5 Financial & Legal Mistakes Pushing Companies Closer to Bankruptcy

Big-name brands like Bed Bath & Beyond, Serta Simmons and Party City – all of which you’d assume have their finances in great shape – have wrestled with financial troubles and found themselves either filing or close to filing for Chapter 11 bankruptcy. 

With everything that’s been going on for the last few years – COVID-19, supply chain disruption and rising inflation – you might assume bankruptcies have risen as a result. But our State of Credit Risk: 2022 report shows the opposite is happening. The total number of U.S. corporate bankruptcies has dropped consistently for the last three years, dropping from over 35,000 in 2019 to just over 20,000 in 2022.

At first glance, you might think this doesn’t seem right. But you have to consider what’s been going on in the background. Remember, COVID-19 led to multiple lockdowns and closures of businesses for months at a time. So, bankruptcy courts had to close too, meaning bankruptcy hearings couldn’t take place. It’s also important to note that it’s not a legal requirement for all companies in the U.S. to file for bankruptcy. So, you often see smaller businesses simply shutting down without filing for bankruptcy. Plus, our data lines up with findings from S&P Global Market Intelligence, which highlights US corporate bankruptcies fell to a 13-year low in 2022.

What’s the takeaway, you ask? Being too lax with your company’s financial management and not doing proper due diligence on your customers could hurt your cash flow and push you closer to bankruptcy. In this article, we’ll discuss the financial and legal mistakes many companies make – and how to avoid them. 

As a business, you’ll accumulate debt over time. That’s a given. But how you keep track of your debt and how you pay off those debts are critical to keeping your cash flowing. It's also the most common area where businesses fall short. And when debt grows too high and too fast, companies often find themselves in panic mode and considering bankruptcy.

Bankruptcy filings go onto your company’s credit report and can make it tough for you to secure a loan, financing or investment down the road. But even if you haven’t filed for bankruptcy, lenders and investors will certainly be looking at your business credit report to see how much outstanding debt you have. So, they’ll be looking to see how much money you owe – if it’s upwards of $1 million or more, that’s a red flag.

They’ll also be looking at how you pay your bills and specifically at your average DBT (days beyond terms). If your DBT is over 10, that doesn’t look good to potential lenders and investors because it indicates you may have an ongoing cash flow problem or are spending too much (beyond what’s necessary). 

As our State of Credit Risk: 2022 report found, nearly three-quarters (68%) of U.S. companies across all sectors were classified as ‘very high risk’ in 2022. But just 5% were classified as ‘very low risk.’ If your business is deemed to be ‘very high risk,’ the chances of getting approved for a business loan will go down significantly. And if you’re in talks with a venture capital firm for potential investment or a merger/acquisition deal, they’ll also look at these figures and could likely walk away from a deal.

Our report also found that the three sectors with the highest percentage of businesses categorized as ‘very high risk’ were agriculture, forestry & fishing (53%), transportation & public utilities (42%) and construction (41%). Like other businesses, the U.S. agriculture, forestry & fishing sector faced major challenges amidst the uncertainty of the economic downturn, rising inflation and increased costs. And according to a McKinsey survey, more than half of U.S. growers with small to medium-sized farms (less than 2,000 acres and 2,000-5,000 acres, respectively) and two-thirds of growers with large farms (more than 5,000 acres) believe they’ll be paying 10% to 20% more for key inputs over the next 18 months.

Meanwhile, transportation & public utilities businesses need to have sufficient funds daily to pay for fuel, maintenance, fleet growth and freight brokers to pay carriers. But it’s not always possible to have cash available. So, these businesses often seek out leasing options for equipment and loans or credit to purchase what’s necessary to keep their businesses running and meet customer demands. 

Now let’s examine the transportation and public utilities sector. These businesses need to have sufficient funds daily to pay for fuel, maintenance, fleet growth and freight brokers to pay carriers. But it’s not always possible to have cash available. So, they often seek out leasing options for equipment and loans or credit to purchase what’s necessary to keep their businesses running and meet customer demands. 

So, how do you avoid letting your debt pile up on top of you?

Here’s a few things you can do to:

• Don’t take out more credit than your business can afford. It might seem tempting to take out multiple business loans and business credit cards – that gives you a cushion for expenses. But if you can’t repay those debts in a timely manner, it’s just going to hurt your own company’s creditworthiness and reputation.

• Keep track of all your debts, the amounts owed, the total payments made to date and remaining balance. Then make sure you have enough income to cover those payments as well as your other expenses. When in doubt, make sure you have less money going out than you have coming in. Also, build in extra cushions and contingency plans into your budgets so you don’t get caught off guard if customers pay late or if you lose customers and revenue due to the economic uncertainty.

• Create risk profiles on all your customers – designating them into the following categories: very low risk, low risk, moderate risk, high risk, very high risk. You’ll need to use data from their business credit reports to build these profiles. For instance, if a customer’s business credit report shows they have an average DBT of 10 days (meaning they pay their invoices 10 days past terms) and owe suppliers over $1 million, this company is likely to be classified as a ‘very high risk.’ Of course, what risk level you designate your customers in depends on your company’s credit policy, how you assess risk and the potential consequences of those risks. The takeaway here is that you need to do the work to determine how much risk each of your customers brings with them and could expose your business to.

• Automate processes within your accounts receivable function. Don’t rely on manual processes and physical paperwork. That’s not only outdated, but it’s a sure-fire recipe for errors, duplications and delays. Also, make sure those processes use data from the credit risk profiles you’ve created for each of your customers. And send reminder emails to suppliers who haven’t paid overdue invoices. You can scale up the level of urgency in those reminder emails depending on how quickly you need the cash. Remember, you’re legally entitled to issue statutory interest rates for late payments and communicate it clearly in your contract.

• Don’t jump the gun and write off bad debt. According to Gartner Finance Research, bad debt has been rising over the past couple of years – increasing 25.8% year-over-year in 2020. So, yes, bad debt is a problem for many businesses. But that doesn’t mean you have to write off. You could still recoup some or all of that debt if you hire a debt collection agency. Just make sure the debt collection agency is reputable, is respectful in how it communicates with your customers and looks for ways to recoup your debt. 

DSO (days sales outstanding) refers to the average number of days it takes for an organization to collect payments. This metric is useful for understanding how efficient your accounts receivable process is. A high DSO rate indicates your business could have a cash flow problem, which could come from customer satisfaction declining, sales teams offering longer payment terms to drive more sales or extending credit to customers with poor credit.

Often, DSO is tied to DBT (days beyond terms), which refers to the average number of days it takes a company to make a payment. The longer it takes to get paid by your customers, the longer it’ll take to pay off your suppliers and settle debts, which could push you further down the bankruptcy path. 

The importance of DBT scores can’t be overstated. And it’s a mistake to think working with big, well-respected companies automatically means you’ll be paid on time. Our research shows large businesses had an average DBT of 19 in 2022. Meanwhile, small businesses fared slightly better with an average DBT of 18 and mid-market companies had an average DBT of 16. 

Why am I telling you this? It’s because I don’t want you to go into working with a customer blindly. Most importantly, you need to monitor the DBT scores of your customers and your DSO rates. 

Here are some ways to reduce both: 

• Check the business credit reports of your customers every week. Yes, you heard me. Every week. Take a look at their average DBT – if it’s higher than 10, that should be a sign that not all is well with the company’s finances. And if you can see how their DBT is trending – if it’s increasing each month by a significant amount, that’s another sign that they won’t be very reliable and could be less likely to pay their invoices on time.

• Benchmark your customers’ payment behaviors against others in the industry. For example, check to see if your customers have a higher DBT score than other businesses in the same industry. Do they have a DBT of 20, while others in the same industry have a much lower DBT (3)? That’s a red flag you shouldn’t ignore. It signals that you may want to adjust their payment terms or cut ties with them and work with a different company that has a lower DBT score. 

• Create an analysis comparing the average DBT of your customers against the net terms you’ve set for them. Look at which customers have been paying late (frequently) and see if you’ve set a Net 60 or Net 90 payment terms for them. You may want to shorten their payment terms to Net 30. If they’ve repeatedly paid late, you may also want to ask for a full upfront payment or partial deposit to protect your cash flow. That’s not unreasonable.

• Automate your invoice collection process with software that sends consistent electronic reminders and eliminates physical invoices. Use tech to build in workflows so that you can make the right decision on whether to work with a company or pass on them based on how risky they are. Imagine if you could plug credit risk intelligence software into your accounting software and then let the tech cross-check all the data for you and tell you whether you should work with them or not. How easy and useful would that be? Very.

One of the surest paths to bankruptcy is to treat credit risk management like it’s your Achilles Heel, instead of your greatest strength. This is a problem that can come up in your finance team, with team members either prioritizing other metrics or having their own way of doing things. In other words, they don’t communicate how they assess customers' credit risk to the sales team. On the other side, sales teams may be laser focused on chasing leads and don't see how the bad credit history of a prospect could cause irreparable damage in the future. 

Not to sound cheesy, but credit risk data is and should be your best friend. It doesn’t matter what department you work in. That’s why you need to push to prioritize and invest in the use of technology that brings that data to you. It’ll give you a window into your customers’ financial well-being and is likely to uncover red flags they might not want you to see. At the end of the day, that’s what you need to protect your company from risks and to position yourself to grow the business long-term. 

Here are a few ways to make credit risk management work harder and better for you.

Get sales and finance singing from the same hymn sheet: Creating synergy between your sales and finance teams is crucial, especially considering 54% of sales managers waste up to 20 hours a week chasing leads that don’t meet the company’s credit policy. And the fact that 52% of sales managers report losing up to $200,000 per month because the deals are deemed ‘too risky’ by the finance team isn’t good either. 

There is a lot you can do here. One scenario is to have your finance team run monthly workshops to upskill sales on your existing credit policy. Use real-world scenarios and show them just how important it is to use credit risk data. And show them examples of big companies that they might assume are great sales prospects, but have all sorts of financial, legal and compliance troubles that are bleeding them dry. If you don’t show them and help them see how signing ‘risky’ deals actually hurts them and the business, they won’t be all that bothered to look at and follow your credit policy. And they certainly won’t be inclined to push their boss to use credit risk data.

Don't make decisions without having the right data: Data is a beast in most companies today. There’s so much of it and it can be hard to parse through it all, let alone make sense of it. But it’s also so important. It’s often the basis for making decisions on how much budget to allocate to certain initiatives and departments. It’s also critical in finding flaws and gaps within a business so your business isn’t susceptible to financial, legal, security and compliance risks. 

If you look at most finance teams in companies today, they’re using some technology already. For example, ERP software is typically used to manage the day-to-day financial activities within accounting, procurement, project management, risk management, compliance and supply chain management. This software is meant to make it easier for companies to plan, budget, forecast and report on financial performance.

But there are several challenges with ERP software.

• ERP software doesn’t always have important metrics you need to manage your cash flow, such as accounts receivable (AR) metrics. Without this, you company could be left with a huge blind spot that puts you at risk of increasing your DSO (days sales outstanding) and reducing your cash flow significantly.

• In many instances, ERP software isn’t correctly implemented across all functions, which leads to internal errors and failures.

• Another problem is that businesses don’t properly integrate their ERP software across their entire technology stack. This happens because legacy systems are so outdated that they can’t communicate and integrate properly with ERP software. And that leaves companies stuck with data quality problems that often lead to misinformed decisions that expose their business to financial, legal and compliance risks.

Get more clarity with digital ledger management: Guesswork is the enemy of business and could spell death for your company’s financial health. But this can be easily solved with a digital ledger management tool. Incorporating it into your tech stack means you can see how much cash is going in and out of your business and prioritize the debt collection strategy for high-risk clients.

As our State of Credit Risk: 2022 report found, legal filings cost American businesses over $54 billion in 2022. Clearly, lawsuits, court judgements, tax liens and Uniform Commercial Codes (UCCs) take a serious financial toll on companies.

On digging deeper into our data, we found the highest number of legal filings came from professional, scientific & technical services firms, retailers and construction companies, each with over 200,000 legal filings. Of those sectors, retail was hit the hardest, losing over $10.28 billion.

These stats are pretty dismal, right? I’m not telling you to frighten you. I just want you to understand how your customers’ legal troubles can actually hurt your cash flow and lower your chances of surviving the impending recession.

Let’s talk about lawsuits and court judgements. You can’t escape news headlines of class-action lawsuits being filed against large companies. Some are the result of massive data breaches; some are due to employee grievances for unfair dismissals, unpaid wages, discriminatory practices or sexual harassment.

Whatever the reason, class-action lawsuits are a huge problem. According to global law firm Morrison Foerster, 43 major data breach class-action lawsuits were filed in 2022 with an estimated 8.2 million individuals impacted. Healthcare companies accounted for 42% of those data breach cases, while support services, technology and financial services companies made up the remaining cases.

The settlements (i.e. court judgments) resulting from these types of lawsuits are nothing to balk at either. According to Gerard L. Maatman Jr., a partner at the Chicago office of legal firm Duane Morris, “the number of billion-dollar settlements set a new annual record in 2022, surpassing even the extent of settlements from Big Tobacco litigation two decades ago.”

Clearly, companies have their fair share of legal trouble. But if you decide to sign a contract with one, you may not see your payments coming on time (or at all) because all that money is going towards legal fees, settlements, fines and other related costs. So, wouldn’t you rather know the legal red flags in your potential and existing customers’ background? I certainly hope so. If you don’t, you could be left holding the bag and your cash flow could end up severely drained.

To avoid working with companies embroiled in legal trouble, you should check your customers’ business credit reports every week. You should always know what types of legal filings are filed against them and how much those are costing the business. You can also cross-reference this information with their payment data to see if there’s any correlation between a high amount of legal filings and financial problems.

You also need to stay on top of your accounts receivable function and make sure that you know exactly how many of your customers have paid late and how much money you’re owed. Why? Because you need to map that against your expected expenses – including operational and infrastructure costs, supplier bills and employee wages. If your customers are paying their bills upwards of 15+ days past their terms, that’s money you don’t have in your accounts to pay for those ongoing expenses. Do the math – it doesn’t add up.

As you take out more credit to offset unavailable funds, you’ll need to be especially careful about how much credit you take out and how much of that credit you use. For example, if you’ve taken out multiple new business credit cards and have spent 90% of the total credit limit on all of them, that could negatively affect your business credit score and make your business appear to be too risky to potential suppliers. 

Credit limits exist to set boundaries on how much you can spend with creditors. While your operating expenses may be high at times, constantly going over or near the limit points to deeper financial management and cash flow problems. 

The first step to making sure you’re operating within your credit limit is to understand how it relates to your credit score and risk level. Here’s our scoring model for reference.

Credit Scores & Risk Levels

• 71 – 100 = Very Low Risk
• 51 - 70 = Low Risk
• 30 - 50 = Moderate Risk
• 21 - 29 = High Risk
• 1 - 20 = Very High Risk

When assigning a score, we look at different sources and factors that include your industry, previous bankruptcy filings, company size and payment history. From there, we define a measurable credit limit that looks like this:

• Public Limited Company (PLC) with a credit score of 30 and above: $50 million
• Non-PLC company with a score of 30 and above: $1 million
• Any company with a score below 30: $0

This information echoes the common thread of what I’ve been saying. You can’t protect your company against financial and legal risks if you aren’t looking at credit risk data regularly. And you certainly won’t be well positioned to stave off bankruptcy if you’re flying blind or using guesswork.