Fatihah Ramzi, DigitalCFO Newsroom | 7 June 2022
With an economic recovery predicted to overlap with trade finance’s ongoing transformation, now is the moment for businesses to equip themselves with effective credit risk management solutions.
Commercial challenges remain aggravated by the COVID-19 pandemic, in both international and domestic trade. With the risk of insolvency and default being ever-present, trade credit risk management solutions can help businesses navigate these important business risks by offering protection and facilitating commerce.
Given the current economic crisis precipitated by COVID-19, businesses in all industries are facing significant hurdles. Many businesses are experiencing large payment delays on their receivables, which can lead to cash flow issues and concerns about debtors.
Companies frequently keep receivables that have been unpaid for 180 days or longer in the hopes of reclaiming these overdue bills. Leading credit insurers, on the other hand, forecast that insolvencies would climb dramatically in 2021 and 2022, increasing the risk of nonpayment. Due to the gloomy outlook, most businesses have seen an increase in late payments, which has impacted their cash flow.
Risk Management Solutions
There are several solutions available to safeguard organizations against bad debt and help credit risk management, but it’s easy to become lost in the sea of possibilities. Companies must establish an effective credit risk policy when issuing trade credit to protect their firm from the danger of non-payment. The first component to consider is a company’s own human and financial resources: do you have the skills and time to monitor your receivables across the credit risk lifecycle? Once you are able to answer this question, you can move forward and take a look at the various risk management solutions available.
(1) Self-Insurance
Building up your own financial reserves to offset a company’s losses in the case of a client default is known as self-insurance. Administratively, it is the simplest and most cost-effective option. However, this method exposes a corporation to a high level of credit risk, and damages in the case of a substantial contract default can be significant. Furthermore, there are major hidden costs:
- Companies must handle credit risk management activities on their own, which often forces them to rely on third-party data suppliers that aren’t always trustworthy, especially when it comes to credit risk assessment.
- Companies must manage debt collection services, which necessitate a significant investment of both human and financial resources.
- Cash flow must be tied up on a company’s balance sheet, and it is not protected in the event of a major customer going bankrupt.
(2) Letter Of Credit
A letter of credit is a pledge from a client’s bank to pay the company once they have validated that the company’s responsibilities have been fulfilled properly (delivery, nature and quality of the delivered goods or services and paperwork). It’s a form of protection for both the company and the customer, in which the risk of non-payment is passed on to the bank. It enables companies to trade with confidence, knowing that they will be compensated for the goods they export.
This type of system is extensively utilized in international trade, especially when determining the client’s or supplier’s reliability is challenging. However, such a system is costly to the client and must be renewed with each transaction. Above all, it’s a time-consuming administrative solution, and it’s considerably more time-consuming in the case of a claim process, which might be disrupted by minor documentation problems.
(3) Factoring
Factoring is bringing in a third party, referred to as a “factor,” who buys the debt at a reduced price (typically 70 percent to 85 percent of the total invoice). Invoicing and debt collection services are frequently offered as part of these contracts. This is the best way to get the money from a transaction as soon as possible without putting up any security. As a result, the company’s credit risk is reduced.
These contracts, however, are costly in terms of charges (1 to 4%), and only cover a percentage of the debt. Furthermore, financial organizations that provide debt factoring frequently need companies to include all of their client receivables. It practically means businesses would have lost control of their client relationship: the factor is the one who will collect the money from the receivable. Businesses who use factoring will be liable for collecting the debt and must eventually repay the amount advanced.
(4) Trade Credit Risk Insurance
Trade Credit Risk Insurance is a type of bad debt insurance in which the insurer reimburses the company for the amount insured if the customer fails to pay them. It’s the most comprehensive solution because it combines a financial information service on your clients and prospects, a debt collection service, and compensation in the event of non-payment all in one package. As a result, companies save a lot of money on structural costs. In this instance, a company’s credit risk insurance acts as a true partner, advising and assisting them throughout the course of their business operations.
The insurance rate is determined by the size of the business, its industry, and the level of coverage the company desires for each customer. After companies have paid the subscription, their cash flow will be completely safe. This technology allows companies to enter new markets with confidence and make competitive bids to prospects while protecting the business’ cash flow.
Finding the finest trade credit management solution is dependent on your requirements and circumstances. The capacity to obtain a thorough grasp of the available options and make the best decision is critical to optimizing the credit risk management function. Outsourcing a credit risk management solutions provider is the greatest way for businesses to get the finest alternative for their credit management needs.
