10/19/2012 04:37 pm ET Updated Dec 19, 2012

Protect Your Business Against Partners' Credit Woes

Commercial bankruptcy filings have slowed this year, but they are on track to be higher than the annual averages for pre-recession years, and experts say businesses are wise to protect themselves against financially unstable partners.

Commercial bankruptcy filings from Jan. 1 through Sept. 30 totaled 44,750, according to recent data from the American Bankruptcy Institute and Epiq Systems Inc. That's the lowest level since 2009, but it remains above the annual numbers filed between 2005 and 2008.

And as the Chapter 11 bankruptcy protection filing by electric car-battery manufacturer A123 Systems Inc. (NASDAQ:AONE) shows, a company's troubles can affect both customers and suppliers. Dow Jones Newswires reported A123 owes trade creditors nearly $33 million, and the company's plans to sell some assets to Johnson Controls Inc. (NYSE:JCI) could mean customers have to renegotiate new terms of their deals.

When it comes to protecting themselves against credit risks, businesses could do more, according to a recent survey by Sageworks Inc., a financial information company.

Accounting professionals by nearly a 2-1 margin said in an online survey that their business clients don't do enough to ensure creditworthiness of customers, vendors and other potential transaction partners before they extend credit. Sixty-five percent of respondents said business clients don't do enough before extending credit, while 35 percent said clients sufficiently ensure creditworthiness.

The survey was conducted between Aug. 29 and Sept. 5 among accounting professionals who are Sageworks' clients. The poll had 100 respondents who volunteered to answer the survey and were not randomly selected.

Certified Public Accountant Tom Menk, who is co-director of Pittsburgh accounting firm Alpern Rosenthal's construction services group, said it's especially important for a business to check out a company before extending any type of credit to customers.

"Obviously, if you're entering a new relationship, you want to ensure the company has the wherewithal to pay for the products and services you're providing to them," he said. "In these economic times, a business' situation could change fairly quickly, and you don't want to be caught by surprise."

Menk said his firm often recommends general contractors conduct due diligence on developers to make sure financing's in place to build the project properly and to guard against subcontractors who are unstable financially.

"I do know of occurrences where a subcontractor would default on the performance of a project because they got into financial difficulties, and the general contractor is then forced to find someone else to complete it," he said. "That costs them money that they typically can't recoup."
Nathan Myers, director of consulting services at Sageworks, said that in addition to protecting your business against a hit related to a default, there are other, more subtle reasons to check creditworthiness of potential business partners.

"What's slightly less obvious is that checking a credit score before signing a deal can offer the opportunity for a business to shield itself from these situations by negotiating more favorable terms for that deal," he said. "For example, if your research turns up that a software vendor has a lot of down-time and you need to secure a contingency plan, then this might help you negotiate a discount to cover the extra cost of the backup. Or, if you learn that a prospective customer has many accounts closed in poor standing or many prior contracts that went unfulfilled, then you can justify requesting payment in full for your products or services. "

Myers said it is common practice for banks and insurance companies to adjust terms or rates on loans and policies based on the party involved. They charge riskier parties more so that the impact is minimized should a default occur.

"It's simple risk management, and a business that takes the same precautions can offset or mitigate these potential costs when a business partner fails to deliver," Myers said. "But remember, it's not all about mitigating risk. It's also about finding and targeting creditworthy partners to help grow your business over time. Finding and keeping good customers, vendors and suppliers can be the difference between success and failure in a business. You've just got to do your homework."