What if it was possible to mitigate the risk of uncollectible customer receivables and improve cash flow? Moreover, what if this was possible regardless of whether the risks were due to concentration of credit with financially distressed customers, changing market conditions, or other unforeseen events?

Thankfully, there are several credit risk mitigation tools that can protect your receivables in the marketplace today.

What Are the Benefits?

During stable or growing economic times, there are fewer reasons to worry. Receivables are generally paid, and organizations are profitable. Unfortunately, there are significant economic challenges in the Midwest today, as reflected in the recent high-profile bankruptcies, including Delphi, Dana, Collins and Aikman, Meridian Automotive, Tower Automotive, and Northwest Airlines.

By protecting your receivables, you’re reducing the impact of bad debt that negatively affects profitability. Some credit products even allow you to improve cash flow necessary for growth. In addition, you’re likely to receive better terms from lenders and ease the administrative burden often associated with attempting to collect on bad debts.

What Programs Are Available?

There are several different ways that organizations can mitigate their credit risk; this article focuses on three: credit insurance, claims put option, and factoring. Each has its own advantages and disadvantages. The goal is to optimize your risk mitigation at the lowest possible cost within the framework of your specific needs. Pricing on programs depends on a variety of factors, such as the customer’s credit worthiness, product supply and demand, and the size and duration of the contract.

Credit Insurance

Also called “accounts receivable insurance,” credit insurance protects against your customers’ failures to pay their trade debts within a specified period. The failure to pay can arise because a customer has become insolvent or because they don’t have the cash available to meet all trade debts.

Credit insurance gives organizations the option to avoid catastrophic bad-debt losses, safely expand sales, secure better borrowing terms, and reduce bad-debt reserves. On the downside, the policy may contain clauses that allow the policy terms to be modified (with notice), the rates changed, or the policy cancelled altogether. In addition, you’re typically required to insure multiple customers (it’s difficult to get insurance on a single customer), thereby driving up the overall cost.

Claims Put Option

Created in response to the need for organizations to mitigate risks on difficult-to-insure accounts, a claims put option gives the buyer the right to sell one or more specific receivables for an agreed-upon period of time at a pre-negotiated price. Unlike receivables insurance, a trigger event must occur (typically a Chapter 11 or 7 bankruptcy or a general moratorium on payment to trade vendors) before the buyer has the right to “put” the receivable(s).

Coverage cannot be cancelled with a claims put option, providing your organization more protection on the specific receivable than other options (i.e., receivables insurance). Contract terms are negotiable, and vendors can ensure a specific recovery rate (usually 90 to 95 percent of the average receivable) and specify coverage duration (usually 6 to 12 months). Because the claims put option offers single account coverage, it can be used to supplement traditional credit insurance.

Payout following a trigger event is dependent upon contract terms but will typically occur three days after the trigger event (bankruptcy or general moratorium). This option does not provide accounts receivable administration or protect against disputed accounts receivables.

Factoring

With factoring, receivables are sold to a third party at a discount, and the third party collects the receivable when it becomes due from the customer. The customer is typically aware of and supports the program. How does it work?

The third-party factor purchases a vendor’s account receivable at a discount at the time of shipment, which provides immediate liquidity to the vendor. The third-party factor then collects full payment from the customer when the invoice matures.

This option provides immediate cash flow to the organization, creates no new debt, transfers credit risk, and provides receivable administration for the vendor.

Assess Your Risk

While organizations are increasingly taking advantage of these programs, they may not be the answer for everyone. Each organization must assess its own specific needs, price sensitivity, and risk tolerance in order to identify the right product. For more information on whether these programs may be right for you, contact Mandy Townsend or Krissa Corkins at 800.544.0203.

• How diversified are you? Are you dependent on a single industry? Are you dependent on a single vendor?
• How diversified is your customer base? Are you dependent on a single customer?
• What’s the credit worthiness of your customer base? Your organization?
• What are your cash flow requirements?