In recent weeks we have begun reminding our clients of the importance of regularly stress-testing their debtors as a crucial exercise to understand the potential impact on their business in different scenarios, such as when a large debtor is late or if their business fails. By conducting this exercise, the leadership team can assess a business’s ability to withstand financial shocks and determine whether the current debtor policies and thresholds are appropriate for the current economic climate.
When a large debtor is late in paying their debts or their business fails, it can have a significant impact on a business’s cash flow, profitability, and liquidity. It can also affect their ability to pay their own debts, meet their financial obligations, and invest in their business’s growth. In extreme cases, it can even lead to insolvency and bankruptcy.
Stress testing your debtors can help you identify potential risks and vulnerabilities in your business’s financial position and develop contingency plans to manage them effectively. It can also help you determine whether you need to revise your debtor policies and thresholds to better align them with the current economic climate and mitigate potential risks.
In times of economic uncertainty, it’s especially important to regularly review and adjust debtor policies and thresholds to reflect changes in market conditions and ensure that a business adequately protecting a business’s financial health. By taking a proactive approach to managing debtors, the leadership team can position the business for long-term success and resilience
In terms of debtors, companies should review their policies and ensure that they are effectively managing their accounts receivable. This may involve implementing more rigorous credit checks, offering incentives for early payments, or outsourcing collections to a third-party provider.
It’s also important for companies to monitor their cash flow closely and maintain accurate financial records. This can help them to identify potential issues before they become serious problems and make informed decisions about how to manage their finances.
Overall, with careful management of creditors and debtors, companies can help to mitigate financial risk and ensure that they are well-positioned to navigate changing economic conditions.
One activity which is highly useful is to build stress-test models to understand different scenarios such as when debtors are late paying an invoice. If your company doesn’t have an analyst (i.e. a financial controller or similar) who has the skills and experience to complete these activities, then it may be best to consider talking with your external accountant or engaging an advisory firm who can complete this work with you. At a high level, the steps involved in creating and using stress-test models include;
- Define the relevant variables: Identify the variables that are relevant to your business, such as the total amount of outstanding invoices, the number of days a payment is overdue, and the impact of late payment on your cash flow.
2. Collect data: Collect data on your past and current invoices, such as the payment dates, the amount paid, and the duration of the delay. Use this data to calculate metrics such as your average payment delay and the percentage of invoices that are paid on time.
3. Define scenarios: Define different scenarios that could impact your cash flow, such as an increase in the number of overdue invoices or a decrease in the amount paid per invoice.
4. Use statistical models: Use statistical models, such as Monte Carlo simulations or regression analysis, to model the different scenarios and predict the impact on your business. These models can help you estimate the probability of certain outcomes and the potential impact on your cash flow.
5. Analyse the results: Analyse the results of the stress test models and identify the potential risks and opportunities for your business. For example, if the models predict a high likelihood of cash flow problems in the event of an increase in overdue invoices, you may want to take proactive measures to reduce this risk, such as implementing stricter payment terms or improving your collections process.
6. Continuously monitor and update the models: Continuously monitor and update the stress test models to ensure they remain accurate and relevant as your business evolves over time.
Overall, having regular internal conversations regarding your current debtors, your debtor (and creditor) policies and running scenarios using your stress-test models can help the leadership team better understand the potential impact of late payment by debtors on your business and identify ways to mitigate these risks, before they have a serious impact on your business.For more information on financial reporting, contact Patrick.Arnfield@chathamcapital.com.au
