Bad Debt Reserve vs. Factoring vs. Letter of Credit vs. Credit Insurance

Recap: Bad Debt Reserves vs. Factoring vs. Letter of Credit vs. Credit Insurance

Option 1: Self-Insurance (Bad Debt Reserve)

Definition: Use of a bad debt reserve to offset losses should any customers become unable to pay

Pros of Bad Debt Reserves: 

  • Minimal cost to the company in years with no losses
  • Simple to administer

Cons of Bad Debt Reserves:

  • Company bears burden and cost for internal credit management resources needed to mitigate risk
  • Depending on risk tolerance, may result in overly conservative limits that reduce potential revenue
  • Ties up working capital that impacts capital allocation of the balance sheet
  • Typically does not protect from large and unexpected catastrophic loss
  • Utilize unreliable third party data services

Option 2: Factoring

Definition: An agreement with a third party company to purchase accounts receivable at a reduced amount of the face value of the invoices

Pros of Factoring: 

  • Immediate access to ccash
  • Option to outsource invoicing, collections, and other bookkeeping activities
  • No long-term contracts
  • Doesn't require collateral

Cons of Factoring:

  • Depending on contract structure, may not protect against non-payment events
  • Loss of control of customer relationships
  • Capacity constraints associated with line availability
  • Cost range between 1% and 4% of a receivable plus interest on the cash advance that can equal up to 30% in annual interest
  • Does not indemnify full invoice

Option 3: Letter of Credit

Definition: A bank guarantee that the payment of a buyer's obligation will be received on time and in the correct amount


Pros of Letter of Credit: 

  • Security for both seller and buyer
  • Financial standing of the buyer is replaced by the issuing bank
  • Because of the guarantee, seller can borrow against the full receivable value from its lender


Cons of Letter of Credit: 

  • May only cover a single transaction for a single buyer and can be tedious and time consuming
  • Expensive, both in terms of absolute cost and credit line usage with the additional need for security
  • Ties up working capital for the buyer
  • Competitive disadvantage when competitors are offering open terms
  • Lengthy and laborious claims process

Option 4: Credit Insurance

Definition: A business insurance product that protects a seller aginst losses from nonpayment of a commercial trade debt


Pros of Credit Insurance:

  • Empowers companies to confidently grow sales without credit concerns
  • Guaranteed protection against non-payment or slow payment
  • Enhances efficiency of a company's internal credit department with fast credit limit requests and ongoing buyer monitoring
  • Allows exporters to offer safe, open terms overseas
  • Expands a company's financing options by increasing its borrowing base with secure receivables


Cons of Credit Insurance: 

  • Most cost-effective for businesses with $3M in B2B sales
  • Not suit for companies with only government or B2C sales
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