Insolvency Risk: Definition & How to Prevent it (2024)

Insolvency risk is the real possibility that a company may be unable to meet its payment obligations in a defined period of time – generally within a one-year horizon. It is also known as bankruptcy risk. Business insolvency can originate from various factors such as bad cash flow management, excessive expenditures, and even the failure of clients.

Recent economic calamities illustrate that insolvency risk is not only the result of bad management: the global economic recession of 2008 and the global Covid-19 pandemic of 2020 have shown how even the best-run companies can face insolvency risk through no fault of their own.

Customer insolvency, especially if it involves your biggest customer, can impact your own cash flow and jeopardize your business. Supplier insolvency can also have strong repercussions if what they supply is more expensive or difficult to obtain from other suppliers.

In the worst-case scenario, the loss of a vital business relationship can also lead in turn to your own insolvency – the ‘domino effect of insolvencies’ in action.

Making accurate credit risk assessments of your own company and of your customers and suppliers is the first step in creating protection against insolvency risk. Keep an eye on these warning signs:

• Declining profitability: for example, are your sales lower or your cost of goods sold higher?
• Declining capitalization (also referred to as “book value”): has your debt to equityratio fallen below 30%?
• Poor interest coverage ratio: this shows operating profits may not be able to cover interest expenses.
• Weakened balance sheet.
• Cash flow and liquidity problems: are your fixed costs or interest payments creeping up, or do you have a high number or amount of customer overdue payments? Check out our business liquidity calculator to assess how your liquidity could evolve depending on external factors such as a drop in sales, payments delays or one-off losses.
  
• Operating margins: are they becoming thinner?
  
• Debt maturities, refinancing, and ability to raise capital: under what terms can you refinance your debt? Can you go to the capital markets or turn to your line of credit to raise money if need be?
• Your order book: what does your future business workload look like?

  Learn more about the difference between insolvency and bankruptcy by clicking here.

If your customers are paying late or can’t pay you at all, your cash flow will be at risk. If your suppliers cannot deliver materials on time, your own production will slow down, making it difficult to fulfill your own commitments. Keep an eye on these warning signs of potential supplier or customer insolvency.

When it comes to hunting for financial distress and insolvency warning signs among customers, you should ask the following questions about the companies you do business with. These points form a sliding scale which increases in severity. Generally speaking, the more questions answered with ‘yes’, the greater a company’s risk level.

• Are they taking longer to settle invoices or make deliveries?
• Have they asked to renegotiate contracts, to extend (if they are customers) or to shorten (if they are suppliers) payment terms?
• Is there a trend toward disputes over billings or deliveries?
• Has your customer recently lost a major client/supplier?
• Are funders refusing to support your customer during renewal facilities?
• Have they attempted to switch to alternative funding sources?
• Are their stocks performing badly? Are they being shorted?
• Have the credit default swaps (CDS) prices increased?
• Are they attracting negative press coverage?
• Have any C-suite members resigned unexpectedly?
• Is your customer unable to pay employee salaries/social charges?
• Have they appointed restructuring advisors?
• What is happening in their sector or country?This is part of the economic climate in which they operate and can impact customer insolvency. Check out our country risk reportsand sector risk reports for insights.
• In addition, keep your eye on news reports or business organizations which may circulate information about your clients: large turnover among staff and executives, or difficulties such as meeting their payroll.

There is also the natural climate to take into account. In the last several years, extreme weather, climate-change-related events, and the Covid-19 pandemic have halted business operations or shut down supply chains at an accelerated rate.

Taking the following steps within your own company can help you prevent risks and create insolvency protection:

• Shorten your supply chains and avoid concentration in one geographic region.
• Always evaluate your client’s creditworthiness before signing agreements.
• Make sure your client portfolio is balanced so you are not relying heavily on one or two clients for most of your income.
• Create a cash buffer that your business can access in an emergency.
• Review the credit terms you extend to customers and suppliers, and benchmark your trade terms against the rest of your industry. For example, you could include a right to terminate the contract should your customer or supplier enter an insolvency process, or a right to charge interest on late payment and to recover your costs of enforcing payment.
  
• Go digital as much as possible to make “pivoting” easier. Think of the retail shift to online when Covid-19 shut down bricks and mortar establishments overnight.
• Invest in payment monitoring and debt recovery processes, including professional insolvency risk services.

Insolvency protection is an inexact science given the myriad risks that exist outside the control of your own business operations. But if not caught early – for example with the help of insolvency risk services – you could find yourself trapped in a downward spiral of insolvency risk.

In particular, when insolvency is the result of something unforeseen, insolvency protection insurance safeguards your cash flow and considerably limits the damage of credit risk to your own company by getting you compensation in case of bad debts.

For example, market-leading trade credit insurers such as Allianz Trade, in addition to helping you avoid bad debts and compensating you if they happen, provide additional insolvency risk services as part of the trade credit insurance cover, such as:

1. Debt recovery, with the skills and experience needed to maintain an effective, on-going dialogue with debtors and their legal teams, no matter which country or jurisdiction they operate in.
2. Predictive protection by helping you choose the right customers and the right markets to avoid bad debt in the first place, thanks to acute financial analysis.
3. In-depth market intelligence, providing you with 360-degree visibility on business sectors and impending difficulties.

It would be a simplification to think a trade credit insurance begins and ends with premiums and pay-outs. The industry focus is increasingly on predictive prevention. In other words, an effective trade credit insurer will do everything within their power to identify high-risk trading partners and break the chain of potential insolvencies before it can start. For example, our risk assessments are based on data from our proprietary intelligence network which analysis daily changes in corporate solvency representing 92% of global GDP.

Remember, swift reaction time is key. The ideal scenario is to identify and act on warning signs before your customer becomes insolvent. Insolvency protection insurance can mitigate customer insolvency risk, preserve cash flow and help you grow your business. When companies are faced with a chain reaction of insolvencies throughout global supply chains, data of this granularity will continue to provide the confidence to trade, and be paid, no matter what.