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Bad Debt Reserves vs. Factoring vs. Letter of Credit vs. Credit Insurance

Option 1: self-insurance (bad debt reserve)

Definition: Use of a bad debt reserve to offset losses should any customers become unable to pay


Pros of Bad Debt Reserves: 

  • Minimal cost to the company in years with no losses
  • Simple to administer

Cons of Bad Debt Reserves:

  • Company bears burden and cost for internal credit management resources needed to mitigate risk
  • Depending on risk tolerance, may result in overly conservative limits that reduce potential revenue
  • Ties up working capital that impacts capital allocation of the balance sheet
  • Typically does not protect from large and unexpected catastrophic loss
  • Utilize unreliable third party data services

Option 2: factoring

Definition: An agreement with a third party company to purchase accounts receivable at a reduced amount of the face value of the invoices


Pros of Factoring: 

  • Immediate access to cash
  • Option to outsource invoicing, collections, and other bookkeeping activities
  • No long-term contracts
  • Doesn't require collateral

Cons of Factoring:

  • Depending on contract structure, may not protect against non-payment events
  • Loss of control of customer relationships
  • Capacity constraints associated with line availability
  • Cost range between 1% and 4% of a receivable plus interest on the cash advance that can equal up to 30% in annual interest
  • Does not indemnify full invoice

Option 3: letter of credit

Definition: A bank guarantee that the payment of a buyer's obligation will be received on time and in the correct amount

 

Pros of Letter of Credit: 

  • Security for both seller and buyer
  • Financial standing of the buyer is replaced by the issuing bank
  • Because of the guarantee, seller can borrow against the full receivable value from its lender

 

Cons of Letter of Credit: 

  • May only cover a single transaction for a single buyer and can be tedious and time consuming
  • Expensive, both in terms of absolute cost and credit line usage with the additional need for security
  • Ties up working capital for the buyer
  • Competitive disadvantage when competitors are offering open terms
  • Lengthy and laborious claims process

Option 4: credit insurance

Definition: A business insurance product that protects a seller aginst losses from nonpayment of a commercial trade debt

 

Pros of Credit Insurance:

  • Empowers companies to confidently gorw sales without credit concerns
  • Guaranteed protection against non-payment, late payment or unpaid invoices.
  • Enhances efficiency of a company's internal credit department with fast credit limit requests and ongoing buyer monitoring
  • Allows exporters to offer safe, open payment terms overseas
  • Expands a company's financing options by increasing its borrowing base with secure receivables

 

Cons of Credit Insurance: 

  • Most cost-effective for businesses with USD $2M+
  • Not suite for companies with only government or B2C sales

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Credit management is defined as your company’s action plan to guard against late payments or unpaid invoices by your customers. An effective credit management plan uses a continuous, proactive process of identifying account receivable risks, evaluating their potential for loss and strategically guarding against the inherent risks of extending credit. Having a credit management plan helps cash flow forecast, optimizes performance and reduces the possibility that a default will adversely impact your business. Late payment and payment default situations happen with alarming frequency – it’s critical to the financial health of your company to minimize them. Many businesses find it challenging to properly evaluate and track the creditworthiness of new customers. And when conducting business with foreign customers, customer's credit risk management becomes even more complex because it can be difficult to interpret and rely on information used by foreign countries to measure creditworthiness.