Talk to any managing director in the IT industry and they are likely to admit that their biggest fear is losing their business because they took a risk on a customer that went belly up.
But while most agree that the best form of defence is to avoid risky deals, it is impossible to trade without taking on an element of risk. The question is: how do you evaluate risk, and how do you protect yourself against worst-case scenarios?
For distributors, credit insurance and credit rating agencies (CRAs) are a way of life. They rely on credit checking to rate the credit worthiness of those they trade with, and the credit limits that they apply are set by the insurance services.
For example, new resellers begin with a credit rating of between £2,000 and £5,000, and this is only upgraded after the first year's successful trading is shown in records published by Companies House.
But such services do not come cheap, and ultimately SMEs have to weigh up the benefits of protection against the costs they incur.
Whatever services you buy in, transparency is the key, believes Chris Williams, senior analyst at credit reference and intelligence agency Graydon.
"The most important thing for distributors is good communication from their VARs," he says. "They rely on VARs telling them what is going on. My advice to resellers is that they keep their distributor well informed; problems usually occur when that kind of transparency breaks down."
But what does a company such as Graydon do? The kind of information that a credit agency looks at is broad. It collects news, gathers intelligence from credit managers with which it has relationships, monitors job changes of key staff and gathers intelligence on what it calls 'lifestyle' aspects of the business.
For example, company executives may be spending huge amounts on company cars rather than ploughing the money back into the business.
Graydon worked with fraud specialist Fair Isaacs to develop a scoring system for evaluating credit worthiness. Essentially, this scoring system measures a number of key characteristics and delivers risk ratings to allow credit controllers to evaluate the risk of doing business with any company.
"It all comes down to risk. A credit manager or a financial director has to decide how exposed they want to be. It is not true that the best companies never expose themselves; they do take risks - the most successful companies always do, but they make sure they win more than they lose," Williams says.
So what if a VAR finds it has the potential for doing a big deal for, say, £1m, but doesn't have the credit rating? Williams urges pragmatism. "The thing to do is to talk to your distributor. The only thing distributors don't like is lack of information," he says.
Williams adds that the common error of VARs is to just ask for credit without thinking what it means for the distributor.
"You are effectively asking them to be a kind of shareholder. Sometimes VARs are asking disties to take more risk than any of the shareholders are. Conversely we advise disties to get as much experience and knowledge of a VAR as they can. This often means visiting the premises to see what is going on.
"What companies have to worry about is if they get credit insurance and find that a particular company that they deal with has had their credit limit removed. That effectively means they are not covered, even though they have insurance."
Credit insurance is designed to protect businesses against non-payment by a debtor. The policies help out when a customer pays late or goes insolvent. Insurance normally covers 90 to 95 per cent of the insured debts, and businesses can choose to insure invoices, specific customers or their whole book of debtors.
Whole-book cover generally costs between 0.15 per cent and 0.5 per cent of a company's turnover. Insuring selected invoices or customers starts at about 0.4 per cent of the invoice amount.
So have credit insurance companies cleaned up their image? Paula Evans, industry development manager at credit insurance firm Atradius, admits the industry has suffered from some negative press.
"There has been bad publicity as a result of the activity of some of our competitors, and some customers are concerned about credit limits being pulled. But we are not like car insurance: it's not compulsory, and we believe that when we pull a buyer's rating it is in the best interests of all our customers," she says.
Like most credit insurance firms Atradius offers a range of options for insurance and has a debt collection service for firms seeking only to minimise the damage of bad debts when they occur. "My advice to resellers is to think again about insurance and at the very least take a debt collection service," Evans adds.
Atradius's debt collection facility involves taking on the debt, chasing by letter and phone, and legal advice where the problem needs to be escalated. Payment is on a no-win, no-fee basis.
Evans also offers basic housekeeping advice. "As a starter you should be looking at all your procedures. Make sure they are tight and well managed," she says.
In fact such introspection is essential for firms wanting insurance because any insurer will look closely at the business before agreeing a contract. Atradius looks at forecasts for the business sector, past growth of the business, debts to date and existing credit control procedures.
Resellers can reduce overall costs by taking an insolvency package that limits insurance to cases of insolvency only. But typically policies vary depending on size of turnover and types of buyers.
Atradius gathers information on credit-worthiness and passes ratings on to customers, but it does not supply more detailed information in the way that credit rating agencies do. However, Evans says the company is in the process of developing more advanced information services for customers "although not in competition with the likes of Graydon".
So what are the main reasons for messing up cashflow?
Patrick Wadsted, partner at insolvency and business rescue specialist Middleton Partners, says low and falling margins are widely acknowledged as a key issue for businesses in the IT sector.
"This makes it a tough market to operate in, especially for firms at the smaller end of the marketplace. Poor cashflow is the cause of about 60 per cent of business failures, and this is often the result of bad debt collection," he says.
Wadsted adds that resellers have to watch out for customers that go bust, subsequently putting pressure on their own cashflow.
"In an ideal situation you should seek payment in full before goods even change hands. This is not always possible, in which case you should ensure that you have an efficient process for collecting your debts," he says.
Wadsted suggests using a CRA and/or Companies House. This should tell you about the history of the company and its directors, their record of paying bills, whether they are litigious and if they have been involved with insolvent firms. A CRA can even advise you on how much credit you should give them.
Resellers can do basic credit checking by getting information from the Companies House web site and using services such as CRN's checking service at www.crnservices.co.uk.
"Many companies go out of business needlessly because they are afraid to seek professional advice. They mistakenly think insolvency practitioners are only in business to close companies down. We spend a great deal of our time trying to find solutions that will save businesses.
"In most cases what appears to be a helpless situation to a company is an everyday occurrence with a solution for an insolvency expert," Wadsted says.
"One problem we come across is firms that have had problems in the past which have now been resolved but are so crippled by debt that they are unable to operate. In cases such as this, one solution is a company voluntary arrangement [CVA].
"This is something we will see a lot more of now that the Enterprise Act is in place and with the planned merger of the Inland Revenue and Customs and Excise."
A CVA allows a company with cashflow problems to repay its unsecured liabilities (including those owned to the Inland Revenue and HM Customs), by entering into a binding agreement with its creditors detailing how its debts and liabilities will be dealt with.
The basis of a CVA is to repay what the firm can afford - which can result in either a part or a full payment to creditors - over a fairly long period of time, usually two to four years.
Typically, once the company's liability has been restructured, any monies generated or owed to the company, such as book debts, can be used as working capital rather than to pay its old debts.
Meanwhile, some believe that a way to mitigate risk is to get customers onto finance packages.
Philip White, sales director at finance and leasing firm Syscap, says IT finance can be the solution to cashflow problems. "In a finance situation, the equipment supplier and VAR are paid in full on delivery, leaving the finance firm to worry about collecting the money over time," he says.
Importantly, all the credit risk attached to such an agreement lies with the finance company, not the reseller. Finance, therefore, reduces the debtor days for that transaction to zero, with no financial risk.
Syscap also offers a pre-screening service for resellers where potential customers can be credit-checked before any equipment changes hands. Even if the customer decides not to use finance, the reseller has more background details on the customer.
White also believes finance helps resellers do more business. "Finance helps resellers to up-sell. By being able to offer the equipment that a customer wants, rather than just what they think they can afford, there is the opportunity to make much more on every deal," he says.
But tightening up internal procedures can go a long way to solving problems before they occur.
Nick Tiltman, director of credit services for the northern region at Tech Data Europe (parent company of Computer 2000), believes that resellers often fail to tighten their back-office procedures.
"You should always insist on a properly completed application form when providing credit and have checks in place to prevent fraudulent applications. Check the address exists and do not accept mobile telephone numbers or non-geographic numbers," he says.
Tiltman also advises ensuring that you and your customer understand the terms and conditions under which transactions are taking place. "You should chase up invoices promptly. The longer the debt is overdue, the higher the risk of bad debt and the less profitable your initial sale becomes," he adds.
Finally, he urges firms to use credit reference agencies and personal visits to check out customers.
"Don't just rely on a couple of trade references and a bank reference. Many credit information suppliers can offer monitoring services for your customers, but there is no replacement for talking to your customers and visiting them to discuss their plans for the future and how the business is performing," he says.
Increasingly, firms are looking at factoring and invoice discounting to manage cashflow problems.
Greg Carlow, managing director of reseller Repton, says his firm began with factoring but now, like many other resellers, exclusively uses discounting. In factoring, the debt is taken on by a third party, while discounting involves a loan being provided to cover the debt to effectively pay most of it immediately.
"With discounting we can get 85 per cent of the payment up front and we are only paying slightly above base rate for the loan. It's a very effective system which means we don't have to look at credit insurance either," Carlow says.
In fact, he believes SMEs often suffer at the hands of credit insurance rather than benefit from it.
"The credit insurance firms set the limits that larger firms work off when they do business with you. So when they find that you have reached your limit they sometimes unnecessarily decide not to trade with you when, in my view, you are no great risk. It's their loss," he adds.
Managing cashflow is a subtle art at the best of times. Increasingly it is becoming a challenge for resellers to understand how to make best use of the financial products available, and to ensure they can make best of the credit rating the providers of such products are assigning to their business.
Atradius (020) 7173 3400
Graydon (020) 8515 1400
Middleton Partners (0845) 061 6000
Repton (020) 8894 9000
Syscap (020) 8254 1800
Tech Data Europe (0870) 060 3344
Check the ratings of customers by using CRN's own credit checking services, in association with Graydon, at www.crnservices.co.uk.
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