How to Protect Your Business from Insolvency Risk

What is Insolvency Risk?

Insolvency risk refers to the possibility that a company will be unable to meet its financial obligations within a specified period, usually one year. Also known as bankruptcy risk, insolvency can stem from various factors such as poor cash flow management, overspending, or even customer defaults.

Recent economic crises have shown that insolvency risk isn’t always the result of mismanagement. The global recession of 2008 and the COVID-19 pandemic of 2020 demonstrated that even the best-run companies can face insolvency risk through no fault of their own.

Customer insolvency, especially involving your largest clients, can impact your own cash flow and jeopardize your business. Supplier insolvency can also have significant effects if you have to pay higher prices or face difficulties obtaining necessary supplies from alternative sources.

In worst-case scenarios, losing crucial business relationships can lead to your own insolvency – a phenomenon known as the “insolvency domino effect.”

Assessing Your Own Insolvency Risk

The first step in protecting against insolvency risk is conducting an accurate credit risk assessment of your own company, customers, and suppliers. Keep a close eye on these warning signs:

• Declining profitability: For example, if your sales are dropping or your costs of sales are increasing.
• Low interest coverage ratio: This indicates that operating profits may not be sufficient to cover interest expenses.
• Weakening balance sheet
• Cash flow and liquidity issues: Are your fixed costs or interest payments slowly increasing, or do you have a large number of customers paying late?
• Operating profit margins: Are they getting thinner?
• Debt maturity, refinancing, and fundraising ability: Under what conditions can you refinance your debt? Can you raise funds in the capital markets or tap into your credit lines if needed?
• Your order book: How does your future business volume look?

Identifying Supplier and Customer Insolvency Risk

Your cash flow is at risk if your customers delay payments or are unable to pay at all. If your suppliers can’t deliver on time, your own production slows down, making it difficult to fulfill your own promises. Watch for these potential warning signs of supplier or customer insolvency:

• Are they taking longer to settle invoices or make deliveries?
• Are they requesting to renegotiate contracts, asking for extended (if they’re customers) or shortened (if they’re suppliers) payment terms?
• Is there a trend of disputes over bills or deliveries?
• Has your customer recently lost a major client or supplier?
• Have they received negative media coverage?
• What’s happening in their industry or country? These factors are part of the economic climate they operate in and could affect customer insolvency.

Additionally, stay alert to news reports or business organizations that might spread information about your customers: mass departures of employees and executives, or difficulties in paying wages, etc.

Natural climate should also be taken into account. In recent years, extreme weather events, climate change incidents, and the COVID-19 pandemic have led to increasingly rapid business interruptions or supply chain closures.

How to Protect Against Insolvency

Take these steps within your own company to help mitigate risks and build insolvency protection:

• Shorten your supply chain and avoid concentration in one geographic area.
• Always assess customer credit before entering into agreements.
• Ensure your customer portfolio is balanced so that most of your income isn’t heavily dependent on one or two customers.
• Set up a cash buffer that the business can use in emergencies.
• Review the credit terms you offer to customers and suppliers, and compare your trade terms with others in your industry.
• Use online technology as much as possible to make “pivoting” easier. Think of how retail businesses shifted online when physical stores were forced to close overnight due to the COVID-19 pandemic.
• Invest in payment tracking and debt recovery processes, including professional insolvency risk services.

How Can Insolvency Protection Insurance Help?

Insolvency protection is not an exact science, as countless risks exist outside your own business operations’ control. But if not detected early – for example, with the help of insolvency risk services – you may find yourself caught in a vicious cycle of insolvency risk.

Insolvency protection insurance can safeguard your cash flow and compensate you in case of bad debts, thus greatly limiting the damage credit risk can do to your own company, especially when insolvency is caused by unforeseen events.

For example, leading trade credit insurance companies like Allianz Trade offer additional insolvency risk services based on trade credit insurance, such as:

• Debt recovery, with the necessary skills and experience to maintain effective and ongoing dialogue with debtors and their legal teams, regardless of which country or jurisdiction they operate in.
• Providing preventive protection, helping you choose the right customers and the right markets to avoid bad debts in the first place, thanks to astute financial analysis.
• Comprehensive market intelligence, giving you a full understanding of industry sectors and future difficulties.

Remember, quick reaction time is key. Ideally, you should identify warning signs and take action before customer insolvency occurs. Insolvency protection insurance can reduce the risk of customer insolvency, maintain cash flow, and help you grow your business.

Conclusion

In today’s volatile business environment, protecting your company from insolvency risk is more crucial than ever. By staying vigilant, diversifying your customer base, maintaining healthy cash flow, and considering insolvency protection insurance, you can significantly reduce your exposure to this potentially devastating risk. Remember, prevention is always better than cure when it comes to financial health.