Comparing Credit Management Strategy Options: Which is Best for your Business?

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

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

If your customers are unable to pay, your company is at risk of having its cash flow disrupted, affecting your ability to do business. There are solutions available to help mitigate this risk, including self-insurance, letters of credit, debt factoring and credit insurance.

Each solution has its pros and cons and not every solution fits every customer or situation. Here’s what you need to know about different credit management options:

Self-Insurance (Bad Debt Reserve) Pros & Cons

Self-Insurance, or a bad debt reserve , is an amount of money a company sets aside to offset losses should any customers become unable to pay.

If a customer fails to pay, you can draw money from the reserve account to cover the loss. This allows you to avoid service interruptions of disruption of your company’s cash flow. Meanwhile, on your balance sheet, the amount you pay yourself to cover the bad debt is subtracted from your assets and equity and counts as a loss on your business statement.

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

Debt Factoring Pros & Cons

Debt factoring is 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 ccash
  • 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

Letter of Credit Pros and Cons

A letter of credit is a bank guarantee that the payment of a buyer's obligation will be received on time and in the correct amount.

It’s important to differentiate between a line of credit and a letter of credit, because while a bank or other lender provides both, they work differently. A line of credit works like a credit card for a business, providing them with the ability to draw funds up to a pre-set limit. If your customer has a line of credit, they can draw funds from that to pay you. If you have a line of credit, you can draw funds to cover your expenses.

A letter of credit is akin to having the lender co-sign or guarantee a loan. A letter of credit provides a financial backstop for both your business and the customer, but it doesn’t guarantee upfront payment. If you require your customer to apply for a letter of credit as part of the transaction, you provide proof to the lender that the goods or services were received in order to receive payment.

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

Credit Insurance Pros & Cons

Credit insurance is a business insurance product that protects a seller against losses from nonpayment of a commercial trade debt.

Credit insurance is designed to cover your business-to-business accounts receivable. Your credit insurance will pay out a percentage of the outstanding debt if you do not receive what you are owed due to a buyer’s bankruptcy, insolvency or other issues, or if payment is very late. This helps protect your capital, maintain your cash flow and secure your earnings so you can extend competitive credit terms and access more attractive financing.

Pros of Credit Insurance:

  • Empowers companies to confidently gorw sales without credit concerns
  • Guaranteed protection against non-payment or slow payment
  • Enhances efficiency of a company's internal credit department with fast credit limit requests and ongoing buyer monitoring
  • Allows exporterrs to offer safe, open 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 $3M in B2B sales
  • Not suite for companies with only government or B2C sales
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