Bad debts can occur despite a company’s attempt at avoiding them – trade credit insurance can manage the credit risk of bad debt.
Second in a five-part series. Click here to read part one.
As we discussed in my previous post, bad debts could occur despite a company’s attempt at avoiding them. However, there are ways to manage the credit risk of bad debt – one way being trade credit insurance.
Thousands of small and mid-size companies purchase trade credit insurance. And, many larger companies (more and more multi-billion dollar revenue firms) purchase it as well.
There are many tactical and strategic reasons why these companies acquire trade credit insurance. And once they buy it, they keep it.
According to Euler Hermes, generally, companies renew their policies 90 percent of the time.
Here are some tactical reasons to purchase trade credit insurance:
Bankruptcy of a customer: As noted above, bankruptcies occur more often than many people realize, making full-collection on an invoice virtually impossible. Banks know this, and often they urge their clients to purchase trade credit insurance. This helps them feel more comfortable lending with accounts receivables used as collateral.
Foreign trade issues: There are many issues that can arise in international trade that can prevent or seriously delay payment, such as communication and culture issues and unforeseen cancellation of permits.
Other disruptive global trade events take the form of serious global political events, government interventions, currency inconvertibility, or even “expropriation” – the act of taking privately owned property by the government for public benefit.
“Thousands of small and mid-size companies purchase trade credit insurance.”
A trade credit partner can provide that service by accessing extensive information databases for a quick assessment of a customer’s viability, including solvency, risk, payment profile and trading history, as well as perhaps some intangibles. On an on-going basis, the trade credit insurance provider can monitor critical accounts, which incidentally avoids the cost of attempting to do that in-house.
Competitive advantage: Trade credit insurance gives a firm the ability to quickly match its competitor’s credit limit and pay terms. If a competitor offers a $250,000 line of credit with 90-day terms, and your company can only offer $100,000 with 15-day terms, who gets the business?
Qualitative: As one business owner said, “Having trade credit insurance allows me to sleep better at night, and that’s worth a lot.”
In addition to these tactical reasons for purchasing trade credit insurance that arise day-in and day-out, there is a wide range of strategic reasons influencing why companies should buy trade credit insurance.
In fact, if employed correctly, trade credit insurance can be a significant strategic advantage.
Here are some strategic reasons to purchase trade credit insurance:
Business growth with confidence: All businesses need to be able to grow and grow confidently. In fact, the typical company that buys trade credit insurance is one that wants to build and grow its business.
Some examples help illustrate this point. In one case, a $30-million company sold goods to its European customers through distributors, representing 48 percent of its total sales. Those distributors were initially aggressive and brought many opportunities for expansion. But, the company was not willing to extend credit and payment terms, and eventually the distributors began focusing where there were fewer roadblocks.
In another example, a firm wanted to sell $4 million in product to a Russian company that would not share all of its financials. By working with a trade credit insurer, it was able to offer $1 million initially, save the account and then expand later.
“When there’s a business opportunity for increased sales, it’s important to respond quickly.”
In a final example, a firm selling globally said that trade credit insurance allowed them to avoid restrictive letters of credit or up-front cash payment requirements. It allowed them to offer competitive, open credit terms in the global market.
According to Euler Hermes, companies that export grew 37 percent, and those that did not decreased by 7 percent. Many, if not most, companies must look globally if they are going to expand. But global trade carries an exponentially larger risk of bad debt.
Therefore, many companies require a wire transfer up front or a letter of credit. Their potential customers will resist paying in advance, especially if they can buy from another company without these restrictions.
Organizational alignment: Companies need to be organizationally aligned and focused on growing the business. Trade credit insurance can bridge the traditional gap between the sales department and the credit department, two areas often at odds.
In addition, with trade credit insurance, a firm can streamline the accounts receivables and collections department. That department can focus on day-to-day issues and leave most of the credit monitoring and credit evaluation to their insurance partner.
Trade credit insurance also provides a more stable and confident environment for sales and marketing to penetrate global markets.
Financial stability: Receivables in the average company represent up to 40 percent or more of its balance sheet assets, and therefore, have a major impact on cash flow and how investors and banks view the company’s financial viability.
Banks loan 80 percent more on insured receivables and can lend an advance against the receivables, according to Euler Hermes, which is especially important for international trade.
A company can potentially get better financing terms and a lower interest rate if its receivables are insured. It also can avoid catastrophic bad debt losses and reduce or eliminate the bad debt reserve. And, it is interesting to note that receivables are usually the largest item on a balance sheet by far.
Most of a firm’s assets on a balance sheet, including facilities, equipment and even inventory are insured, but oddly its largest balance sheet asset, receivables, are not often insured.
Apart from the balance sheet, the loss on a profit and loss statement (P&L) due to a bad debt can be severe. If a business operates on a low margin (say 5 percent), and is unable to collect a $100,000 debt, it has to generate $2,000,000 more in top-line sales just to break even.
Although there are tactical and strategic reasons for purchasing trade credit insurance, some companies resist buying trade credit insurance. In my next post, I’ll explain the three reasons why.
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