Searching out prior payment behavior has long been the gist—and the weakness—of credit-risk assessment. Rarely, if ever, have the weaknesses been more apparent. Rampant inflation, chaotic supply chains, and harrowing international trade and military relations have disrupted normal business practices and expectations with little or no improvement in sight. Now's the time to search out your customers' trade and financial relations more closely than ever before. It could be a time to urge, recommend and even demand changes. 

Any connection between petroleum and undergarments is lost on most of us, but not to those in the women's clothing industry. Cyclohexane, a petroleum derivative, is essential in producing the material that makes women's undergarments comfortable and properly fitting. It follows that any major increase in the cost or any serious shortage of petroleum can have a significant impact on the industry. And that seemed to be impending some years ago when Roger Torneden, Ph.D., Director of the UCLA Extension's Business, Management, and Legal Programs, was an executive with a major clothing retailer.

“My employer was one of the largest purchasers and sellers of undergarments in the U.S.,” he explains. “Substantial increases in oil prices were expected, and we visited the vendor's home office and talked about what that would do to both our businesses. We suggested pre-paying the contracted cost of what we would be acquiring from them for a much longer period than normal. 

Bridged for a Year

“We actually bridged for almost a year,” he continues. “By working with the main supplier, we were able to avoid increasing our prices when oil prices went up. The supplier also benefitted, locking in a price and a more certain margin. Our competitors didn't do that, and we found that prices of competing products at other firms were going up, while we didn't need to increase our prices for a year.”

Befitting Torneden's prominent position in trade credit expertise today, he focuses mainly on the supply chain risks in extending credit to businesses. “A certain amount of my DNA is in credit, but it's the credit that's related to protecting and growing overall cash flows,” he says. “It focuses on credit practices that are needed to support sales growth without adding unanticipated credit risks. What I've done is to reach out to some large providers to ask them what their plans--or their contingency plans--are for protecting their own asset quality and their own ability to pay. What I'm looking for are areas that could be troublesome, raising credit risk for both of us because we're both in the same boat. Neither of us can have bad debt expenses trending substantially higher.”

He notes that years ago in the retail industry, the bad debt of 1 percent of sales and profit margins of 4 or 5 percent of sales were typical. “If our bad debt went up to, say, 2 percent it would drop our profit margin by 20 or 30 percent,” he says. “It was such a highly sensitive area that we tried to keep in touch with our important suppliers and find out what their strategies were to contain their own costs, particularly for labor and raw materials.”

“We needed to better understand the business linkages and the remediation actions for the upheavals that we'd had in the supply chain and that would probably get worse.”

Upheavals Worse

Now, of course, those upheavals have gotten worse—much, much worse. Before COVID, inflation was running high and intensifying trends that were in place before, especially with supply chains. “We've entered a period where companies are paying a lot more in getting products, particularly fabricated products, and these extra raw materials, processing, and transportation costs did not find their way into the metrics of the inflation reporting until a couple of months ago. Global exports from Ukraine and Russia have slowed or largely stopped and wages are rising rapidly. Our European suppliers are working on survival instead of fulfilling purchase contracts given that their access to Russian oil and natural gas as well as raw materials are threatening total business shutdowns. We are shifting from globalization to localization at a pace similar to the shift to remote work to counter COVID in 2020.” 

“These are all tsunamis that are approaching but haven't hit the shore yet. They are still not entering into the metric the government is using for reporting inflation, estimated now at over 8 percent. Long terms interest rates which are typically inflation plus 1 to 2 percent, are now heading strongly upward.” 

He notes that this will have a major impact on credit, which will be more expensive and have a bigger impact on P&Ls. “Together with all the price increases of the inputs, companies over the next year or so will be squeezed on margins. That will cause another cycle of bankruptcies and foreclosures. The media talk about trillions in savings, but it's in the hands of a very small percentage of Americans. Well over 90 percent will have less spending power. The consumer will not be the engine bailing out the economy because we're now moving into a recession.” 

The Fed's Role?

What can the Federal Reserve do about this? Not as much as is generally thought. He points out that the Fed controls interest rates in the very short term but cannot control long-term rates. “The markets are just too large, and the Fed does not have that kind of a resource base. They can control the overnight and 30-day rates, even possibly the 60-90 day bill rates. They can have a lot of influence on that, but pretty soon it's going to be apparent that companies wanting to finance longer-term will have a hard time doing it, and interest rates are going to be significantly higher than last year.”

“That will make carrying ARs more expensive in the intermediate-term. It will make credit decisions trickier because the worthiness of a lot of companies will be changing and global trade will have another negative impact. Just when we're coming out of COVID and just when the ports are getting more imports, we're in the midst of a lot of sanctions, and these sanctions seem to be getting greater and involving more countries.”

So how do you best assess how your customers will fare in this radical new business and economic normal, and, of course, how they will manage to pay you? He suggests taking a step back from the day-to-day operations and phone calls and taking a look at alternatives in what the supply chain this year could look like. Chances are they will be buying raw materials and pre-fabricated parts from different sources, particularly if they have relied on Russia, and Russia's traditional customers in Europe. European vendor relationships have new and substantial credit risks and our own businesses have new supply contract fulfillment risks.

You need to look into what the alternative supply chains they may be forced to use, might look like. “Never mind looking for the ideal supply chain,” he says. “Consider models in which negative environments maintain themselves or get worse, which could include China, and look at what contingency plans for supply chain alternatives could be.” 

He suggests taking a step back and holding discussions with consulting firms, maybe even the D&B of the world. “Really step back and try to find credit evaluation sources in advance that would relate to revised supply chains. That could involve sourcing more from the U.S. That could make it a bit easier, though maybe more expensive in the short term, as the U.S. builds its own supply chains in some of these areas. Or it could result in Southeast Asia, India, or Latin America credit evaluations, which many businesses don't use or even think about now.

Supply-Chain Alternatives

He also suggests looking at digital supply chain alternatives that exist now but did not exist five or 10 years ago. “Raw materials can be bought and sold on some of the large digital platforms. It's a different and much more digital world. But it's not a certain or even stable world. A lot has changed including large amounts of supply chain items that can be bought and sold using digital platforms, albeit with new credit risks.” 

This would take some strategic, as opposed to day-to-day, thinking that can come from consulting firms, some of which might be low cost, he notes. It may be associated with or acquired through banking connections. “Some might be more expensive but not require a long-term commitment. It's up to credit managers and directors to show a lot of initiative.”

Clearly, these discussions go well beyond normal Credit/Purchasing interactions. CFOs of both organizations must be involved, as well as the heads of involved business units. “In my experience, the business units have every desire to collaborate,” he says. “They want their products at a more certain price, and they're the ones who set the price in the wholesale marketplace, if not retail. The main challenge is to get the CFO on board because if there's a pre-or advance- payment, that will require more immediate cash outflows and credit policy exceptions. You need to show what the trade-off would be by basically making an additional payment to lock in prices for a longer-term. You have to show that the additional revenue margin will more than pay for that, as well as additional credit risk protections.”

It is essential that looking at the supply chain, you identify where there are going to be risk over the next year or two. “Not every risk, but the major risks,” he says, “maybe the top four or five. It has to be very focused, and, once this is done for the first time in a company, it's much easier for the credit department to have the legitimacy or respect to actually have this be more of accepted practice.”

Change Can Be Difficult

There will be naysayers to all of this, he acknowledges. “Unless it's the CFO or the owner who is acting as the CFO, getting approval to make that kind of a change is really difficult. There will be those opposed. The key is to get the buy-in of the approver. There can be a lot of people along the way who can be distracted. It's a matter of searching out what is really indisputable in terms of today's new risks and managing these new risks.” 

“For example, back when cyclohexane was the issue, it was indisputable that oil prices were going up. You have to anticipate that there will always be people who will disagree so you have to get data from wherever you can. And it won't be perfect. It never is. It requires persistence plus brevity to actually boil down the issues to plain speak. Get the final decision-maker(s) involved in your assessment early on. Don't get distracted by people who will be against it ‘no matter what.' There will always be people who do not want change. It's a given.”

“With the aforementioned undergarment case, we basically needed one senior management advocate who happened to be, as it usually is, the CFO. It's not a matter of putting it up to a vote of hundreds of people. It's basically looking at who in the organization would be advocates of positive change and focusing on those one or two people.”

Contact Information:

Phone: Office 310-206-1720

Email: RTornaden@unex.ucla.edu

LinkedIn: https://www.linkedin.com/in/roger-torneden-64ba395/

Credit Today is continuously adding resources to strengthen our Credit and Treasury ideas, data, and best practices. We'd all agree that reading the tea leaves of today's volatile and rapidly changing financial markets is too much of an add-on to our daily deliverables and responsibilities. Dr. Torneden has agreed to make his UCLA Extension Business Insights Podcast (bi-weekly) available to all our subscribers starting today!

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