April 28, 2022

 

Tips for Managing Credit Before and During a Recession

Annacaroline Caruso, editorial associate

Many businesses believe that today’s environment reflects the calm before the storm and worry that today’s robust economic activity won’t last beyond this year. Several financial institutions recently released forecasts for the probability of a recession in the coming years. Moody’s Analytics and Goldman Sachs both predict the U.S. economy has a 35% chance of slipping into a recession within the next two years, and Deutsche Bank forecasts a recession sometime in the next three years.

Even in the best of circumstances, recessions are hard to predict. While it is difficult to say if and when a recession will happen for sure, credit professionals should stay vigilant. The biggest piece of advice echoed by experienced creditors who worked through the Great Recession is to “start preparing now.”

That means being proactive about checking in with your customers, said Kim Hanlin, credit manager with Kloeckner Metals Corporation (Dallas). “It’s good policy anyways to have a pulse on your customers and to stay aware of payment trend variations,” she said. “Watch those trends, see whose payments are slowing and get ahead of them before things are too far gone.”

You also should start gathering additional, up-to-date information on existing customers. Banking references and financial statements can help you better gauge how much cash a company currently has, which is crucial during a recession because “cash is important and its access to cash is also important,” Hanlin said. “It tells us, if we were to go into a recession tomorrow, whether or not they would be able to sustain their business.”

Credit limits should be revisited now because several companies have steadily extended higher limits to accommodate supply chain disruptions and inflation over the last few months. Reducing credit limits now can be a saving grace if a recession were to hit in the near future, said Don Burell, CCE, regional credit manager with Schlumberger Technology Corporation (Houston).

“We have accounts that we set up multiple years ago based on information available at that time, but those limits are not necessarily valid today,” he said. “If you are anticipating a contracting market, then your limits should be adjusted downward because the last thing you want is a distressed customer buying $5 million worth of product before filing for bankruptcy.”

Even with all these precautions, managing credit will still be challenging during a recession. The day-to-day credit functions you already perform become even more crucial to helping your company survive, said Dave Beckel, CCE, who was NACM National chairman toward the end of the Great Recession in 2009.

“[During a crisis], senior management usually realizes collections are going to be tougher so we kind of come into the limelight,” he said. “Be proactive with senior management and point out areas of concern to show that you are out in front of this. A recession can be good in a way because it can help you show that you are an experienced credit manager and can control any possible losses.”

Aside from regular credit duties, you have to be able to quickly pivot to whatever issues may arise during a financial crisis, said Aaron Braun-Duin, CBA, credit manager with American Woodmark Corporation (Winchester, VA). “During healthy times, the thought process always is ‘how do we keep orders flowing,’ and we have a more general trust because the macro environment is healthy,” he explained. “But when the macro environment is a little tougher, we look at things from a more stringent standpoint. Because the folks who are not super healthy during the good times, they fall off quick and go bankrupt and you have to try and identify those people before it happens.”

Communication with customers is important when preparing for a crisis, but it becomes a critical tool to getting paid during a crisis, Beckel said. “Ask your customers for a plan and how they expect to pay their bills over the next six months. Have a definitive plan, and watch out for the people who don’t have a plan with focus. That’s where the credit professionals need to know who can really pull together and pay, and who is just waiting to get bailed out.”

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April CMI Points to Continued Economic Stability

Annacaroline Caruso, editorial associate

The April NACM Credit Managers’ Index remained somewhat stable as this month’s combined score rose 0.2 points to 59.1 despite all of the uncertainty surrounding the economy today.

However, that stability could deteriorate if supply chain disruptions continue much longer and the Federal Reserve relies on higher interest rates as a way to slow inflation, said NACM Economist Amy Crews Cutts, Ph.D., CBE. “The CMI indicates steady conditions overall despite the supply and logistical problems that continue to plague businesses as well as the uncertainty of the war in Ukraine. Although other factors have me thinking recession sooner than later, the CMI indicates the risk is more balanced.”

The combined index of favorable factors lost 0.6 points (69.9). Every favorable factor fell except one, the amount of credit extended, which jumped 2.9 points (72.1). Sales declined 2.4 points (74.1); new credit applications, 1.7 points (67.1); and dollar collections, 1.1 points (65.9).

Improvements in combined index of unfavorable factors buoyed the loss in favorable factors with a 0.7-point gain (51.9). Within the index, dollar amount beyond terms grew 3.0 points (54.2); dollar amount of customer deductions, 1.5 points (50.5); and disputes, 1.1 points (49.1). And three factors declined: accounts placed for collection, 0.9 points (50.6); rejections of credit applications, 0.6 points (51.3); and filings for bankruptcy, one-tenth a point (55.7).

“Even if businesses can get the goods made, transportation logistics are a nightmare,” Cutts said. “Like the small butterfly wing thought to cause a hurricane, seemingly small missteps in the delivery chain are wreaking havoc. In some cases that means ruined product, while in others it means disgruntled recipients that demand concessions from the transporter or the manufacturer. Higher gasoline prices also are hitting hard and will make profits more elusive in early 2022 for this segment and many others.”

What CMI respondents are saying:

  • “My clients are deeply concerned about the rest of this year and next due to inflation [and the] Fed's monetary policy of raising interest rates and lack of energy policy.”
  • “Supply chain constraints and supplier/employee wage inflation is taking a bite out of operations—driving price increases which are then inflaming customers.”
  • “Raw materials on allocation are hindering our need to increase production to meet demand.”
  • “It was expected sales and volumes would decrease by this time in 2022. They've only increased and increased substantially.”
  • “Retail business has started to decline over the past few months.”

If you would like to participate in the monthly CMI, sign up to receive survey participation alerts. For a complete breakdown of manufacturing and service sector data and graphics, view the April 2022 report. CMI archives also may be viewed on NACM’s website.

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Metric Series: The Collection Effectiveness Index

Diana Mota, editor in chief

Tracking a credit department’s effectiveness at collecting outstanding invoices is an important aspect of managing collections. One such tool creditors can use is the Collection Effectiveness Index (CEI). CEI compares the amount of receivables collected in a given time period to the amount available for collection in that time period.

“It operates at a somewhat higher level of precision than the days sales outstanding measurement,” according to AccountingTools, Inc. However, “a collections manager can drive a high CEI number by focusing on the collection of the largest receivables. This means that a favorable CEI can be generated, even if there are a number of smaller receivables that are very overdue.”

CEI results tend to be more accurate than standard DSO for short periods such as a month because DSO includes receivables from prior periods that do not relate to the credit sales figure in the calculation, “which is why DSO is calculated every three to six months,” according to Strategic CFO.

The CEI formula consists of (Beginning AR Balance plus Credit Sales During Period minus Ending Total AR Balance) divided by (Beginning AR Balance plus Credit Sales During Period minus Ending Current AR Balance) multiplied by 100. The closer the result is to 100% the more effective a collection department has been in collecting from customers.

In essence, CEI measures the quality and effectiveness of collection practices and policies, while DSO measures the length of time it takes to collect payment. CEI also serves as an internal measurement, while DSO is a benchmark.

NACM Chairman Darrell Horton, ICCE, uses CEI to measure his team’s performance. “No one outside the world of collections—and even many inside it—understands the metric. So, using it for reporting purposes is futile. The scale is very large—going from zero to 100—and does not relate back to a number that is easily discussed such as average delinquency being X number of days or being paid on average by X days after due date.”

However, “The Collection Effectiveness Index is a measure that takes the impact of the sales out of the equation, something DSO does not do,” Horton added. “It is a true measure of the ability to collect cash once the sale is made, and it really helps me find trends on procedures and policies, both within credit and collections. I can then adjust them accordingly.”

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Senate’s Bankruptcy Threshold Adjustment and Technical Corrections Act Retains $7.5 Million Eligibility for Subchapter V Small Business Debtors

Colleen M. Restel, associate, Lowenstein Sandler

The Small Business Reorganization Act (SBRA) went into effect on Feb. 19, 2020, creating Subchapter V of the Bankruptcy Code. Acknowledging that a bankruptcy proceeding is not “one size fits all” and that a Chapter 11 proceeding can be prohibitively expensive and lengthy for a business, the goal of the SBRA was to reduce costs and increase efficiency in bankruptcy proceedings for small business debtors.

The SBRA therefore set forth abbreviated and simplified procedures for qualifying “small business debtors,” which have a maximum aggregate secured and/or unsecured debt of $2,725,625, which increased to $3,024,725 on April 1, 2022, among other requirements. The aggregate excludes debt owed to affiliates or insiders, as long as the majority of the debt comes from business activities (Aggregate Debt Limit).

For a qualifying small business debtor, Subchapter V creates several advantages over the traditional Chapter 11 process. For example, a creditor’s committee is not appointed in a Subchapter V case absent exceptional circumstances. In lieu of a creditor’s committee, a Subchapter V trustee is automatically appointed to “facilitate the development of a consensual plan of reorganization.”

Subchapter V also promotes the speedy resolution of cases under the subchapter by requiring that the debtor in possession file a plan within 90 days after the bankruptcy petition is filed. The Subchapter V process also is less expensive for a debtor, as the small business debtor is not required to pay quarterly fees to the United States Trustee’s Office. Additional advantages bestowed upon a qualifying Subchapter V debtor are that (i) the debtor maintains the exclusive right (and requirement) to file a plan throughout the case,1 and (ii) the debtor need not satisfy the absolute priority rule as a condition of confirmation.2

Instead of the absolute priority rule, a Subchapter V debtor must dedicate, at a minimum, the amount of its disposable income for a period of three to five years, providing an easier path to cramming down a plan on unsecured creditors. As these features of a standard Chapter 11 case often provide significant leverage for creditors, these differences in a Subchapter V case can make this option very attractive to a potential qualifying debtor.   

Shortly after the enactment of the SBRA, businesses experienced unprecedented and historic economic pressures as the Covid-19 pandemic shuttered them and impacted supply chains worldwide. With the intent to enable small businesses to use Subchapter V in order to survive the pandemic, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), enacted on March 27, 2020, increased the Aggregate Debt Limit to $7.5 million. The increased Aggregate Debt Limit was, pursuant to the CARES Act, set to expire on March 27, 2021. As the pandemic wore on, the expiration of the increased Aggregate Debt Limit was subsequently extended by the COVID-19 Bankruptcy Relief Extension Act of 2021 for an additional year, to March 27, 2022.

After expiration of the increased Aggregate Debt Limit on March 27, 2022, the definition of “debtor” in Subchapter V cases reverted back to its prior definition ― “a small business debtor,” which includes a $3,024,725 Aggregate Debt Limit as of April 1, 2022.

As of April 21, 2022, more than 3,250 cases have been filed since the enactment of the SBRA, highlighting Subchapter V’s perceived utility and advantages.3 It is not clear how many of those debtors would have qualified as a small business debtor absent the increased debt ceiling in the CARES Act.

On March 14, 2022, the Bankruptcy Threshold Adjustment and Technical Corrections Act (Corrections Act), was introduced in the Senate in an attempt to make the $7.5 million Aggregate Debt Limit permanent. On April 7, 2022, an amendment was introduced that would impose a two-year sunset on the increased Aggregate Debt Limit. Similar to the CARES Act, the Corrections Act, if enacted, would amend Section 1182(1) of the Bankruptcy Code to include the increased Aggregate Debt Limit of $7.5 million in Subchapter V’s definition of a “debtor” and, upon sunset, would revert and refer to the definition of a “small business debtor” in Section 101(51D) of the Bankruptcy Code. The Corrections Act also would apply retroactively to all cases commenced under Chapter 11 on or after March 27, 2022 that remain pending as of the date of enactment.

The Corrections Act, as amended, was unanimously approved by the Senate on April 7, 2022. The House of Representatives received the bill on April 11, 2022. If passed by the House, the Corrections Act will reach the president’s desk before becoming law.4 In the meantime, small business debtors will be subject to the reverted Aggregate Debt Limit of $3,024,725 as of April 1, 2022.

1 Section 1189(a) of the Bankruptcy Code provides that “[o]nly the debtor may file a plan under this subchapter.” Comparatively, Section 1121 provides that, in a standard Chapter 11 case, if a debtor does not file within 120 days of the bankruptcy filing (as may be extended but may not exceed 18 months), any party in interest may file a plan.

2 Section 1129(b)(2) of the Bankruptcy Code encompasses what is commonly referred to as the absolute priority rule. The absolute priority rule directs that, absent consent by the impacted class of creditors, a senior class must be paid in full before classes of claims and equity that are junior to it in priority can receive any money or property in a Chapter 11 plan.

3 See Am. Bankr. Inst.: https://app.powerbi.com/view?r=eyJrIjoiNzJmYWJlNDQtMGNlMy00MDA5LThmZWMtODU5YTQyMDRjYWNjIiwidCI6ImI0NDBhOWMyLThjNmYtNGNlYS1iYzI1LWYzZTI0MGJjNGI1ZCIsImMiOjF9 (last visited April 21, 2022).

4 The most up-to-date status of the Corrections Act can be found at the following link: https://www.congress.gov/bill/117th-congress/senate-bill/3823/all-actions?overview=closed#tabs.

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