One Way Credit Portfolios Get Blindsided: The Wrong Credit Risk Metric
It was a perfect storm.
Aggressive expansion plans. Lots of leverage. Sales falling like a knife through butter, followed by cost-cutting and other measures to preserve working capital.
We happen to be talking about Performance Sports Group, a sports equipment and apparel manufacturer that filed for bankruptcy last year.
But to any credit executive who’s been around the block a few times, this scenario is common. And yet, a payment-based credit score would have missed the signs of growing financial distress for this public company, and many others.
Today, we examine a commonly used metric that can lead your credit decisions astray, and how to more accurately predict public company financial distress.
Public vs. private companies: one key difference
Since private companies do not report financials, credit managers must dig deep to detect financial distress. You piece together what you need from the financial data that’s available, and use it to detect risk.
In this regard, one of the most commonly used financial risk indicators is a trade receivables-based metric like days-beyond-terms.
History has shown that when liquidity gets tight, privately-held companies start picking and choosing which creditors to pay. Payments get less timely as financial pressures build, and deterioration of a metric like a DBT Index or a payment-based credit score can be a the precursor to a private company bankruptcy filing.
But public companies are different. Even when they’re in financial distress, payment history often won't change. In fact, after analyzing thousands of public company bankruptcies, we’ve found that public companies often pay on time, right until they file for bankruptcy, with no degradation in payment behavior.
Why public companies behave differently
What’s the reason for this difference in payment behavior? Turns out, large public companies have one thing many private companies don’t: greater access to capital.
Even as financial health deteriorates, they have broader facilities to draw down as working capital becomes strained. They typically continue to access capital markets and credit facilities for the working capital they need, drawing funds to operate right until they file for Chapter 11.
As we’ve already seen, private companies lack this same ready access to cash. They stretch payments to preserve working capital, so financial distress shows up in their trade history long before it would for a public company.
How this "cloaking effect" can blindside credit portfolios
Since public companies don’t change their bill payment behavior, it’s easy to miss the signs of growing financial distress. Bankruptcy risk is often “cloaked” under a positive payment history, leaving portfolios exposed by the time a financially distressed public company files.
For an example of this "cloaking behavior", take a look at our many bankruptcy case studies: Vanguard Natural Resources, Stone Energy Corporation, Performance Sports Group, Cosi Inc., and many others.
What you’ll find is a DBT Index that doesn’t budge, even as financial health deteriorates sharply. Had you been watching the DBT Index for any of these public company bankruptcies, you wouldn’t have gotten a timely heads up of weakening financial condition.
NOTE: The days-beyond-terms (DBT) calculation shown below is based on data we collect from Trade A/R aging snapshots contributed to the CreditRiskMonitor database. A DBT Index of 8 (example shown below) represents 11-20 days beyond terms.
A more reliable predictor of public company risk
The good news is that we have far more predictive data on which to make public company credit decisions.
The FRISK® score predicts deterioriating financial health and ultimate bankruptcy risk with 96% certainty, by taking a much wider range of metrics into account -- market data, financials, even crowdsourced click data from other credit professionals.
Taken together, these other metrics can give you a leg up on financial distress, even when payment scores don’t.
Are you using the wrong credit risk metric?
If you're still relying on a payment-based score to monitor customer financial health and detect public company distress, be advised: public companies that are paying you timely, could be riskier than you think.
See the FRISK® score in action, and learn why more than 35% of Fortune 1000 companies use it to manage public company financial risk.
CreditRiskMonitor is a financial news and analysis service designed to help professionals stay ahead of public company risk quickly, accurately and cost-effectively. More than 35% of the Fortune 1000, plus thousands more worldwide, rely on our commercial credit reporting and predictive risk analytics for assessing the financial stability of more than 56,000 global public companies.
At the core of CreditRiskMonitor’s service is its 96%-accurate FRISK® score, which is formulated to predict public company bankruptcy risk. One of four key components calculated in the FRISK® score is crowdsourced subscriber activity. This unique system tracks subscribers' patterns of research activity, capturing and aggregating the real-time concerns of what are essentially the key gatekeepers of corporate credit. Other features of CreditRiskMonitor’s service include timely news alerts, the Altman Z”-Score, agency ratings, financial ratios and trends. CreditRiskMonitor’s network of trade contributors provides more than $140 billion in trade data on their counterparties every month, giving them visibility into their biggest dollar risks.