Posted July 11, 2017

 

In previous blogs, I have explored the risk and volatility that exists in the current market environment. The retail sector is fraught with numerous major defaults, bankruptcies and closings. These already tenuous market conditions are further complicated by the risk, volatility and uncertainty associated with expanding sales in foreign markets, or by parent companies not financially guaranteeing the payables obligations of their subsidiaries, as in the case of Target Canada.

 

In such conditions, driving business growth through the extension of credit is a veritable financial minefield. Yet, increasing profitability by growing sales remains a key strategy for many firms.

 

So how does credit management figure into this equation? The goal of effective credit management is to manage, not prevent risk. If you truly want to prevent risk, sell on cash and do not extend credit terms to your customers. Simple – no credit, no default risk. Requiring pre-payment for goods or services sold is a commonly used technique for preventing credit-related risk.

 

Imagine the following all-too-common scenario: Your sales department has just submitted a credit application for a potential new customer in Mexico they’ve been working to land for the past several months. This potential customer is requesting net 60-day terms and to carry an on-going credit balance of $300K.

 

Now imagine the response you can expect from your credit department: “No way! We have no idea how to recover our money from Mexico, given the economic uncertainty in Mexico and the associated weakness of the peso. Tell the customer they need to wire in advance.”

 

Now imagine this opportunity vaporizing and the frustration of your sales person. Sales on a cash basis, including prepayment, do not actually prevent risk. It merely transfers the risk from payment default to loss of sales.

 

Effective credit management encourages sales growth and seeks creative solutions to extend increased credit in support of sales growth. One such solution is credit insurance. Credit insurance? Really? Yes, credit insurance and here are some reasons why.

 

1. Protecting against catastrophic loss: Credit insurance protects one of the largest company assets – Accounts Receivable – in the event of a protracted default (non-payment) or insolvency filing by a customer. In the event of a covered loss, credit insurance provides the insured the ability to file a claim and receive payment for the loss up to the credit limit minus any co-insurance and or deductible. Typically, payment is issued within 60 to 90 days of filing a claim. Unfortunately, many companies feel comfortable because their customers “have always paid on time” or “my customers are big companies” or the greatest fallacy of them all, “we have never had a significant loss.”
    

2. Growing sales: Credit insurance is an effective means for managing payment risk and can expedite the onboarding of new customers. The reluctance to extend credit is primarily based upon a lack of knowledge regarding a new or existing customer and the economic environment in which they operate. Credit insurers are experts in collecting and maintaining the information required to assess and manage payment risk. Let’s re-imagine our previous scenario involving that potential new customer in Mexico. This potential customer is requesting net 60-day terms and to carry an on-going credit balance of $300K which could be covered by credit insurance. What response would you expect from your credit department in this situation? “Great! We can manage our risk through credit insurance. Additionally, after an appropriate period of time, we may be able to increase the credit limit either with or without credit insurance. Tell the customer they are approved.” Credit insurance provides a tool to transform a credit manager into a partner for growing company sales while concurrently managing payment risk.
    

3. Enhancing borrowing power: Credit insurance may also increase a company’s borrowing ability. In the case of asset based lending, current accounts receivables are often a significant component of a company’s borrowing base. However, lenders often exclude or reduce the availability of receivables. Foreign receivables often fall into this category. By covering such receivables with credit insurance, you can increase its collateral value while reducing the collection risk, which can also result in an increased borrowing base. Additionally, credit insurance can also allow a company to reduce reserves for bad debt.
    

4. Increasing credit functional productivity: The three largest credit insurers – Euler Hermes, Atradius and Coface – represent roughly 80 percent of the global credit insurance market. Their underwriters have access to some of the best credit information and sources available to justify credit insurance coverage. To manage their risk, these credit insurers maintain robust credit management platforms that enable them to continually monitor companies and accounts they name for coverage. This allows them to provide clients with notifications of derogatory information as it becomes available.  Unlike traditional credit reporting agencies, these credit insurers often provide Non-Disclosure Agreements to obtain financial statements for granting credit, which precludes them from publishing their information. Additionally, these credit insurers often have some form of past due reporting requirements and strict deadlines for filing claims allowing for early notification of slow payment or collections issues. As a result, the credit insurers provide their clients with credit monitoring services that can reduce the demands placed on the company’s internal credit function. This can provide the company with reduced collection costs and improved DSO performance.
    

Looking at the record, there is a greater risk of loss resulting from payment default than of loss resulting from property damage from fire yet insuring property is commonplace while insuring receivables isn’t.  Credit insurance covers losses, allows a company to onboard new customers quickly, constantly monitors named accounts for coverage, notifies you of derogatory information and frees up reserves which can greatly improve your lending situation. It is fascinating that insuring a $600 cell phone is essentially a no brainer while insuring a $600K receivable is a significant decision.

 

For more answers to this and any other questions you may have, please contact Larz Soper, Expert Credit Advisor at ToYourCredit@sopermail.com.