In 2022, UK SMEs were owed on average an estimated £22,000 in late payments. It’s therefore vital to ensure you have a suitable solution to protect your business against the risk of bad debt and support your credit risk management, but it’s easy to get lost among all available options. What is a letter of credit? What does invoice finance or factoring exactly cover? What are the advantages and disadvantages of trade credit insurance? To find your way through the jungle of trade credit risk management, it’s better to have a guide to follow!
Credit risk management: can you take on the risk?
When offering trade credit, it’s necessary to set up an effective credit risk policy to protect your business against the risk of non-payment.
The first question to ask yourself is about your own resources, both human and financial: do you have the necessary expertise and time to manage your receivables throughout the credit risk lifecycle?
For many companies, calling on a specialised credit risk management company is the most protective and least expensive option.
Self-insurance and bad debt reserve management
Self-insurance consists of building up your own financial reserves – also known as a “bad debt reserve” – to cover your losses in the event of a customer not paying. It’s the simplest credit risk management solution administratively speaking, and the least expensive... to all appearances.
However, your credit risk exposure could not be greater. In the event of default on a major contract, your reserve could take a huge blow and leave you exposed to any further defaults. Moreover, the hidden costs are significant:
- You have to manage the admin side of credit risk management yourself, often forcing you to go through third party data providers that aren’t always reliable, especially in terms of credit risk rating.
- You have to handle the debt collection services, which require a lot of human and financial resources.
- You tie up cash flow on your balance sheet and are not protected in case of a big customer going insolvent.
Above all, such an approach will prevent you from adopting an ambitious strategy to grow your business – unless you’re ready to accept the risk.
For tips on cash flow management, have a look at our article on How to prevent cash flow problems.
Letter of credit
A letter of credit is defined as a promise from your client's bank to pay you when you have certified the proper execution of your obligations (delivery, nature and quality of the delivered goods or services, paperwork...).
It’s a security for both you (the seller) and your customer (the buyer), where the risk of non-payment is transferred to the bank. It allows you to trade with the certainty that you’ll be paid for the goods you export.
This kind of credit risk management system is widely used in international trade (and has been since the Middle Ages!) when it’s difficult to assess the reliability of the client or the supplier.
Nevertheless, such a system is expensive for the client, and must be renewed for each transaction. Above all, it’s an administratively cumbersome solution, where minor discrepancies in paperwork can derail the claim process.
Factoring and invoice financing
Factoring is bringing in a third party, called the “factor”, who purchase the debt at a discount (typically 70% to 85% of the total invoice). These contracts often offer to outsource invoicing and debt collection services.
This is the best credit risk management solution for recovering the cash from a sale as quickly as possible, without mobilising any collateral. Your credit risk exposure is thereby minimised.
Nevertheless, these contracts are expensive in terms of fees (1 to 4%) and only cover a portion of the debt. Moreover, the financial institutions who offer debt factoring often ask you to include all of your client accounts receivable.
It means you effectively lose control of your client relationship: it’s the factor that will collect the money from the receivable itself.
Invoice financing is an alternative credit risk management solution that is close to factoring: it allows you to borrow the amount of the invoice using your trade receivables as collateral. Interest is due in addition to the fees, which can altogether represent a total of up to 30% in annual interest.
Here, you remain responsible for collecting the debt, and must ultimately reimburse the amount advanced. Unlike factoring, your customer is not aware that the invoices have been discounted.
Trade credit risk insurance or accounts receivable insurance
What is trade credit insurance? Simply put, it’s an insurance against bad debt: if your customer fails to pay you, your insurer indemnifies you for the insured amount.
It's the most complete credit risk management solution: it integrates a financial information service on your customers and prospects, a debt collection service and compensation in case of non-payment. You therefore make big savings on structural costs.
Your credit risk insurer is a partner who advises you and accompanies you throughout your commercial development. Check out our article on how to find the right trade credit insurance provider.
The insurance premium is calculated based on your company turnover and its sector of activity, as well as the level of coverage you want for each customer. Once this premium has been paid, your cash flow is totally secured.
This particular solution gives you the confidence to enter new markets and make competitive offers to your prospects while protecting your cash flow.
When it comes to trade credit management, finding the best solution depends on your needs and on the circumstances. However, trade credit insurance remains the most complete and reassuring solution to support your credit risk management and commercial development. If you’re interested to know more or want to get a quote, call our UK team on 0800 056 5452.
