Business failures set to blow as economy tanks

Frank Knight

By Frank Knight, chief executive of Debtsource

Few people realise that the largest source of business funding in South Africa is provided by private companies themselves. Businesses extend credit to their customers and obtain credit from their suppliers, usually in the form of short-term funding which lasts for 30 to 60 days per transaction.

This form of funding helps businesses both large and small to effectively manage their cash flow and diminishes the need for bank or state institution funding. Known as “trade credit”, many of these transactions are secured using trade credit insurance companies and the funding system operates as an efficient mechanism that facilitates enormous trade volumes in our country.

The effect of a ratings downgrade; together with political uncertainty; mass action; and the notion of what radical economic transformation might mean for business is undoubtedly set to interrupt the efficiency within which trade credit transactions takes place. As soon as there is economic upheaval in either an industry or an economy, private businesses become more wary of their trade credit risks and this immediately leads to a contraction of economic activity.

What we have seen from massive economic upheaval in recent times in other countries is that the business sector is far more sensitive to these changes than citizens appreciate. By way of example, during the Greek financial crisis in 2011/12 almost 200 000 small businesses closed as a direct result of their financial meltdown – in just two years! Not only do companies themselves become more loathe to extend credit due to increased credit risk in the market, but trade credit insurers who secure many of these transaction start limiting their risks too. For instance, during the 2008 financial crises trade credit insurers globally (and in South Africa) implemented a limit reduction exercise that had the effect of a wholesale reduction of trade credit securities. And when trade credit insurers start withdrawing their securities, companies stop trading with each other, and when that happens on a wholesale basis, businesses can’t get credit, and it all eventually leads to economic meltdown or recession.

The most vulnerable businesses in this scenario and in South Africa are small businesses. They usually do not have meaningful reserves to call on in order to keep their cash flow going, and may not qualify for bank finance or credit of sufficient proportions to help them through tough times. Moreover, they themselves become more exposed to credit risks from non-paying customers or from late paying customers which further worsens their cash flow, increasing their demand for finance, and causing them to start paying their suppliers late, which leads to further credit downgrades and suspensions.

So vulnerable is the cash flow of these small businesses to late payments from their customers (not to mention non-payments) that in the United Kingdom they enacted a law that compels their credit customers to pay them on time. Known as the Late Payment of Commercial Debt Act, the law means that the business can claim interest and debt recovery costs if another business is late in paying for their goods or services – irrespective of whether their client agreed to such a condition in their terms and conditions of sale.

The other reason why a downturn in the South African economy comes at such a precarious moment is that some of our largest companies – and especially those operating in higher risk sectors such as steel, mining or construction – are already extremely vulnerable, with many of them having reported that if management is not able to turn the business around within the short-term, significant “restructuring” will have to take place. That short-term turnaround was banking on an improved economy.

End



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