Who’s really responsible? Managing credit risk with subsidiary companies

Business credit, in theory, is a pretty straightforward concept. A company decides to purchase a specific product or service from another company. Rather than paying in full upfront, they apply for credit terms.

After careful consideration, the seller decides whether to approve or deny the buyer’s request. Sounds pretty simple, right? The reality, though, is that a credit transaction is a deliberate process because companies—even the most financially sound ones—carry some level of credit risk.

Why it matters: When it comes to child or subsidiary companies, that risk only grows. By knowing their customer and understanding the parent-child relationship dynamic, credit professionals can adjust strategies to better safeguard their company’s interests.

Understanding the parent-child company relationship

In business credit, the parent-child relationship forms when a company takes ownership of one or more companies. The parent company is able to diversify and gain tax advantages while maintaining separate liabilities.

Imagine a hypothetical company called Company A. Despite being a well-established producer of clean energy and power solutions, they lack a highly demanded product in their market—solar power plants. After a vigorous search, they decide to acquire an emerging solar power manufacturer called Company B, which they rename Company AB.

In this scenario, the child company inherits more than a name—it gains access to the parent’s resources and capital while maintaining legal identity and brand recognition. With shared financials, however, the subsidiary may carry additional credit risk from its parent, who may or may not be liable for payment.

If the parent company is based internationally, the child company’s risk exposure may increase significantly. “Some international economies are highly unstable, and because some countries have specific trade laws, the risk mitigation process becomes more stringent,” said Debra Schoenecker-Dixon, credit manager at CTS Corporation (Lisle, IL). “In India, for instance, a 10% retainage may be held until an installation is completed to the company’s standards, a process that can take years.”

To minimize this risk with subsidiary accounts, credit professionals may secure a parent company guarantee (PCG) or cross-corporate guarantee, and in some cases, a personal guarantee (PG). Because cross-corporate guarantees aren’t standardized, they don’t often fit the sovereign laws of the parent country. Credit professionals are then tasked to make a guarantee that complies with those laws.

So, if Company A is based in Switzerland and Company B is based in the United States, the credit professional would have to abide by the parent’s specific country laws along with navigating foreign exchange risk of that country.

Best practices to minimize risk

When working with a child or subsidiary company, it’s critical that credit professionals understand who they’re selling to and whether additional information, a credit application or a contract is needed.

Most credit professionals treat child companies as they would any other new customer, requesting a credit application, bank and trade references and financials. “We require a new credit application be filled out along with a PG and terms against that child company as they are ultimately responsible for their own AR,” said Nancy Behrenshauser, credit manager at J&L Building Materials Inc (Frazer, PA). “The only difference is we don’t ask for references as they are already financially supported by their parent.”

For wholly owned subsidiaries, additional information may not need to be attained if the credit evaluation is based on the parent company and existing agreements are satisfactory. For example, if a company already has an account with Company A, a rigorous credit investigation or amendment of contracts for Company B would not be necessary.

Having a clear understanding of the parent-child relationship can help determine who’s ultimately responsible for payment should anything go wrong. “I make an effort to learn about the specifics of the relationship and how each entity operates,” said April Tovar, credit manager at QXO (Bend, OR). “I also refer to the parent company’s website for additional insight and chat with their financial officer to better understand the corporate structure and have the confidence that the parent and subsidiary are truly operating as two separate entities.”

Identifying whether a Federal Employer Identification Number (FEIN) is shared can help credit professionals determine whether the parent is directly liable for the child’s financial obligations. “From my experience, a child company is a division that operates under the same FEIN as the parent,” said Schoenecker-Dixon. “They might have a different trade style or DBA as a result of a merger or acquisition.”

From the purchase order, credit managers can quickly discern who it’s from and who’s ultimately liable for the debt. Getting sales involved is crucial as they are often the first ones to learn of parent-child relationships and can provide additional information they gained talking to the customer directly.

Bottom line: In credit, knowing who you’re doing business with is critical for mitigating risk. By having a solid understanding of subsidiary relationships and effective strategies, credit professionals can confidently manage child companies without leaving their own company exposed.