They’ll all eventually pay ... right?
Managing credit risk is not for the faint of heart: 90% of contractors will fail in the first ten years of business, and most of these contractors will fail within the first three (Source: Michael Stone, markupandprofit.com). The question of bad debt is really not a matter of if, but when it will happen to you and how badly.
The key to protecting yourself is to understand the difference between a customer who is having
a temporary dip and someone who is becoming a dangerous credit risk. Many dealers falsely believe that if their customer is busy and buying a lot, they must be doing well. To truly understand the difference between someone who is busy and someone who is healthy, you must first understand what the death spiral looks like.
If a contractor is low on cash, his normal behavior is to delay payments as long as he can—so he will pay you more slowly and pay others more slowly, too. Those that are in trouble start to underprice to win jobs and to get cash. Oftentimes it also means he goes outside of his
geography or outside of his specialty to win jobs. If he’s underpricing to win jobs, those jobs will not be profitable and he is right back at the top of the cycle where he is low on cash again. This downward spiral can go on for weeks, months, quarters and even years.
The downward spiral ultimately results in business “death” when accelerants come into play. For example, if a contractor trips one of his bank covenants, that line of credit can become restricted or even lost. Similarly, if you or other dealers start to restrict your credit lines and put temp stops on them, that’s like taking oxygen away from a fire. Third, disputes tend to be a big accelerant for contractors. If someone is counting on getting paid and they have a dispute over payment, that’s a big problem. And lastly, if a major customer does not pay that contractor, that can turn a contractor who is in the spiral into someone that becomes a bad debt risk for you.
Bank covenants tripped
Supplier credit lines restricted
Disputes over payment
Major customer no paying them
So how do you know if someone is getting in trouble? First, pay close attention to his behavior with you. We recommend to our dealers to take note of the things that you see regularly when you interact with him. A big sign for us is a break in the consistency of payment trend. At BlueTarp, we find it much more troubling to see a prompt payer all of a sudden become 30 or 45 days late, than someone who is chronically late and pays 45 days consistently. Inconsistency can be a big warning sign that something is not quite right.
Pay close attention to how customers behave
A second indicator is short pays and rounded pays. Anybody who is not paying in full, especially if he is paying a rounded amount, is generally signaling that he doesn’t have the cash to pay in full and is paying enough to make sure his account stays active. Another sign is difficulty in connecting or unreturned calls. Sometimes this means something, or sometimes it just means a person is busy or on vacation.
- Break in consistency of payment trend
- Short pay, rounded pays (000s)
- Unreturned calls, hard to connect
- Lost invoice
- Broken promises to pay
- Over-reaction to holds on the account
If somebody promises to make a payment and misses that commitment, that is major signal something is amiss. If you then move towards a temp-stop or hold on his account, watch what reaction you get. Most contractors are contrite and (sometimes) embarrassed they’ve let their account slip and readily agree to make good. If instead of this you get an emotional or angry response, that’s usually a great tell that the business itself is under great stress. Paying attention
to what your customer shows you can tell you a lot.
Pull credit 3x a year and monitor for trouble signs
The more important part of the puzzle is to pull credit at least three times a year on all customers and monitor for trouble signs. You’ll be able to determine who is actually risky and who is having some lumpiness in their cash flow. Few dealers do this regularly. Check the payment trends with other trades. Are they getting worse with other dealers? Is anything severely delinquent—90-days plus? Recent judgments or liens are strong indications that this customer is not fully meeting his obligation and other dealers are taking action.
There are more subtle indicators as well. If the amount of money they owe to other suppliers is approaching a historical high credit limit, that customer is borrowing more than they ever have before. We also raise an eyebrow if we find several new inquiries or trade lines, especially if someone has been with a certain dealer for a long time. That can be a sign that his former dealer suspended their account and he is looking for credit at another dealer.
Most dealers are very good about asking for personal guarantees. The important part is to not just ask for the guarantee but to check to see how they are performing and if there are other signs of duress. If the FICO of the owner or personal guarantor is less than 700 or is worsening, pay attention. We advise dealers to try not to have a hard and fast rule but to look at the trends that matter. By watching your customer’s behavior with you and pulling his credit regularly, you will be in a strong position to know whether someone is in trouble. It’s ultimately a judgment call for you to make, but as Bob Dylan said, “you don’t need a weatherman to know which way the wind blows.”
Key Signs of Trouble
- Payment trends with trades worsening
- Other trades reporting >90 day delinquency
- Recent judgment or liens
- Money outstanding approaching historical high credit
- Several new inquiries and/or new liens
- FICO of owner or PG <700 or weakening