Evaluating Trading Partner Risks

 
 

According to the January Atradius Economic Update report, in 2019 global trade growth will remain strong but will decelerate slightly, reaching 3% this year in comparison to last year, which saw 3.7% growth. One big factor behind the deceleration is uncertainty, which seems to lurk everywhere these days and can be depended upon to have a negative effect on business investment and consumer spending.

A major area of uncertainty at the moment is the unfolding U.S.-China trade war with current negotiations focused primarily on intellectual property and technology transfer issues. If the trade conflict escalates, 2019 economic growth forecasts will likely be revised downward with specific industries likely to be more severely impacted than others. In the United States, trade protectionism threatens to further increase input costs, which, combined with the 2018 interest rate hikes and associated rise in borrowing costs could result in a less favorable business environment.

The U.S. corporate sector faces its own risks, not least of which are rising interest rates and historically high leverage. As a result of the fiscal stimulus following the 2008 financial crisis, many companies took advantage of easy access to financing to fund growth. Now, corporate balance sheets show more leverage than ever before, with a large proportion of BBB-rated debt. These heavily leveraged businesses could face refinancing risk in light of the significant interest burden coupled with expectations for earnings growth pressure. Given the current state of corporate balance sheets and uncertainty surrounding monetary policy and trade negotiations, U.S. corporate insolvency rates face increasing downside risks that could lead to higher insolvencies moving forward.

These large-scale economic trends are important to take into account when assessing business risks, but they hardly tell the whole story. From the perspective of global trade, areas of risk and opportunity exist regardless of industry sector and can be identified through bottom-up, company-specific credit analysis. Even within underperforming industry sectors such as traditional retail, agriculture and paper, the underlying strength and health of company balance sheets vary greatly depending on the strategic decisions surrounding growth and debt taken over the last decade.

This is why effective risk management includes a thorough evaluation of each potential trading partner. Credit managers and finance executives should focus on potential growth, the trend of input and output costs, the ability to generate cash flow and access to external financing. Once a trade relationship is established, expand your knowledge of your customers through regular visits and conference calls.

A trading partner’s financial situation can quickly deteriorate during a period of economic stress.  When looking for warning signs that a trading partner is headed for disaster, the old adage “cash is king” continues to ring true. While growth, strategic share repurchases and even dividend policy can be funded through debt in the short term, companies ultimately need to deliver sustainable positive free cash flow and reduce their dependence on external financing in order to remain financially flexible during an economic downturn. Red flags indicating potential financial trouble could include requests for extended trading terms, significant short-term debt at high interest rates, top line pressure, credit rating downgrade and/or fundamental changes within the industry sector related to new entrants, technology advancements or regulatory policy.

Beyond evaluating each trading partner, additional steps companies can take to protect themselves against risk include:

  • Diversifying customer and supplier concentrations.
  • Establishing credit procedures and policies in line with industry best practices.
  • Actively monitoring high-risk credit exposures.
  • Purchasing trade credit insurance, which will help to mitigate trade receivable and cash flow risk.

One of the benefits of utilizing trade credit insurance is the team of credit analysts hired by the insurance carrier, which essentially functions as an extension of a customer’s credit department. In addition to unparalleled access to trade credit data, carrier investment in emerging technologies surrounding big data and artificial intelligence are expected to address the ongoing challenges of processing increasingly massive amounts of information available in a format that is approachable, useful and successful in establishing sound credit decisions.

What Risks Are Worth Taking?

Some risks are simply a part of doing business, while other stem from uninformed decisions and can endanger a company’s existence. So how do you tell the difference between the two?

Business leaders should assess both the likelihood of a particular risk factor occurring and the ultimate impact to the business should the risk occur. For example, if there is a particularly high-risk credit exposure within your accounts receivable and the associated potential bad debt loss would materially impact the financial health of the business, there is high motivation to mitigate this risk through credit insurance or a trade receivable put.

At the end of the day, the health and strength of a company’s financial profile will dictate a company’s ability to take risk. The key is to determine appropriate risk tolerance and to establish a risk management process that appropriately and actively monitors risk exposures.

 
David Culotta

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About the Author

David Culotta, CFA, is the senior manager of U.S. buyer underwriting for Atradius Trade Credit Insurance Inc.

 
 
 

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