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
