Credit risk management solutions

Several solutions exist to protect your business against the risk of bad debt and support your credit risk management, but it is easy to get lost among all available options. What is a letter of credit? What does invoice finance or factoring exactly cover? What are the advantages and disadvantages of trade credit insurance? To find your way through the jungle of trade credit management, it’s better to have a guide to follow!

When offering trade credit, it is necessary that you set up an effective credit risk policy to protect your business against the risk of non-payment.

The first question to ask yourself concerns your own resources, both human and financial: do you have the necessary expertise and time to manage your receivables throughout the credit risk lifecycle?

For many companies, calling on a specialised credit risk company is the most protective and least expensive option.

In the UK, SMEs are chasing an estimated £50bn in late payments, with on average five outstanding invoices at once for each business, representing an hour and a half of labour everyday (Source: Tide, January 2020).

Self-insurance consists in building up your own financial reserves – also known as a “bad debt reserve” – to cover your losses in the event of a customer default. It is the simplest solution administratively speaking, and the least expensive... to all appearances.

Your credit risk exposure here could not be greater, and damages can be significant in the event of default on a major contract. Moreover, the hidden costs are significant:

• You must manage yourself the tasks of credit risk management, often forcing you to go through third party data providers that are not always reliable, especially in terms of credit risk rating.
• You yourself must handle the debt collection services, which require a lot of human and financial resources.
• You tie up cash flow on your balance sheet and are not protected in case of a big customer going insolvent.

In the UK, before the Covid-19 crisis, late payments put 50,000 small firms out of business every year (Source: HM Treasury 2019).

Above all, such an approach will prevent you from adopting an ambitious commercial policy to grow your business – unless you’re ready to accept the risk.

For tips on cash flow management, read our ebook How to protect your cash flow or have a look at our article on How to prevent cash flow problems.

Letter of credit definition: a promise from your client's bank to pay you when you have certified the proper execution of your obligations (delivery, nature and quality of the delivered goods or services, paperwork...).

It’s a security for both you (the seller) and your customer (the buyer), where the risk of non-payment is transferred to the bank. It allows you to trade with the certainty that you’ll be paid for the goods you export.

This kind of system is widely used in international trade – and has been since the Middle Ages! – when it is difficult to assess the reliability of the client or the supplier.

Nevertheless, such a system is expensive for the client, and must be renewed for each transaction. Above all, it is an administratively cumbersome solution, and even laborious in the case of a claim process as it can be derailed by minor discrepancies in paperwork.

Factoring is bringing in a third party, called the “factor”, which purchases the debt at a discount (typically 70% to 85% of the total invoice). These contracts often offer to outsource invoicing and debt collection services.

This is the best solution for recovering the cash from a sale as quickly as possible, without mobilising any collateral. Your credit risk exposure is thereby minimised.

Nevertheless, these contracts are expensive in terms of fees (1 to 4%) and only cover a portion of the debt. Moreover, the financial institutions who offer debt factoring often ask you to include all of your client accounts receivable.

It means you effectively lose control of your client relationship: it is the factor that will collect the money from the receivable itself. 

Invoice financing is an alternative that is close to factoring: it allows you to borrow the amount of the invoice using your trade receivables as collateral. Interest is due in addition to the fees, which can altogether represent a total of up to 30% in annual interest.

Here, you remain responsible for collecting the debt, and must ultimately reimburse the amount advanced. Unlike factoring your customer is not aware that the invoices have been discounted.

What is trade credit insurance? Simply put, it is an insurance against bad debt: if your customer fails to pay you, your insurer indemnifies you for the insured amount.

It's the most complete solution: it integrates at the same time a financial information service on your customers and prospects, a debt collection service and compensation in case of non-payment. You therefore make big savings on structural costs.

Your credit risk insurer is in this case an actual partner who advises you and accompanies you throughout your commercial development. Check out our article on how to find the right trade credit insurance provider.

The insurance premium is calculated based on your company turnover and its sector of activity, as well as the level of coverage you want for each customer. But once this premium has been paid, your cash flow is totally secured.

This particular solution gives you the confidence to enter new markets and make competitive offers to your prospects while protecting your cash flow.

 

When it comes to trade credit management, finding the best solution depends on your needs and on the circumstances. However, trade credit insurance remains the most complete and reassuring solution to support your credit risk management and commercial development. If you’re interested to know more or want to get a quote, find us in your country and contact our local teams.