Peace of mind that is practically free.
There are a number of tactical and strategic advantages of purchasing trade credit insurance, as discussed in my last post. However, not every company purchases it. Here are the three primary reasons:
Lack of knowledge
Perhaps the biggest reason is simply lack of knowledge of the product.
It has always been more popular in Western Europe, but it has struggled to gain as much traction in the United States, despite being available in the country for more than a century. Perhaps Europeans are more conservative than Americans.
In any event, they buy trade credit insurance at a rate of five times that of U.S. companies.
However, the 2008 to 2010 Great Recession made the need for trade credit insurance painfully apparent and caused many companies to look for ways to better protect themselves in the future.
Without sufficient knowledge of the product, some firms mistakenly worry that trade credit insurance is too expensive, and they will have a difficult time actually processing claims and collecting. Or, they hear that customer disputes regarding the wrong product or bad quality can interfere with coverage, which is not true with a clearly written policy.
Some companies don’t know the true risk they face. Ignorance is bliss until the wheels come off.
And finally, some feel that the economy is now in good shape and bad debt is at a minimum. Of course, no one can predict when the next recession will hit, and it could be too late to put the right protection in place.
Some companies assume that they are large enough to self-protect against bad debt. But these firms have to carry and finance a substantial bad debt reserve.
In addition, some losses may be totally unexpected and not anticipated in setting up the bad debt reserve.
“ Ignorance is bliss until the wheels come off.”
The chief executive officer may question why trade credit insurance is needed if the credit department is doing its job.
Unfortunately, almost no company has the resources to continuously monitor the credit situation of all of their customers, nor do they have the resources to try and collect, especially in the global arena.
Moreover, trade credit insurance provides protection against the unforeseen losses that even the best credit departments cannot see coming.
Many times, these companies do not realize that trade credit insurance can pay for itself.
It may sound too good to be true, but trade credit insurance can provide substantial benefits and not cost the company a dime — essentially paying for itself.
Trade credit insurance can help in the following ways:
Lower interest rates from banks
Companies that insure their receivables often receive lower interest rates from their bank, and therefore, lower interest costs.
Some companies have 15-day terms with their suppliers, and 60-to-90 days with their customers.
Clearly, they need an on-going credit line with the bank, and they must carry a substantial loan balance. Interest costs are a significant expense for many firms.
Credit and collections cost
With trade credit insurance and the credit monitoring services that come with it, companies can save on credit and collections cost. See the example below.
Margin on increased business and more aggressive goals for growth
Credit insurance allows for confident expansion of the business; and therefore, the chief executive officer can set more aggressive internal goals for growth.
In one company, the chief executive officer heard from his sales department that the credit department was constraining growth by being too conservative.
He agreed to ease credit terms as long as sales agreed to set a goal to grow the business 15 percent. He then used trade credit insurance to protect his firm.
To illustrate this idea, here is a scenario where a small company purchases trade credit insurance:
A small company has $10 million in annual sales and receivables of $1,000,000. It decides to purchase trade credit insurance, which for illustrative purposes, costs 0.15 percent of sales, or $15,000.
“ Trade credit insurance can help companies while essentially being “free.””
The firm no longer has to carry a bad debt reserve of 1 percent of sales or $100,000, and therefore, it doesn’t have to tie up money at a cost equal to its cost of capital of 3 percent, or $3,000.
The company uses on average a credit line of $2 million. The bank gives a lower borrowing percentage of two-tenths of 1 percent, or a savings of $4,000 per year in borrowing cost.
The firm then has the confidence to expand the business by 10 percent, or $1,000,000, at a 10 percent margin, generating $100,000 in additional profit.
In this example, trade credit insurance more than pays for itself, even without a bad debt loss.
Now you know why some companies don’t purchase trade credit insurance, as well as how it can help companies while essentially being “free.”
In my next post, I will talk about the companies that offer trade credit insurance and the principles to consider when purchasing it.
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