When a company is growing, finance executives must continuously balance the benefits of doing new business with the associated risks. On average, one in every 10 invoices becomes delinquent. So each time a business grants credit to a customer, it is taking a chance that the debt will not be paid. Obviously, this creates risks for the business's cash flow and profitability, since one large unpaid invoice may have the potential to blow the bottom line, halt growth, or even trigger insolvency.
Representing up to 40 percent of the typical company's balance sheet, accounts receivable (A/R) are naturally both a vital and vulnerable component of a healthy business. Losses attributed to nonpayment of a trade debt are a regular occurrence, even as the United States continues its gradual economic recovery. In 2013 alone, nearly 40,000 North American companies declared bankruptcy, leaving their creditors holding the bag.
In the face of today's changing economic climate, recognizing and managing future A/R risks has become a priority for business leaders. Every business should have a well-defined and vetted strategy in place to mitigate the risk of bad-debt losses. This not only provides protection in the case of customer default, but it also ensures that a company is growing sales safely, domestically and abroad, to new and existing customers.
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There are several layers to a successful A/R risk management strategy. A company should conduct a thorough review of its customers, analyzing—at minimum—each customer's financial status, credit history, and relationship with other buyers and sellers. It should also undertake a cost-benefit determination for every prospective customer to decide how detailed of an analysis to conduct and how often, keeping in mind that even a very small customer can have a devastating impact should a company have to write off its entire receivable. Then the company should regularly review updated information for each customer with a frequency that is in line with the perceived risk that the particular buyer presents and its potential for default. Ongoing reviews enable the company to continue to assign credit terms that maximize profit while minimizing risk.
Options for Hedging Risks
Even with this type of comprehensive strategy in place—a strategy that could entail the review of dozens of credit requests per day—a business can't necessarily cover all unforeseen risks. Companies have several options for mitigating those risks, each of which can be valuable in certain circumstances.
Letters of credit (L/Cs), which can be expensive and time-consuming to procure, are more common for less-creditworthy buyers with whom a business has more leverage to pass on the cost of payment assurance. One downside of this approach is that it can put the company at a competitive disadvantage if it's requiring an L/C from a buyer to whom its competitors are willing to extend open credit terms. Letters of credit can also limit the seller's ability to borrow, as they tie up availability of the company's bank line of credit. Nevertheless, for some transactions, an L/C may be the only option.
Another method for mitigating trade credit risks is factoring, which entails selling receivables to a factoring firm, often at a discount to face value of between 1 and 10 percent. Factoring is common in certain industries and is used by businesses without traditional access to financing. Though factoring agreements are useful in providing cash faster than a company could access it by simply waiting for receivables to be paid, factoring firms may not agree to take all of the credit risk in the event of nonpayment. Depending on the agreement, the factor can retain the right to a refund if the buyer is unable to pay. Moreover, when a company uses a factor, it loses an opportunity to cultivate the client relationship, which is possible when the seller continues to own its receivables.
Sellers also have the option of buying a credit default swap (CDS), a financial instrument through which the seller of the CDS compensates the buyer in the event of a loan default or other credit event. Although CDSs were once a popular tool, they've become much more problematic as a hedging mechanism since the passage of the Dodd-Frank Act.
The Insurance Alternative
One option that's gaining in popularity is trade credit insurance. It's interesting that many companies which insure themselves against other unpredictable, high-exposure events like property loss or liability claims leave their A/R assets exposed. Trade credit insurance fills this gap by reducing or eliminating the risk of nonpayment of commercial debt: If a policyholder's client fails to pay an insured debt, the insurance company makes good on the obligation.
In addition to compensating a seller in the event of unforeseeable losses, a trade credit insurance policy can help policyholders avoid foreseeable losses. The best credit insurers invest in developing proprietary credit and financial information, and they employ risk analysts as well as industry- and country-based underwriters in many geographic regions in order to have a close physical proximity to policyholders' buyers. The risk analysts research and evaluate information about a policyholder's individual customers, analyzing payment behaviors to identify early signs of financial trouble. They use this information to support policyholders' decisions to extend, deny, or hold down credit-limit requests.
In this way, trade credit insurance can help a company cultivate clients in sectors or geographies that are outside its traditional client base. The insurance company's credit risk analysis and management expertise can provide insight into the true risks of doing business with prospective new trading partners. For companies that sell on an export basis, this can help improve their competitiveness by offering open terms when letters of credit or prepayment may have previously been the only safe way to do business.
Trade credit insurance can also improve a company's relationships with its lenders. It is not uncommon for a bank to reduce the interest rate charged to the holder of a trade credit insurance policy. In some cases, banks require trade credit insurance before they will approve a loan. For example, a $25 million lumber wholesaler had extreme concentration in its accounts receivable because it had only eight active customer accounts. The company's bank was concerned about this concentration, and it required trade credit insurance before it would consider the A/R portfolio as collateral for a loan. The lumber company established a trade credit insurance policy that specifically named each of its buyers, which provided the bank with the comfort level it needed.
Self-Insurance
Self-insurance is one more option for protecting a business from potential A/R losses. The biggest downside to self-insurance is that it involves setting aside reserves to cover any losses from customers' failure to pay their debts. The IRS estimates that bad debt reserves, which obviously eat into margins, can reach up to 2.2 percent of annual sales, depending on the industry.
Self-insurance also requires an investment in systems, credit risk monitoring, and analysis expertise, the quality and scope of which may or may not be comparable to those available from a third-party trade credit insurance provider.
Ongoing Risk Management
All A/R risk management mechanisms have certain administrative requirements. These vary, but they are typically incorporated into a company's day-to-day business operations. These requirements may include compiling proof that products were shipped; gathering evidence that fraud is not in play; and preparing to demonstrate, if necessary, that the company did its due diligence in attempting to collect a given receivable. Despite the added workload, effectively mitigating trade credit risks is worth the effort.
Few companies can compete successfully without extending credit to their buyers. Carefully and deliberately managing accounts receivable—whether through trade credit insurance, letters of credit, factoring, or other means—enables a company to more intelligently make credit decisions. Doing so can significantly expand an organization's sales opportunities and can enhance customer relationships, as the company can confidently extend more favorable terms to customers and prospects.
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Kevin McCann is senior vice president, regional risk director, and general counsel at Euler Hermes Americas, part of the world's largest trade credit insurance company. With Euler Hermes since 1997, his responsibilities include oversight of all risk underwriting, information, claims, and legal activities in the U.S., Canada, and Brazil.
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