When you’re a company that extends credit to other businesses for sales opportunities, you can run into some risky situations. You can end up providing the product or services and the customer turns around and never makes payment. This puts your company in a delicate situation. You’re left trying to find a way to make up for the unexpected cash flow issues by either making more sales or refusing credit to other customers, who need the payment terms in order to purchase your products.
Either way, it’s not a great way to have to run your business. As a result, it’s important to come up with a way reduce these risks of non-payment. There are 4 main ways of mitigating credit risk that businesses commonly choose. We’ve outlined these four strategies below.
When companies choose self-insurance as a method to mitigate credit risks, they are basically creating a “rainy day” fund. Companies will create a bad-debt reserve that they tap into if a customer is unable to make payment. Although this sounds like a good idea, there are also some downsides, as well. First of all, your company needs to have the ability to create a bad-debt reserve in the first place, which might not be possible for a small company starting out. Additionally, there needs to be enough money in the bad debt reserve for large losses. If your company has a large deal with a company that ends up not paying, for say $1 million, your bad debt reserve needs to have that much or more to cover the cost.
Some companies choose to work with a factoring company when they come across customers unwilling to pay on their debt. A factoring company purchases the invoices that you are unable to collect on and then takes a percent of your margin after they have collected on the invoice and collect a fee from you. This option can be tempting for people who are strapped for cash now, since the company will buy your invoices from you, however, the downside is that you will never be collecting on the full amount you are owed since the factoring company charges a fee and takes a percentage. Additionally, depending on the factoring company you choose, if their methods of collection are unaligned to how you normally treat your customers could erode your customer relationships.
LETTERS OF CREDIT
At face value, this option seems like the best method of credit risk mitigation. Requiring letters of credit means the customer will approach their bank and ask for an agreement which guarantees the creditor (your company) will receive payment in full by the due date. This seems like a dream for most accounts receivable departments, however it can greatly hinder your sales process. Customers are forced to go through and extra set of hoops in order to apply for and obtain and letter of credit from their bank. This will also count against their credit limit with the bank, so it could tie up the total amount they are able to spend. Overall, using this in every single opportunity that comes across your sales reps desks could hinder your total sales.
TRADE CREDIT INSURANCE
Trade credit insurance works similarly to any other type of insurance. If a customer will not pay, the policyholder can submit a claim and be reimbursed by the trade credit insurer. It’s pretty simply and ensures that you can recoup a majority of the unpaid accounts that the accounts receivable department encounters. However, the downside to this is – again – it works like traditional insurance. Disputed accounts typically aren’t covered, so you would need to ensure that your company has processes in place to reduce invoice disputes greatly. When taking out a trade credit insurance policy, it’s also important to look over the terms and conditions to ensure that the situations you most often see for unpaid accounts are covered.