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They’ll eventually pay…won’t they?

by Scott Simpson

Managing credit risk in building supply is not for the faint of heart: According to Michael Stone of markupandprofit.com, 90% of these customers will fail in the first 10 years of business, and most of them will fail within the first three. The question of bad debt is really not a matter of if it will happen, but when—and how badly. The key to protecting oneself is understanding the difference between the customers that are having a temporary dip and those that are becoming dangerous credit risks. Many distributors falsely believe that customers that are busy and buying a lot must be doing well. But to understand the difference between a busy customer and a healthy one, one must first understand the death spiral.

If a customer is low on cash, normal behavior is to delay payments as long as possible. Payment will be made more slowly. Underpricing to win jobs for quick cash and maybe even going after jobs outside one’s geography or specialty can occur. But underpriced jobs aren’t profitable, and soon that customer will find itself right back at the top of the cycle, low on cash again. This downward spiral can go on for weeks, months, quarters, and even years.

So how does a distributor know if a customer is getting in trouble?

• Warning sign No. 1: There’s a break in consistent payments. It’s more troubling to see a prompt payer start paying 30 or 45 days late than to have one that pays 45 days late consistently.

• Warning sign No. 2: The customer is making short and rounded pays. Not paying in full—and especially paying a rounded amount—is generally signaling that the customer is paying just enough to make sure the account stays active.

• Warning sign No. 3: There is difficulty in connecting with the customer. Of course, this can just mean a person is busy or on vacation—but it can also mean that something is very wrong.

• Warning sign No. 4: The customer is breaking promises. Customers who promise to make payments and then miss these commitments are displaying a major red flag.

If any of these warning signs occur and the decision is made toward putting a temp stop or hold on the account, watch the reaction. Most customers are contrite and (sometimes) embarrassed that they’re behind and will agree to make good, while an emotional or angry response is usually a sign that the business is under stress.
The most important part is to pull credit at least three times a year and monitor for trouble signs. Doing so will be a big help in determining who is actually risky and who is having some lumpiness in their cash flow.
It’s also important to check payment trends with other trades. Is the customer getting behind with other suppliers? Is anything severely delinquent—90 days-plus? Recent judgments or liens are also strong indications that this customer is not fully meeting its obligations and other suppliers are taking action.

There are more subtle indicators as well. If the amount of money owed to others is approaching a historically high credit limit, that customer is borrowing more than ever before. It’s also concerning if there are several new inquiries or trade lines, especially if someone has been with a certain distributor for a long time. That can be a sign that the former distributor suspended the account.

Finally, it’s important to not only ask for the guarantee, but also check to see how the customer is performing and if there are other signs of duress. If the FICO of the owner or personal guarantor is less than 700 or worsening, pay attention. When it comes to dealing with these problems, a hard and fast rule is not the answer. Rather, look at the trends that matter. By watching customer behavior and pulling credit regularly, you’ll be in a strong position to know whether one of your customers is in trouble.

Simpson is president and CEO of BlueTarp Financial (bluetarp.com). He can be reached at 207-797-5900 or ssimpson@bluetarp.com.

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