You know that times are tough when credit insurers are making headlines in the business pages.
During the good years, trade insurance is typically a precautionary formality for suppliers to the retail sector. But, in a downturn, it can become a prerequisite of doing business and the fate of companies may hang in the balance.
Like Caesar in the coliseum, a thumbs-up or thumbs-down from a credit insurer can sometimes make the difference between life or death to a business.
In the past week, the withdrawal of credit insurance from some retailers in the furniture sector has dealt the affected companies another harsh blow as they battle to cope with decimated trading in the consumer downturn.
Suppliers to listed retailers Land of Leather and ScS both had cover withdrawn by Euler Hermes, the world’s biggest credit insurer, while private equity-backed MFI had to switch advertising agencies after two companies originally selected for a£24 million campaign had cover withdrawn.
Cancellation of cover contributed to strains that have led Land of Leather to seek a fresh injection of funds – probably via a rights issue – and ScS to look for extra working capital.
Both retailers had been experiencing problems for some time – their share prices slumped as a slew of profit warnings reflected how hard conditions were. But the withdrawal of credit cover still had a dramatic impact. In the case of ScS, the news sent its shares to a record low. Worth£190 million just a couple of years ago, ScS ended last week valued at just£3.5 million.
So how does credit insurance work and what factors prompt insurers to review coverage?
Although the recent stories have been about suppliers to big-ticket retailers such as furniture or electricals groups, credit insurance is provided across all retail sectors.
Suppliers, often based abroad, frequently make use of invoice discounting or factoring services and it is a condition of eligibility for such services that credit insurance is in place.
The role of the credit insurer is to gauge the risk of payment default by customers of client companies. The value of such a service is obvious when, according to Euler Hermes, more than half of all UK insolvencies involve established, previously prompt-paying customers.
Giants such as Euler Hermes, which has a 36 per cent share of the global credit insurance market, or Atradius, with a 31 per cent share, operate internationally and their customers range from companies with turnover of less than£10 million to multinational corporations.
Although most news coverage has focused on the retail sector in the past week, Euler Hermes calculates that risk has increased by 15 per cent across the whole of UK business and retail has not been singled out as worse than many other business sectors.
Euler Hermes does not discuss individual cases, but its risk director, Mark Wyatt, is willing to talk in general terms about how the process works.
He says that some of the indicators of looming problems that the insurer must take account of are obvious. “At a large corporate level, the evidence is often clear – a profits warning, a business consistently underperforming against expectations, a change in funding arrangements or security, or breaching a banking covenant,” he says.
Insurers also scan financial reports for data. “The inability to control cost base, pressure on margins, changes to dividend policy or accounting policies, for example, may all mean problems being stored up for later,” says Wyatt.
“Other signs may become evident. Stock levels may be high, while the sales are not there to see a suitable turnaround. The company may be suffering from growing indebtedness or a deterioration in its liquidity or cash flow position.” Customers will often provide the insurers with information too, such as that their invoices are being paid more slowly than usual or that spurious queries are being raised.
In some instances, suppliers may be reliant on one customer for the bulk of their business, so the withdrawal of coverage can have serious consequences for all parties concerned.
Wyatt is anxious to point out that highly publicised company travails will not necessarily result in withdrawal of coverage. “Our relationship with our customer is clearly critical, so we do everything we possibly can to communicate to our customer’s customer to ensure they are supported. We do everything we possibly can to support our customers’ commercial relationships,” he says.
“Not every warning sign means a company is on the verge of becoming insolvent. While being cautious is understandable, precipitous action could have far-reaching consequences in terms of lost trade, missed opportunities and ultimately lost customers.”
So, if cover is withdrawn, what does it mean for a retailer?
In the case of ScS – which has 14 suppliers – cover was lifted from five, which all used invoice-discounting services. ScS chief executive David Knight says: “At the moment, all of the suppliers that have had issues are continuing to deliver. We’re having discussions with them about how they can continue to do business with us because they’re all very keen to do so. We’ve been told by them that they haven’t closed the door and they’re waiting for us to produce the budget for next year so they can see how to take things forward.”
Sanjay Vidyarthi, analyst at broker Dresdner Kleinwort, observes: “There are two options left to affected suppliers: one, they negotiate terms with their banks; two, ScS pays them faster.”
Shore Capital analyst John Stevenson says: “Suppliers will now be looking for faster or even pro forma [immediate] payment terms, we suspect, placing further cash constraints on ScS as the working capital cycle changes against its favour.
“Previously, ScS would enjoy a positive working capital cycle of up to 45 days between sales receipts and supplier payments. Such terms are clearly under pressure, with production also said to be slowing marginally, although the suppliers are, in many cases, highly dependent on ScS also.”
In the case of Land of Leather, Stevenson says: “The company’s business model differs materially from its competitors by the relatively high level of directly sourced product – about 50 per cent of sales – as opposed to the usual made-to-order approach taken by others.
“A useful point of difference for lead times and pricing in a growth retail climate, this is likely to put significantly greater pressure on working capital requirements over the next six months, a point exacerbated by a lack of credit insurance.”
Land of Leather was expected to unveil an£18 million fundraising as Retail Week went to press and had already secured “indications of support” from shareholders, including directors, who hold more than 50 per cent of its shares.
The role of the credit insurers can be controversial. The former chairman of one store group that experienced problems several years ago when cover was withdrawn found dealing with the insurer concerned – not one of those mentioned in this article – extremely difficult.
He recalls: “If a bank was going to pull funding, you’d probably have the chance to go before a review committee, but there seemed to be no appeal, nobody you could talk to – their judgements couldn’t be questioned. They appeared to be able to control a company’s fate without being accountable.”
However, Wyatt insists that Euler Hermes’ analysts visit their clients’ customers and engage in a dialogue to gauge situations. “Conducting visits means that a number of issues can be covered including an assessment of ownership, corporate structure, the management team, strategic focus, key market issues, competitive position, funding arrangements and risk factors,” he says.
“The end result is a much more accurate and up-to-date depiction of a business and its financial position.” Sometimes, for instance, the upshot will be that a company would have to supply the insurer with quarterly management accounts.
A survey carried out this month on behalf of Atradius found that 73 per cent of UK companies believe an increase in payment defaults by customers will have the most significant impact on them in the coming months. The ability to increase sales, extend credit to customers and raise outside capital, as well as an increase in the cost of capital, also remain significant concerns.
While such conditions persist, the credit insurers are likely to continue to play an influential role. Like retailers, they are focused on their customers and, if risks to their customers look too great, they will act.
Retailers sometimes believe that the withdrawal of insurance cover is the straw that breaks the camel’s back during difficult trading but, in many instances, it is more likely to be a symptom of the bigger problems affected stores face.