The hard realities of ‘soft credit’
February 2, 2023
Those who run and manage businesses are familiar with the two traditional sources of funding. They understand balance sheet finance, whether it is debt from lenders or equity from shareholders. They also live with the vagaries of the liquidity (positive or more usually negative) that is generated from trading and operations, in the form of the difference between what they pay out to suppliers and service providers as compared to what they receive from customers.
What comes less naturally is an appreciation of other sources of support, which are less tangible but equally important and which are emerging as a growing cause of financial pressure according to a recent report on listed company profit warnings by EY Parthenon. This is what the report describes as ‘soft credit’. It comes in a wide variety of guises.
Trade credit insurance
In its simplest form, this provides protection to a company’s suppliers against its failure. It is based on far more sophisticated and timely data than the out-of-date published and unaudited management accounts often relied on by traditional lenders. For example, it draws on real time information on payment practices and a host of commercial information.
The problems come when an insurer starts to reduce cover or withdraw it altogether, which will strangle cash flow as suppliers start asking for prompter payment or cash on delivery. Some suppliers will stop trading with companies who lose their trade cover, even on cash terms. The reluctance of trade insurers to provide cover can be specific to issues at an individual company, or it can be prompted by strategic decisions to withdraw from sectors they consider to be too high a risk or to reduce their overall exposure to the UK market.
Credit card processors
Card processors take a significant contingent risk on returns, non-deliveries, customer disputes and fraud. Here too, they have a wealth of data about the merchants they deal with and can defer or reduce settlements to build a reserve if they decide an individual merchant or a sector is becoming a risk, with which they are uncomfortable.
Bonding facilities
These feature in a wide range of business scenarios. Examples are performance bonds in the construction sector, travel bonding arrangements or export-import bonding to enable international trade. Loss or curtailment of these facilities can cause major business disruption.
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The snowball effect of soft credit
Previous financial crises have shown that cuts in a company’s soft credit facilities can very easily leak across into core lending relationships and affect its ability to raise new money. It can even lead to going concern issues with auditors because of the risk to overall liquidity.
Proactivity pays dividends
In tough economic times like the present, it is vital that business owners get ahead of any soft credit risk, especially as the providers such as trade insurers are already gearing up for a significant surge in corporate insolvencies and adjusting the cover they are willing to provide accordingly.
In particular, they need to make sure they have a firm grasp of their soft credit exposure, as well as looking at how they can strengthen their provider relationships, which typically are not as strong as with mainstream lenders. Most of all, there needs to be an action plan in place as well as regular reporting on potential issues.
As and when issues do arise, prompt communication and dialogue with providers is essential to try to resolve problems, as will be the advice and support of an independent expert with experience in the soft credit sector.
If you are seeking professional advice for your business, Opus is here to help. You can speak to one of our Partners who can discuss options with you. We have offices nationwide and by contacting us on 020 3326 6454, you will be able to get immediate assistance from our Partner-led team.