A lot of companies buy trade credit insurance for protecting capital, cash flow as well as earnings. The product affords them safe and strategic expansion of their businesses, thus improving sales and profits.
Boosting of Sales
A wholesale company may for instance have restricted a client’s credit line to $100,000. The firm then buys an insurance policy covering trade credit, with the insurer approving a $150,000 limit on the client, upon analysing the client’s credit as well as financial performance data. The wholesaler can boost sales accordingly to realize incremental gross annual profit of $60,000 on the same customer account, when margins of 15 percent and 45 days of average days sales outstanding (DSO) apply.
Improved Borrower-Lender Relationship
As well, trade credit insurance can improve the relationship of a company with its lender. Banks in certain cases require this form of insurance as a prerequisite for approving a loan. A scrap metal dealer covered up to $25 million for example, might have an excessive concentration within its accounts receivable as a result of only having eight customer accounts active. The smallest customers among these would have receivables balances lying within the bottom six-figure range and the largest one within the bottom seven-figure range. Naturally, the company’s bank would then get concerned about such concentration and require insurance of trade credit as a prerequisite for fully leveraging the accounts receivable as collateral. In this case, the dealer of scrap metal buys the corresponding insurance policy that names all its buyers specifically. This affords the bank the level of comfort it requires for increasing eligible receivables.
Alternatives to Trade Credit Insurance
Other ways of hedging receivables include letters of credits that could be quite costly. Self-insurance is yet another option that involves putting aside reserves for covering losses due to payment failure by customers. Reserves however eat into margins, while failing to protect against unexpected, catastrophic failures. In addition, for self-insurance to work, it requires an investment in systems, monitoring of credit risk as well as expertise in analysis. However, both the scope and quality of these aspects many times hardly compares favorably to that availed by a provider of trade credit insurance.
Factoring is yet another alternative whereby receivables are sold to a factoring firm. This oftentimes requires for one to accept between 1 and 10 percent margins of discount to face value. Factoring firms may also fail to absorb all credit risk in lieue of non-payment. The factoring discount could prove to be an appreciable burden, if a business entity operates within narrow business margins along with high competition levels. In addition, the company ends up losing the client relationship advantage which is sustained by ownership of receivables.
A lot of business gains present alongside securing insurance of trade credit, both in terms of growth and unpredictable market environments. It mitigates risk in a very cost-effective way, while affording companies the confidence of expanding their sales to new markets and clients. A firm is also capable of selling a lot more on open account terms upon obtaining this form of insurance. See more at NicheTC.