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May 1, 2019

Lessons From the PG&E Bankruptcy: Managing Key Customer and Credit Risks Is Critical

Posted by Restructuring Team

bankruptcy

The bankruptcy filing in late January 2019 by the California utility PG&E Corporation is the latest example of how a significant event at one organization can have ripple effects through the ecosystem of companies that do business with that organization.

In an interconnected global economy, every company must understand its markets and growth opportunities while also anticipating a variety of potential events that can affect not only their customers or suppliers, but also their customers’ customers and their suppliers’ suppliers.

As PG&E develops its reorganization plan, the filing will likely have implications for its customers, suppliers, debt holders, investors and other stakeholders. Assumptions about the utility’s financial ability to meet its contractual obligations, for instance, may need to be revisited.

This event provides an important reminder that every company’s risk management plans have to consider factors including how much credit you’re extending to customers, if you’ve become too dependent on one or two customers, how an unplanned event at a key customer can affect your company, how you might respond to a major customer or supplier declaring bankruptcy, and other negative developments.

Managing Customer Risk

Landing a large contact with a new customer is great news for any company, but it’s important to look beyond the excitement of the deal to understand whether the agreement will change your company’s risk profile.

For instance, say a customer that has ordered $15,000 worth of inventory from your company weekly doubles its order to $30,000 weekly. If your agreement calls for 30-day payments, your credit exposure to this customer has similarly doubled from $60,000 to $120,000 a month, and you should evaluate whether that change can affect your company’s cash flow.

Similarly, it’s important to try and understand the customer’s reasons for increasing its order. This may be difficult to ascertain, but the increase may result from satisfaction with your product and service, or it may have been caused by another supplier cutting back on the customer’s credit — a red flag.

You also have to understand whether a large ongoing order increases your dependency on one or two key customers. To mitigate this risk, it’s important to diversify your customer base routinely to ensure that problems with one customer don’t create disproportionate problems with your cash flow and operations.

Review Financial Assumptions

It’s also important to review your company’s credit risk and financial assumptions consistently. This should take place, at a minimum, as part of your annual planning process, but is more effective during quarterly reviews of your company’s financial and operating performance.

In addition to understanding what percentage of your revenue is being generated by your major customers, it’s helpful to evaluate factors such as:

  • How much credit are we extending to customers?
  • Are all customers meeting their payment obligations?
  • Can we afford payment problems from a key customer, or the loss of that customer?
  • Are we pricing our products or services properly?
  • Are we collecting deposits from new customers?
  • Are we billing customers efficiently?

Answering these questions is especially important before meeting with your bankers, who are often applying more rigorous analyses of their customers. For instance, most banks are now examining up to six months’ cash flow from their customers, instead of the traditional 90 days.

Warning Signs – Red Flags

You should also monitor your customers’ payment histories carefully to determine any potential warning signs of financial problems that can affect your company’s cash flow.

For instance, if a customer is beginning to make payments in 45 days instead of the contractual 30, that may be a sign of a seasonal slowdown in its business, or may indicate a major problem that can affect your company (as well as your ability to pay suppliers and employees); further, that $30,000 weekly order, has now reduced your working capital/cash by $60,000 to cover this delay.

A potentially awkward conversation with the customer may be in order to understand the reasons behind their slowing payment schedule and to determine whether you need to take any steps in response.

Contingency Plans

Looking beyond routine cash flow and credit risk management, it’s important to periodically consider the potential effects on your company if a key customer experiences a natural disaster or similar unplanned event.

For instance, you should consider what would happen if a key customer has to stop accepting deliveries in the aftermath of an emergency situation. How would you respond? Who needs to decide that? How would you communicate with your customer or suppliers?

While you can’t plan for everything, some “what-if” thinking can help you set up a framework for making important decisions. It’s easy to panic or make hasty decisions in the initial stages of an unplanned event, so it’s important to consider the possibilities during the relative calm of your day-to-day operations. 

This is especially important in the immediate aftermath of a key customer filing for bankruptcy protection. As soon as you learn about a filing or proposed reorganization, it’s vital to assess how this situation could affect your company.

Depending on the situation and the size of your receivables, you may want to consider retaining external advisors who can help you understand and protect your rights during the bankruptcy process.

While a bankruptcy filing represents an extreme situation, prudent risk management calls for paying attention to your customers and suppliers to watch for a variety of unplanned events, both severe and routine, and thinking about the potential effects on your company and your cash flow.

To learn more about how to reduce your company’s risk or protect your rights during a bankruptcy, contact our Corporate Finance and Restructuring Practice Group team.

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