Options for mitigating credit risk

There are several options and tools to mitigate credit risks. You should weigh the costs and benefits of these options and investigate carefully to determine the best fit for your company.

Some of the most common tools are:

SELF-INSURANCE

Many companies choose to self-insure in the form of bad debt reserves.
This fund, set aside, is available to offset the deficit should any of your customers become unable to pay. The cost considerations are as follows:

  • You will need to invest in credit management resources, systems and data to consistently analyse and monitor your credit risks;
  • It may impact your sales, depending on your given risk tolerance: you will not want one customer to eat up all of your reserves should they go insolvent;
  • It will impact your working capital;
  • You may struggle to build reserves fit for large and unexpected catastrophic losses.

Invoice finance gives you access to money from your outstanding invoices before your customers pay you. An invoice finance company will purchase your invoices at a reduced amount of their face value plus a fee. You may choose to get funding against a single/ handful of debtors or all of your outstanding invoices.
Factoring companies will also control the sales ledger and collect the debts.

It is important to take into account that not all invoice finance companies will assume the risk of non-payment of the invoices they purchase (this is known as non-recourse finance). If they don’t, you will need to reimburse the funding if your customer does not pay.

Other impacts include:

  • It will affect your margin;
  • You may lose control of customer relationships;
  • Factors will have a maximum amount they are prepared to purchase.
Letters of credit (sometimes knows as documentary credits) allow you to trade by providing certainty that you’ll be paid for the goods you export. A letter of credit is a promise by a bank that the payment will be made as long as the right goods are shipped at the right time with the right paperwork. It protects both you and your customer by mitigating potential risks. For you, the risk of non-payment is transferred to the bank who issued the letter of credit.
 
In developing markets, it may need to be cash secured by the buyer.

Impacts include:

  • Only covers a single transaction for a single customer – regularly relying on this form of protection can be tedious and time consuming for you;
  • It’s expensive for you and your customer, both in terms of absolute cost, time (administration) and in terms of credit line usage with the additional need for security;
  • The claims process can be lengthy and laborious and can be derailed by minor discrepancies in paperwork.

Credit insurance is a business insurance product that protects you against unpaid trade debts. Credit insurers provide a 3-tiered service: financial information on your customers (credit checks and monitoring), collection of unpaid debts and, if all else fails, you are protected by insurance.

The insurance premium cost is linked to the level of covered transactions, and additional service fees may be charged. The benefits are:

  • It secures trade with new and existing customers;
  • It helps you select the most stable prospects to go after;
  • It enables you to offer competitive credit terms;
  • You can save on credit information costs, third-party collection costs and protect your cash flow.

Click below to find out more:

Can credit insurance and invoice financing work together?

Yes, when you need funding but want non-payment security, you may work with your bank or factor and use credit insurance as well.
The bank or factor will provide the funding and the credit insurance policy will protect the invoices. In this case, when a funded invoice goes unpaid, the claim payment will go to the funder.

 

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Feature

Credit insurance

Letter of credit

Factoring

Self-insurance

Cover / protection against credit risk

Yes,

insolvency, protracted default and political risks

Yes,

buyer default

Yes,

Insolvency and protracted default if non-recourse finance

No

Additional services

Yes,

credit risk information, risk assessment, market intelligence, debt collection

No

Yes,

debt collection and credit information

No

Financing

No,

but can facilitate financing

No,

but can facilitate financing

Yes,

converts invoices into cash for a fee

No

Customer relationships

Your customer is unaware of credit insurance contract. Better terms of payment enhance relationship

Both are aware of the set up

Collection by factor of trade receivable may affect client relations

Maintains direct relationship with customer

Costs

+

+++

++

+

Cost of opportunity and bad debt reserve

Euler Hermes is the world leader in trade credit insurance. For more than 100 years, we’ve invested in people and technology as well as financial, operational and market data to feed powerful predictive analytics and business intelligence. Our unique knowledge of companies, industries and countries help you choose the right customers and the right markets to avoid bad debt in the first place. But, when the unexpected does arrive, you can be confident you’re protected.
We value responsiveness, precision, innovation and helpfulness and are committed to financial innovation and social responsibility.

Our passion is to give you the confidence to trade and get paid, so you can move your business forward, whatever your goal. Let’s take control of tomorrow, together.
55,000+
Clients worldwide
85 Million
Businesses monitored
AA Rating
by Standard & Poor's

 

 

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There are several options and tools to mitigate credit risks. You should weigh the
costs and benefits of these options and investigate carefully to determine the best fit
for your company. Download and feel free to share this guide.