While the number of businesses filing for bankruptcy has declined since the Great Recession, there are warning signs that this trend could quickly take a turn in the wrong direction. If that happens, savvy business owners must be prepared.
Research from the Supreme Court on federal court filings show that bankruptcy filings are at their lowest levels in more than a decade. However, at the same time that bankruptcies ‒ legal processes involving actors that can't repay their debts to creditors ‒ are declining, business debt is rapidly rising. In fact, the Federal Reserve's recent financial stability report shows that leveraged lending is 20% higher than last year and flags a decline in protections for lenders against default.
This is important to be aware of because debt and cash flow ‒ more precisely, the inability to effectively manage debt and cash flow ‒ are the principal drivers of bankruptcy. If you want to understand the risk of selling your goods or services to someone on credit terms, understand the credit report first.
Pay close attention to the credit score and credit limit, both of which will tell you a lot about a company's payment behavior and the likelihood of it becoming bankrupt in the near future.
These are the four warning signs
In my years helping companies manage credit, I've identified some red flags when it comes to debt management issues.
- Changes in payment behavior: It's a major red flag if a business has suddenly slowed payments to its primary vendors, or, worse, to the utility companies in charge of keeping the lights on. While some businesses simply have a style of paying bills past due, it's almost always a bad sign if they aren't paying for water, lights or gas. This is by far the more predictive factor in business failures, as it indicates a real-time, looming cash-flow problem.
- Tax liens: If companies don't pay government taxes, these liens can stack up quickly with local, state and federal entities. Government agencies will always be first in the queue to get paid from the liquidation of a failed company's assets, leaving you with nothing or very few cents for each dollar owed.
- Court judgments: If a business is taking another business to court for unpaid bills, it might be indicative of a cash flow problem. While this is not always the case, businesses should see this as a red flag and investigate further. Keep a close watch on this business, as it might already be on the path to bankruptcy.
- Prior involvement with failures in other companies: If company owners have been involved in previous bankruptcies, especially recent ones, this typically increases the chances of future insolvency. A business owner who has formerly been a part of an organization that has gone through bankruptcy is less likely to have the fortitude necessary to fight off the impending financial downfall of his or her current organization.
If enough of these factors exist, the likelihood of bankruptcy is fairly high. Keep in mind, too, that when a company goes bankrupt, it doesn't do so in a vacuum. The effects of one bankruptcy ripple through the whole economy and cause a chain of others.
Consider, for example, Hasbro. The major toymaker reported a 13% drop in sales over the holidays in the wake of the Toys R Us bankruptcy. Similarly, sportswear brand Under Armour has felt the effects of retailers like Sports Authority filing bankruptcy.
In cases like these, the suppliers of the bankrupt retailer face serious repercussions, no matter the quality of their products or services. For some suppliers, a retailer the size of Toys R Us might account for half of their business. When that piece of the chain breaks, the result can be a crippling loss across the supply chain.
Four ways to manage your business's debt
Protecting your business against debt can save you from bankruptcy and spare the overall economy a bit of trouble. Here are four tips to get your own debt and cash flow management on track:
1. Pay your bills on time.
Don't give yourself a reason not to pay your suppliers on time. If you aren't making timely payments, you're unnecessarily straining those relationships and slowly building up debt. Further, if you get too far behind on payments, your supplier might freeze services to your business altogether or even take you to court.
Your business credit report will suffer if this happens, which will put you that much closer to bankruptcy. If you foresee any problems fulfilling your payments, be honest with your supplier at the earliest opportunity. Ultimately, it's in its interest to help you so it can ensure payment and your business in the future.
2. Give the government what it's due.
The last thing you want on your credit report is a tax lien. If potential vendors see that you're not paying what's due to the government, they'll likely assume that you won't pay for their services either.
That doesn't mean a tax mishap is a death sentence for your business, but you don't want any issues to snowball ‒ and with the government, they can snowball quickly. If you get off course, be proactive. Set up a payment plan, and stay on good terms with the people in charge.
3. Learn to use credit reports.
Credit reports, both your own and those of your customers, are a vital tool for your business success. Start by studying yours to determine where you stand. Potential customers and lenders will look, and you want them to be impressed with what they see.
A credit report is also essential when you're onboarding a new customer. If customer reports raise red flags, save yourself a major headache by extending them little room for error.
4. Don't forget that rainy day fund.
Never assume that even your best buyers won't hit choppy financial waters. If you monitor their credit reports regularly, you can see early warning signs and work with them to change their payment terms or make other arrangements.
If they do face financial downfall, you want to be prepared and have the cash to weather the storm. Plan ahead and add what padding you can to your reserves. The best business owners are ready for the worst.
You might have noticed that there is one common, unifying factor in each of the four tips above: relationships. It's often difficult to cultivate relationships in the world of finance and credit and is even harder in a B2B enterprise. However, building relationships can be the single biggest factor in your organization's successful avoidance of the bankruptcy domino effect.
Knowing your suppliers and the organizations you supply, their habits, the points of contact, and their financial history goes a long way in overcoming issues. Being able to send an email or make a phone call to clear up any confusion or answer any questions can be vital to a proper understanding of a situation.
If things do become problematic, a relationship can help make hard conversations a bit easier and lead to a plan of action going forward. Further, it can be instrumental in minimizing the potential damage caused by an unavoidable bankruptcy.
The bankruptcy process is long and tiresome and not something any business wants to endure. While there is no absolute cure for avoiding the effects of bankruptcy, sound financial practices are just as important in good times as they are in bad, and proactive debt management has always been a critical part of that equation.