Accounts receivable (A/R) can represent up to 40% of a company’s assets, and in today’s challenging environment, non-payment of any portion of this can become a serious financial and operational threat to an enterprise. For example, if a customer defaults on a $100,000 invoice from a company with a 5% profit margin, that company will have to generate $2 million in additional revenues to make up that loss.
The underlying reasons for a default could range from the rapid rate of technological change and its effect on international consumer demand, to political upheaval in key markets, to regional economic trends and government economic policy changes—all of which can quickly change a customer’s risk profile and ability to pay invoices, and leave suppliers holding the bag.
Today’s competitive business landscape can squeeze company margins to the point where it does not take many bad debt write-offs to push the company to the breaking point. Effective management of accounts receivable are, therefore, a vital component of a healthy business.
A/R can, however, be surprisingly volatile. What seemed like a stable business environment one day can become disarray the next. Fortunately there’s a proven solution to protect a business from potential A/R losses and even help expand sales: trade credit insurance. Whether trading with established customers or seeking new markets, a company can use trade credit insurance to protect its cash flow and balance sheet against the unexpected shock of non-payment.
What is Trade Credit Insurance?
Trade credit insurance is a tool used to reduce or eliminate the risk of non-payment of commercial debt. If a policyholder’s client fails to pay, the insurance company makes good on the obligation. This allows a company to reduce the risk it might incur when taking on new—particularly unknown—clients, or when unforeseen economic, business, or other factors affect its clients’ abilities to pay their bills. It enables a company to cultivate clients in sectors or geographies that are outside its normal client base or geographic market, do more business with existing clients, and extend more credit to its customers, all without increasing the risk of non-payment.
Trade credit insurance accomplishes this by giving the company access to the insurance company’s credit risk analysis and management expertise, and ability to monitor domestic and global developments that could affect a customer’s ability to pay its bills. Few companies on their own can rival the expertise or database of a major global trade credit insurance provider, but nearly everyone can access that expertise by purchasing insurance.
Key Benefits of Trade Credit Insurance
Many companies initially purchase trade credit insurance to protect capital, cash flow and earnings. They also find that the product allows them to safely and strategically expand their businesses, thereby increasing sales and profits.
Take, as an example, a wholesale company whose credit department had restricted a customer’s credit line to $100,000. The company then purchases a trade credit insurance policy and, after an analysis of the customer’s credit and financial performance data, the insurer approves a limit of $150,000 on that same customer. With margins of 15% and an average days sales outstanding (DSO) of 45 days, the wholesaler is able to increase its sales to realize an incremental annual gross profit of $60,000 on just that one customer account.
Trade credit insurance can also improve a company’s relationship with its lender. In some cases banks actually require trade credit insurance to approve a loan. For example, a $25 million scrap metal dealer might have extreme concentration in its accounts receivable because it only has eight active customer accounts. The smallest of these customers has receivables balances in the low six-figure range, and the largest is into the low seven-figure range. The company’s bank becomes concerned about this concentration and requires trade credit insurance to fully leverage the accounts receivable as collateral. The scrap metal dealer purchases a trade credit insurance policy that specifically names all of its buyers, providing the bank the comfort level it needs to increase the eligible receivables.
Alternatives to Trade Credit Insurance
There are other ways to hedge receivables, including letters of credits, which can be quite expensive. Self-insurance is another option, but it involves setting aside reserves to cover any losses from customers’ failure to pay. However, reserves eat into margins and do not protect against catastrophic, unexpected losses. Self-insurance also requires an investment in systems, credit risk monitoring and analysis expertise, the quality and scope of which often cannot compare to that offered by a trade credit insurance provider.
Another alternative, factoring, involves selling receivables to a factoring firm, which often requires accepting a discount to face value of between 1 and 10 percent. In addition, factoring firms may not agree to take all the credit risk in the event of non-payment. In an environment of narrow business margins and high levels of competition, the factoring discount can be a significant burden. Also, the company loses the client relationship benefit that owning the receivables helps to sustain.
There are many business benefits to trade credit insurance, both in growth and uncertain market environments. It mitigates risk very cost-effectively, while giving companies the confidence to expand their sales to new customers and markets. A firm may also be able to sell more on open account terms. In addition, trade credit insurance can help free up capital for other programs and projects. While serving as a tactical risk-mitigation tool, trade credit insurance can offer companies a strategic and competitive advantage.
Jochen Duemler is CEO and head of Euler Hermes Americas Region.