Most companies think about insolvency risk in terms of their customers. How will losing a customer impact their revenue? Will they experience bad debt from unpaid invoices?
But losing a supplier to insolvency can be just as devastating as losing a customer. This article explains everything you need to know about managing insolvency risk in your supply chain.
What Is Supplier Insolvency Risk Management?
There are a few terms that it is useful to understand before we discuss how to manage supplier insolvency risk.
What is insolvency?
Insolvency is when a company is unable to pay its debts when they are due. It can also be when the business has more liabilities than assets.
These debts could include:
- Invoices
- Staff wages
- Buying services and materials
- Loan repayments, interest payments and other debts
If a company is in this situation it is at risk of being liquidated—in other words, closed down.
Once a company is insolvent, its directors or creditors can apply to a court to initiate insolvency proceedings.
The insolvency process involves appointing a licensed insolvency practitioner to take control of the company and reclaim as many funds for business creditors as possible.
There are many different types of insolvency, and not all of them involve the company being closed down.
For example, the insolvency practitioner may sell some of the business’s assets, restructure it so it is more profitable or agree on a repayment schedule with creditors.
What is supplier insolvency risk?
This measures the probability that one or more of your suppliers will become insolvent. It is sometimes known as bankruptcy risk or credit risk.
Supplier insolvency risk management, therefore, involves trying to minimise the chances of losing companies in your supply chain to insolvency. It also means reducing the impact that losing a supplier has on your business.
How can liquidity risk and credit risk cause insolvency?
Liquidity risk and credit risk are two slightly different forms of financial risk that businesses face.
Credit risk is that described above. It is the degree to which companies can pay their debts on time.
Liquidity risk is when the business can’t convert its assets into cash quickly enough to cover its costs. In other words, a business’s assets might outstrip its liabilities, but that does not mean it can pay debts on time. And if it can’t pay debts on time, the company is technically insolvent.
Losing Suppliers to Business Insolvency Is Devastating
Suddenly losing a supplier to insolvency is bad news for any company because:
- It can stop or slow down production: This makes it hard or impossible to fulfil current projects and orders or meet targets.
- It can increase your costs: You may have to find new suppliers and they may not offer such good prices or credit terms.
- It can impact your cash flow: If you need to find a new supplier fast, you may have to fund for goods or services upfront.
- It’s inefficient: Switching to a new supplier always involves a bedding-in period where you get set up on their systems and get used to working with each other.
Examples of supplier insolvency risk
There are many ways that your suppliers could face an increased risk of business insolvency.
Examples of the warning signs include:
- Cash flow problems: If the supplier overspends on something, or if its own customers are late paying their invoices. They could borrow working capital to overcome this, but then they would need to cover additional repayments.
- Loss of key customers: If a supplier loses one of its own customers, it will lose revenue. If it is a major client, it could be worse and eat into the company’s cash flow.
- Changing market conditions: For example, your supplier's costs could increase dramatically, or there may be less demand for their product or service.
- Increased competition: New and more innovative companies could take some of your supplier’s market share. This could lead to reduced revenue.
- Loss of key employees: If your supplier loses skilled or experienced employees it can affect their efficiency and productivity. This suppresses income and causes clients to look for new suppliers.
- Reduced sales: Many companies curtail their spending during difficult times like a recession.
Which sectors/companies have a higher insolvency risk?
Some sectors are more at risk of business insolvency than others. Examples include:
Construction
Each business involved in a construction project usually relies on several specialist trades. This often leads to long and complex supply chains.
If one of these companies becomes insolvent, the businesses that relied on it may struggle to deliver their services. This in turn can cause them to experience cash flow difficulties.
The insolvent company’s customers are then at risk of going out of business themselves. The result is a domino effect that can decimate supply chains. Managing risk in construction is key due to the risks related to supply chain.
Wholesale and retail
Wholesale and retail is a broad sector consisting of different types of companies.
Many of these businesses are susceptible to rising energy costs. This has been an issue throughout 2022 and into 2023.
Retail also suffers when consumer confidence is low. Non-essential retail costs are usually one of the first things people cut back on during a recession.
Accommodation and food service activities
Like retail, this sector represents non-essential spending, which consumers are likely to cut back on during hard times.
But these businesses are also susceptible to changes in fuel costs. For example, they have to heat their premises to make them comfortable for consumers.
How to Manage Supplier Insolvency Risk
There are several steps you can take to measure each company’s risk level.
1. Check it is a legitimate business
First visit the Companies House or VIES website to ensure that the business you work with or want to work with is actually a registered firm.
2. Define your terms of business
It’s important to set expectations for how the supplier should deal with payments, delivery, returns and any possible points of conflict.
3. Ask for references
Speaking to a suppliers’ existing customers is the best way to measure how good it is. You should be able to get contact details for their customers via Google or a social media platform like LinkedIn. Drop the company a line and ask what they are like as a supplier.
4. Research company directors
Check on Companies House who the directors are and which other companies they are linked to. Research them on Google too. Avoid working with businesses where the directors have a fixed charge over the business, or those that have late or delayed accounts. These are signs that the business may be poorly managed.
5. Request sample products
This shows the level of quality you can expect from the supplier. It also gives you an insight into how the business works. For example, was the sample delivered on time and in quality packaging? If a company cares about things like this then it is more likely to be a robust, reliable supplier.
6. Assess the proposal
If the supplier's proposal is tailored towards your company’s unique needs, that attitude is likely to be reflected in the way they work with you.
7. Check the company is financially healthy
Use a business database like Red Flag Alert to get a financial health rating for the business. This allows you to make an informed decision on the level of insolvency risk you are taking by working with the company.
8. Monitor suppliers
Managing supplier insolvency risk doesn’t end once you start working with a client. You need to continuously monitor each supplier for signs that the company’s risk hasn’t changed.
You could do this by regularly checking their accounts, balance sheet or financial risk scores. But this is time consuming. A better way is to set up monitoring alerts. This is where you use a business data provider like Red Flag Alert to warn you via notification if your suppliers’ financial health deteriorates. See point 10 in this list to find out what you should do if this happens.
9. Mitigate risk
It’s also a good idea to think of ways you can reduce the level of supplier risk your company is exposed to. Some examples include:
- Find other suppliers. This way, you’ll still be able to source the goods and services you need if one of them becomes insolvent.
- Only work with financially healthy suppliers. Build insolvency risk into your requirements next time you look for a new supplier.
10. Take proactive action
If you do see a supplier’s financial health begin to deteriorate, you should take proactive steps, so it doesn’t become a bigger problem.
You could:
- Ask to speak to the supplier and ask if there is anything reasonable you can do to help alleviate their financial difficulties.
- Ask what guarantees they can provide.
- Pay your invoices to the supplier on time.
- Reduce your reliance on that company and look for other suppliers.
- Buy additional services or materials to make up for any potential shortfall.
Protect Your Business from Insolvency with Red Flag Alert
Firms can be put at risk from their customers or suppliers becoming insolvent.
Red Flag Alert helps you protect your business from this. We are the UK’s only independent credit referencing agency.
We hold data on every UK company, as well as businesses in countries around the world.
Our business insolvency risk scores indicate the likelihood that your customers or suppliers will become insolvent.
We collect more information from a greater number of reliable sources than any of our competitors—meaning we spot risk factors that they don’t.
Our database is updated in real time so that you can base your decisions on accurate, up-to-date information.
To see some of the powerful insights our data provides, read our Q3 Interim Intelligence Report or click here for a free trial.
