Self-insurance means building up your own financial reserves – also known as a ‘bad debt reserve’ – to cover your losses in the event of a customer default. This is the simplest solution administratively speaking and may seem the least expensive.
However, your credit risk exposure is very high, and damages can be significant in the event of a default on a major contract. Additionally, hidden costs will be significant:
- You will need to manage your credit risk management, which may mean using third-party data providers that are not always reliable, especially in terms of credit risk management rating
- You will need to personally handle debt collection services, which require a lot of human and financial resources
- You will tie up cash flow on your balance sheet and will not be protected when a big customer faces insolvency
According to the Federation of Small Businesses the survival of over 400,000 small businesses in the UK is at risk due to late payments.
Taking the approach of a self-insurer will most importantly prevent you from adopting an ambitious commercial policy to grow your business – unless you are ready to accept the risk.
For more tips on cash flow management, read about the effects of trade credit on cash flow management and how to make a cash flow forecast.
Credit risk management: Letter of credit
A letter of credit is 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, etc).
The risk of non-payment being transferred to the bank offers security to both the buyer and seller. It allows you to trade with the certainty that you’ll be paid for the goods you export.
This system of credit risk management is widely used in international trade when it is difficult to assess the reliability of the client or the supplier.
However, it is expensive for the client and must be renewed for each transaction. It is also an administratively cumbersome solution, and the claim process can be laborious and easily derailed by minor discrepancies in paperwork.
Credit risk management: Factoring and invoice financing
Factoring means bringing in a third party known as 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 cash from a sale as quickly as possible, without mobilising any collateral. Your credit risk exposure is thereby minimised.
But these contracts are expensive in terms of fees (usually 1% to 4%) and only cover a portion of the debt. On top of this, the financial institutions that offer debt factoring often ask you to include all of your client accounts that are receivable. This means you will effectively lose control of your client relationship, as the factor will collect the money from the receivable itself.
Invoice financing is similar 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 together total up to 30% in annual interest.
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.
Credit risk management: Trade credit insurance or accounts receivable insurance
Trade credit insurance is insurance against bad debt. If your customer fails to pay you, your insurer indemnifies you for the insured amount.
This is the most complete credit risk management solution, integrating a financial information service on your customers and prospects, a debt collection service, and compensation in the event of non-payment. You will therefore make big savings on structural costs.
Your credit risk management insurer will advise and accompany you throughout your commercial development. 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. Once this premium has been paid, your cash flow is fully secured.
This credit risk management solution will give you the confidence to enter new markets and make competitive offers to your prospects, while protecting your cash flow.
When it comes to credit risk management, finding the best solution depends on your needs and circumstances. However, trade credit insurance remains the most complete and reassuring solution to support your credit risk management and commercial development.
If you are interested to know more or want to get a quote, get in touch.