Remember, this discussion is about private companies, most of whom will be some of your smaller customers. If they are not a key account there is no good reason not to revoke their credit and place them for collections. If they ultimately pay in full and still want to buy, make them a cash customer.
Hold Orders if there is anything past due. Credit holds give you negotiating leverage. Orders should be held until a payment is made of at least the value of the current order. It’s even better if you secure a payment greater than the value of the current order, as this will reduce the total AR outstanding.
Review the financial strength and liquidity of these customers. Some may be too weak to extend any credit – you’ll have to deal with them on a cash basis. For the others, you will probably need to reduce their credit limit to a level that is sustainable for both parties. This will make credit holds more likely due to the customer going over their limit when a subsequent order is placed, which, as noted above, increases your leverage in any negotiations.
Have a meeting with the customer to better understand their situation and explain your policies and expectations. When you have established a credit limit, explain it and your expectations to the customers. A key element is to encourage truthful communications because there will be bumps in the road.
Protecting Your Business from Customer Defaults
Selling profitably to slower-paying customers on credit is often necessary. Follow the steps described above and you will be able to reduce the risk of a crippling bad debt loss. The key activities are:
Identifying your financially weak customers and recognizing the warning signs of a customer’s weakening financial condition.
Adopting a tight order control process (no order accepted unless a payment, preferably in excess of the order value, is received.)
Identifying customers at risk of default is relatively easy for publicly held companies, which are required to disclose huge amounts of financial data every quarter. Its a relatively simple matter of determining if they have the working capital and cash flow to pay your invoices at the present time or not, and assuming they can, if there will be a time in the future when payment could become problematic. Because these are often large accounts, they require constant monitoring.
The assessment of financial strength and liquidity is more difficult for privately held customers. You must rely on external factors since they are unlikely to provide financial statements unless they require a substantial credit limit. Therefore, you need to always be on the lookout for signs of financial distress, especially in our current economic environment.