eNews August 5, 2021
In the News
|I. Creating a Bad Debt Reserve That Accurately Reflects Your Company’s Needs|
|II. Prompt Payment Laws Can Bolster Your Chances of Collecting Payments|
Creating a Bad Debt Reserve That Accurately Reflects
Your Company’s Needs
Annacaroline Caruso, editorial associate
This bad debt reserve is too big, this one is too small … this reserve is just right. Determining the right size of your company’s bad debt reserve requires careful planning.
“It’s important that you try to get as realistic a number as possible,” said Chris Finch, director of credit at Sumitomo Electric Lightwave Corp (Raleigh, NC). “It’s anybody’s best guess because none of us has a crystal ball … but it is an important piece of the puzzle.”
Bad debt reserve acts as a safety net for when one of your customers does not pay or goes bankrupt, he added. “Everybody knows that 100% of the money we have out there more than likely is not going to be collected.”
If the bad debt reserve is too small, there will not be enough protection against nonpaying customers; but if the reserve is too large, it could be seen as an incorrect reduction of taxable income.
“There used to be a lot of leeway in building a large bad debt reserve, but now the IRS has created more specific guidelines of how it has to be done,” said Rick Smith, director of financial services at TTI, Inc. (Fort Worth, TX). The new rules add clarity and consistency to calculating the size of a bad debt account, but credit professionals still have a variety of tools to help calculate it, Smith added.
In a recent NACM eNews poll, the majority of respondents said they determine the amount of money that goes into their companies’ bad debt reserve on a case-by-case basis (29%). Other creditors said they use a sliding scale based off of past-due receivables (21%), a general reserve for bad debt (18%), or a percentage based on historical bad debt to sales (17%).
However, it can be difficult to build a bad debt reserve based on one strategy, so most companies use a combination of methods, said Jeff Paschal, director of risk and credit manager at Premier Trailer Leasing (Plano, TX). “We found looking at the [length of past-due receivables] was not necessarily accurate in predicting bad debt if used alone.”
Paschal calculates funds for the bad debt reserve mostly on a case-by-case basis and adjusts the reserve monthly. “If we do our due diligence on the front end and have high credit standards, then the bad debt on the back end should be less and it should be easy to determine who those people are.” He also tries to avoid large jumps and drops in the amount of funds in the reserve, if possible.
“The only way to get in trouble is if something happens in the world or economy that no one can plan for,” Paschal added. “Then it becomes difficult to predict if my customer base is going to falter and create a lot of bad debt.”
How does your company calculate the size of a bad debt reserve? NACM wants to know the variety of different tools your department uses, so we’re running the poll question a second time with the option to choose more than one answer.
Prompt Payment Laws Can Bolster Your Chances
of Collecting Payments
Bryan Mason, editorial associate
As a materials supplier, maintaining leverage over some of the higher ups within the contractual chain can be a difficult task. To help mitigate this issue, suppliers should consider all of the tools in their toolbox—including the Prompt Payment Act.
The Prompt Payment Act allows suppliers to hold some parties accountable for failing to meet payment deadlines. While the federal Prompt Payment Act applies to companies that provide material or labor on federal construction projects, many states enforce their own prompt payment laws on private and public projects.
Because prompt payment laws vary by state, credit professionals should know how they can effectively use these statutes in the states that they do business. Katy Baird, construction law attorney at Andrews Myers PC (Houston, TX), shared some of the benefits of Texas’s Prompt Payment Act, including:
- The right to stop work due to nonpayment.
- The ability to charge interest at 18% per year (or 1.5% per month) from the dates the amounts became due.
- Recovery of attorney’s fees.
- Rights that cannot be waived under this act.
During a recent meeting of the NACM Construction Thought Leadership Discussion Group, Baird also suggested using prompt payment laws in conjunction with construction trust fund statutes as an even more effective way of gaining leverage. “Provided your state maintains a prompt payment act and construction trust fund statute, it is incredibly helpful to include a reference to those statutes and their potential penalties in your demand letters,” Baird said. “The sooner the party above you in the chain of construction understands its potential liability for violating those acts the more likely you are to get paid prior to filing a lawsuit.”
These statutes can provide more leverage “whether you have lien rights or not,” Baird said. They also can serve as attention grabbers that bring higher ups to the table. “In Texas, the trust fund violation statute allows you to assert individual liability against the parties that exercise improper control over the funds on behalf of the company. This enables you to include the individual officers and directors of the company who might have control over the funds in your demand letter,” Baird said. “Under the Prompt Payment Act in Texas, the threat of 18% interest accruing per year on the total amount due and owing is a huge incentive for the party you contracted with to settle the claim with you quickly in order to prevent interest from continuing to accrue.”
According to Baird, some prompt payment acts will likely include exceptions that accused parties may use in defense of the failure to make timely payments. One exception under current Texas law requires the party you contracted with to have a “good faith dispute” concerning the amount owed, she added. These good faith disputes may come in the form of a claim for defective work or the potential for delays to be assessed by the owner on the project, relating to your performance.
“That being said, it is important to determine if the full amount being withheld is lawful under the statute,” Baird said. “In Texas, the contractor is only allowed to withhold 100% of the value of the good faith dispute, meaning that you can negotiate for a partial release of the funds in excess of the disputed amount while you are working to settle the remaining portion of your claim.”
That may not be the only obstacle suppliers can face when enforcing prompt payment laws. In fact, higher ups may try to eliminate certain benefits that suppliers can gain through a prompt payment act.
“Many contracts will try to waive interest for failure to make timely payment,” Baird said. “In Texas, the statute specifically states that any attempt to waive the prompt payment act is void. It’s important to know whether or not your state allows for a contractual waiver of this provision prior to executing the contract so that you don’t inadvertently waive your leverage under your state’s statute.”
Baird’s final words of advice on prompt payment laws are:
- As soon as possible, include these statutes in your demand letters.
- Send a notice to individual officers who are liable under the trust fund statute.
- Copy individual officers/directors regarding prompt payment act interest.
- Use both prompt payment laws and construction trust fund statutes in conjunction with lien rights.
- Have an attorney draft a lawsuit with the individual officer’s or director’s name on it and attach it to a follow up demand.
Supply Shortages Putting
Credit Departments Under Pressure
Annacaroline Caruso, editorial associate
As the world slowly emerges from the pandemic, businesses are facing new problems. Several critical goods—like resin, steel and lumber, to name a few—are hard to come by these days. Widespread supply shortages are driving high prices, shaking up global trade and creating a more demanding workload for creditors.
“There’s been historic jumps in prices of goods,” said Judy Perttula, CBF, NACM North Central board chair and credit manager at Lyman Lumber Company (MN). “So, we’re having to react to the fact that all of a sudden, customers who have never hit credit limits before are hitting credit limits.”
For example, the price per thousand feet for lumber went from $350 to more than $1,400 in May, according to the National Association of Home Builders (NAHB). This means businesses are buying fewer supplies for more money, making it easy for customers to quickly chew up their credit lines.
So now, credit departments are bogged down with adjusting a rush of credit limits on top of their other regular responsibilities. But increased credit limits come with increased risk, Perttula said. “With materials not being available, it has impacted how [construction companies] can get a project done because our customers have to get to a certain level of completion to draw out a loan to pay suppliers, so everything has gotten delayed.”
The supply shortage also means customers are creating more orders to be first in line to buy as much product as possible, said Luana Starr Gehring, CCE, also a North Central board member and credit manager at H.B. Fuller Company (MN). “You’ve got open orders that have not been fulfilled because there just simply isn’t enough product to go around to match demand.”
Credit limits are relieved only once a payment for product is received, but shortages are holding up the order-to-cash process. Creditors are now forced to think months ahead when adjusting credit limits to try and mitigate risk.
“You have to worry whether your customers are as profitable as they once were and whether they have the cash flow to weather the increasing cost of goods to repay their debts,” Gehring said.
She recommended asking for financials before increasing credit limits, especially with fair and marginal accounts. If you cannot get financials, then doing a credit check would be the next step. It also is important to consider estimated annual sales back into a companies’ credit limit adjustment, especially as prices increase.
“In this world of ever-increasing raw material costs, if a creditor is not quick to pull the trigger on increasing prices … their margins are going to shrink and they’re going to be way less profitable,” Gehring explained.
As supply and demand begin to normalize, credit departments will need to adjust credit limits to match. All of the recent attention to reviewing credit limits, while time consuming, is not entirely a bad thing, Perttula added. “It has forced us to reevaluate our customers more often because typically that has generally not been one of the things we do on a schedule,” she said. “It has given us the opportunity to see if we should we keep them at their limit or bring them back.”
Credit Professionals Offer Advice
When Doing Business in China
Bryan Mason, editorial associate
As supply chain disruptions continue to interfere with international business operations, credit professionals have run into a range of issues themselves when doing business overseas. In a recent FCIB International Credit & Collections Risk Management Survey, creditors shared their experiences in China. (The survey also covered Hong Kong, India and South Korea.)
“For the past 12 months, we have been experiencing an increase in the number of orders being delayed to our customers in Asia due to vessel or transport delays,” a survey taker said. “Customers are unable to pay for our product until goods arrive at the port; at which time, they get clearance documents to apply for payment at their banks. Therefore, most of our orders to Asia are paid late.”
This has been a similar narrative for other credit professionals doing business in China, as about two-thirds of the respondents doing business in that country reported payment delays have either stayed the same or increased in recent months. One credit professional also noted issues with “goods that make it into the port and then onto the customer.”
Through these experiences, creditors have gained more knowledge on how to handle delayed payments while doing business in China. Survey participants advised having thorough “know your customer” processes before establishing business partnerships with customers residing in China.
“Really know your true customer,” a survey taker said, referencing the five Cs of credit: character, capacity, collateral, capital and conditions. “Understand its business model and always look to get financial disclosures.”
Two other survey participants echoed this advice, adding that credit professionals should sell on cash-in-advance terms or at least for the first invoice.
Contractually, a widely mentioned tool among credit professionals taking the survey was letters of credit. One credit professional stated that letters of credit can be used “to secure debt in case of unforeseen delays in payment.” One participant provided three tips on how to devise these documents:
- Ensure the letter of credit is being issued by a top tier bank and that your bank has a positive business relationship with it.
- Ensure you get the letter of credit opened up within five business days of the trade—any longer could impose market risk.
- The less complicated the letter of credit’s verbiage is the better to eliminate potential discrepancies that could hold up payment in the future.
When negotiating contract details with a potential overseas customer, a complete understanding from both parties is critical to ensure business runs smoothly—especially when discussing payment terms.
“Make sure every part of the payment term is explicitly explained and understood,” a survey taker said. For credit professionals having difficulty collecting on payments in China, another credit professional recommends having “someone in [China] to assist with collection negotiations.”
Yet another credit professional suggested compromising with customers in the country. “Make a contractual compromise that stipulates the credit terms and the troubles they will incur if payments are not being made according to the contract such as suspension of service.”
FCIB members can access the complete results of the International Credit & Collections Risk Management Survey via The Knowledge & Resource Center; login required. The current survey, which is open until Aug. 9 to all credit professionals, covers Greece, Italy, Spain and the United Kingdom. Participation in the survey provides members and nonmembers with the results. The International Credit & Collections Risk Management Survey—the only one of its kind in the United States and Europe—allows you to further the collective knowledge of global credit professionals by sharing real-time credit and collection experiences.
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