Even “good as gold” customers can default on their payments. There are four major options to manage the credit risk of bad debt.
First in a five-part series.
Any sale carries risk, because with every sale, there’s the chance the buyer won’t pay.
Non-payment can be damaging or even catastrophic to a seller.
Depending on the size of the company and its operating margin, one or two bad debts can wipe out profits for the year and close its doors.
“There’s the chance the buyer won’t pay.”
The hundreds of billions of dollars in bad debt that were written off during the recent Great Recession brought new attention to managing the risk of receivables.
Today, post-recession industry data show that one in 10 invoices becomes delinquent.
Nearly 30,000 businesses failed in North America in 2014, according to Euler Hermes.
Even “good as gold” customers can default.
Many companies are current on their bills with most suppliers when they file for bankruptcy.
The company can do everything right: It can ship a high-quality product on time, damage free and provide an accurate invoice — and then still not get paid.
Companies are probably not as safe as they think.
Because companies have been burned before with bad debt, they become conservative and limit their growth severely, especially internationally.
Conservatism may be fine until a competitor expands, gains scale, lowers its cost structure and begins to overtake the business.
Companies today use trade credit insurance as a means to safely and more confidently expand into new markets, offering their customers more flexible credit terms.
These companies are viewed as the gold standard for customer satisfaction.
We published Protect Against Bad Debt Risk, a white paper sponsored by UPS Capital that details how trade credit insurance can protect domestic and international accounts receivables against unexpected bad debt loss, as well as provide a foundation for growth.
How do companies manage bad debt risk?
With or without trade credit insurance, it’s a good practice to avoid bad debt situations and still find a way to grow.
But as much as a company tries to avoid them, bad debts will occur.
There are four major options to manage the credit risk of bad debt:
This takes the form of bad debt reserves.
Self-insurance fails to protect against very large, unexpected losses and negatively impacts cash flow and the balance sheet.
Companies that tie up capital with self-insurance hamper their ability to invest in growth opportunities and often become very conservative, limiting their growth, especially in all-important international markets.
These companies have to take on the total responsibility of evaluating the credit worthiness of their customers or potential customers.
They often use tools like Dun and Bradstreet, but even data from highly reputable sources can be outdated, as people found during the Great Recession.
Factoring, or selling receivables to a third party, is another option to manage bad debt.
Factoring has two major drawbacks: 1) cost and 2) the risk of alienating customers when companies turn over debt collection to an aggressive third party.
These tools apply normally to international sales.
Unfortunately, they limit the amount buyers can or will buy; they are expensive (often 3 percent per transaction) and they generally must be set up on a transaction-by-transaction basis.
There is a modest cost, but it comes with many advantages, as described in this white paper.
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Reprinted with permission of Longitudes, the UPS blog devoted to the trends shaping the global economy.