Disruptive events, such as the financial crisis of 2008-09 and COVID-19, can upset the normal flow of working capital. While these are generally out of an individual’s control, business partnerships aren’t.
To establish confidence in counterparties – including their ability to successfully navigate turbulent times – treasurers should develop a method to examine each counterparty’s risk profile by understanding their underlying components, says D. Michelle Golembieski, Executive Director, Corporate Treasury Consulting, Commercial Banking at J.P. Morgan.
Defining the risk
Counterparty risk is the likelihood that one party involved in a financial transaction might default on its contractual obligation, leading to a loss for both parties.
One example of this is if a company is unable to obtain the necessary materials from a supplier to manufacture a product or provide services, the company can’t benefit from the resulting sale of the finished product or service.
Counterparty risk assessments often focus on banking partners, but examining customers and vendors is equally important, explains Golembieski. “Start by learning the risk components affecting your customers and vendors. Then measure and score each counterparty’s risk profile and benchmark them with other suppliers or customers.” This can help your company:
Identify areas of concern within its business ecosystem.
Better assess and plan for impacts to working capital.
Provide more accurate probabilities for cash forecasting models.
It may be difficult to conduct assessments during an economic disruption, especially because doing so requires the participation of treasurers and subject matter experts within each function. “But don’t overlook customer and vendor issues until it is too late to collect on outstanding invoices or receive the supplies you need,” she says.
Golembieski suggests treasurers follow these five steps to help identify and assess their counterparty risk.
1. Identify your data set based on your company's business.
Start with your more strategic counterparties and work down the list. The easiest first pass may be to select the top suppliers and customers using the 80/20 rule – identifying the few who provide the most output. You can also consider assessing customers and vendors based on line of business, product or region.
2. Review the party’s company profile in relation to current market conditions.
Examine each vendor or customer, including its industry, country footprint, currency and organisational structure. Then look at the current macroeconomic factors and consider how they could impact each company attribute. Assess any changes to the potential risks of each attribute to determine the overall effect on that counterparty.
For example, the restaurant and travel industries were hit hard after COVID-19 entered the US. As a result, you would likely rank these companies as a higher risk than a communications company. Prior to the pandemic, an Italian company might be considered lower risk. But after trade in and out of Italy slowed, those companies were considered riskier.
Determine how well the customer or vendor adheres to agreements. Counterparties that don't hamper the flow of working capital are generally considered lower risk. For instance, do you experience a higher rate of returns for one supplier versus another? Does one customer abide by the prescribed payment terms while another is always late?
3. Review customer and vendor operational characteristics.
Consider how specific customers and vendors impact your payables and receivables flows. With limited access to liquidity in economic downturns, you want to avoid seeing your working capital and bottom line reduced as a result of a counterparty’s behaviour. Treasury should focus on making processes as efficient and effective as possible. This includes extending days payable outstanding without damaging vendor relationships and shortening days sales outstanding to optimise working capital.
For example, your risks may increase – and be more costly – when working with a counterparty that uses manual, paper-intensive processes than with a company who can effortlessly transact business.
4. Rank customers and vendors based on their total risk level.
Stack rank customers and vendors and bucket them into groups based on risk levels. Treasury can then direct these groups to the appropriate area for action. For example, you may need to change credit lines or payment terms for higher risk customers. For higher risk vendors, you should work with procurement or supply chain that can help you establish mutually beneficial payment changes or find alternative suppliers.
5. Revisit your assessments
Counterparty risk assessments provide only a snapshot of specific customers or vendors within a defined time. As time passes and events change, it’s important to review your assessments. You’ll be better prepared to execute the strategies necessary to navigate the evolving business environment. In turn, this may reduce your exposure to unknown, riskier transactions.