CASE STUDY #1 : WHAT HAPPENS WHEN A MAJOR CUSTOMER GOES BANKRUPT?
In August 2016, Mr. Zhang had reason to celebrate. The company he founded 20 years ago, ABC Apparel Ltd., was on track for its first year of $40,000,000 in revenue. ABC now sold its clothing to over 50 customers in 6 countries.
Mr. Zhang’s only cause for concern was that his top 15 customers represented 80% of total sales; in fact, ABC’s top customer, BigBox Inc., alone represented 20% of total sales ($8,000,000). Furthermore, BigBox’s creditworthiness was declining as it faced tough competition from online retailers. Mr. Zhang pushed his sales team to find new customers, but this was easier said than done, and ABC continued to sell to BigBox in large quantities. BigBox had recently reached out to ABC with a request to buy even more product, since some other vendors had stopped selling to BigBox.
Across ABC Apparel’s customers, its gross margin was generally 20%; for BigBox, $8,000,000 in annual sales represented $1,600,000 in gross profits to ABC. Mr. Zhang could not have stopped selling to BigBox without finding replacement business, otherwise the production overhead of running the factory would have caused losses across all other revenues—in other words, his overall gross margin would have gone negative—triggering his banks to call his loans! So, although Mr. Zhang read dire headlines about BigBox day after day, he reluctantly continued to sell to BigBox (while losing sleep at night!).
ABC Apparel’s sales to BigBox were fairly constant throughout the year, with some peaks around the ‘back-to-school’ and ‘holiday’ seasons. Since ABC sold to BigBox on 60-day terms ROG (receipt of goods), ABC Apparel usually had between $1,000,000 and $2,000,000 in A/R due from BigBox at any given time.
One unfortunate morning in September, Mr. Zhang received an email stating that BigBox had declared a Chapter 11 bankruptcy. Mr. Zhang had never had a customer declare Chapter 11, but he knew that in this type of bankruptcy proceedings all trade debt would likely be defaulted on and eliminated.
He was correct—ABC’s BigBox A/R were lost. Taking the loss of nearly $2,000,000 caused his banks to reduce his credit facilities, which impacted the terms on which he needed to buy from his suppliers… This began a vicious circle that caused Mr. Zhang to have trouble making payroll and paying his taxes. His bills began to pile up, and workers began to ask questions about the company remaining in business. Mr. Zhang’s own family began to ask if they should be looking for jobs at other factories!
Unhappily, Mr. Zhang did some quick calculations with his financial team, and realized that ABC Apparel would need to do an incredible $10,000,000 in additional new business just to make up the $2,000,000 loss! ($10,000,000 at 20% gross margins = $2,000,000.) This represented an ambitious >30% immediate increase over his remaining sales (less BigBox). Mr. Zhang called an emergency meeting with his sales manager and sales team, and broke the news—they would need to win 30% more sales… immediately! Nobody would meet his eyes. He knew this wasn’t a realistic ask—his team was having trouble getting any new customers, let alone another 30%!
In order to keep his vendors from stopping shipments, and in order to keep his bankers from calling his loans, Mr. Zhang realized he would need to sell one of his three production plants. Sitting quietly in his office, he made the painful decision to terminate his financial management team and sadly realized that he would have to scale back to the level of sales he was doing 10 years ago.
ABC Apparel was in fact not as bad off as some companies, where a customer bankruptcy actually causes an exporter’s bankruptcy, nearly overnight. Regardless, Mr. Zhang could have better managed his risk. Mr. Zhang’s credit insurance options (both government export agency and private market) could not cover his important but risky customer, BigBox Inc. However, Mr. Zhang tragically was not aware that for a cost of just 1% of his sales price (retaining 19% margins!), he could have purchased a non-cancellable A/R put option from a New York-based financial firm.
There’s a reason why many business owners refer to A/R put options as “business life insurance”!
CASE STUDY #2 : CONFIDENTLY SELLING TO A CUSTOMER WITH DECLINING CREDIT
ExportCo Pvt. Ltd. was a local success story. Founded in a quickly growing city in Asia in 2005 by the entrepreneurial Mr. P, it had grown from first year revenues of just $30,000 to nearly $10,000,000 last year! Mr. P had achieved his success through hard work and a keen eye on expenses. In fact, he was so conservative that he did not even borrow much from his bank. While this had prevented him from growing even larger, he preferred to take on little risk.
Despite Mr. P’s overall success, business had been getting tougher recently. Even though his country was still a developing market, the big buyers in the USA had started sourcing in other countries in Asia where prices were even lower. Still, Mr. P maintained his core relationships, and his buyers knew that ExportCo Pvt. Ltd. sold an excellent product at a competitive price. However, getting additional market share was getting increasingly difficult. Mr. P worried that by the time he handed the company over to his children, sales may have decreased, not grown!
Even though Mr. P sold mostly on L/C, he kept a close watch on the creditworthiness of his buyers, even reading the quarterly financial statements of his larger publicly-traded customers. So it was no surprise to him when the buyer at MartCenter Inc. emailed him one day, asking that Mr. P sell on an open accounts basis. Opening L/C’s had become too hard at the moment for MartCenter due to its bankers restricting its credit lines.
MartCenter had been an important driver of ExportCo’s success, and Mr. P sympathized with the buyer’s predicament.
The MartCenter buyer told Mr. P, “I need your product to fill our shelves—we’re going into the holiday season, and if we don’t have product to sell, we won’t be able to come through. On the other hand, with some support, we’ll be able to turn this around and become stronger than ever.”
Mr. P, while sympathetic, had heard this before. As much as he wanted to support MartCenter, he would never sacrifice all of his hard work on a gamble to save a customer.
Luckily, just the previous week, Mr. P had been introduced to the idea of A/R put options. He did not care much for his country’s export credit agency’s trade credit insurance, as it had often been cancelled on risky buyers in the past. But since A/R put options were non-cancellable, Mr. P decided to have his legal and accounting advisors research this trade risk mitigation strategy for him.
After purchasing the A/R put option on MartCenter, Mr. P cheerfully called the buyer at MartCenter to tell him the good news— ExportCo could forgo the L/C and was ready to support MartCenter through the season. The buyer was very pleased and actually decided to increase the usual order by over 50%. A week later, the MartCenter buyer called back and put in another order for an additional 80%! Mr. P told him that delivery of the additional product would take some time, but the buyer said he needed product as soon as possible, as some of the other vendors had stopped shipping to MartCenter.
As the buyer predicted, MartCenter was able to execute a turnaround—and then an interesting thing happened: when the other vendors (ExportCo’s competitors) went back to MartCenter to say ‘congrats’ and to get the next season’s orders, the buyer told them there was no need… ExportCo would be getting all orders for the category.
Here, by giving up 2% of his gross margin on each sale, Mr. P was able both to control his trade risk and to cement his relationship with a key buyer by being there when the going got tough. The whole A/R put option contract had cost Mr. P $75,000 (which was a lot of money). However, in exchange, he received an additional $200,000 in gross profits and locked in a 150% increase in MartCenter sales in the coming years. Speaking to his friends afterward, Mr. P stopped referring to his A/R put option strategy as a cost and started calling it a good return on investment!