Many of the smartest companies we work with regularly scrutinize every major line on their balance sheets to make sure that their capital is deployed most efficiently.
“Why operate a factory,” they might ask, “when we can outsource manufacturing instead?”
Or: “Why own this hotel if we can franchise?”
Or: “Do we need our own HR department—or can a vendor perform that function for less money?”
All good questions, but often owners and operators aren’t thinking hard enough about the biggest asset they may have: Their accounts receivable. With all the uncertainties in the world today, even the most established companies sometimes don’t pay their bills. Exhibit A: Toys “R” Us owed as much as $450 million to suppliers when it announced its liquidation this past March. So far this year, companies including Nine West, iHeartMedia, and BI-LO, the grocery store chain, have filed for bankruptcy, raising concern for all their vendors.
This is why accounts receivable insurance is becoming increasingly popular. Such policies cover most of your loss if a customer goes bankrupt before paying its bill—or even if its payment is late by more than a predetermined time period. Also called trade credit insurance, account receivable policies were first introduced in the late 19th century to facilitate cross-border transactions.
More recently, however, this type of insurance is increasingly used to cover domestic receivables as well. And not just because accounts receivable insurance protects against financial hardship. These policies can also help companies manage leverage, lower borrowing costs and increase sales at the same time. Let’s walk through the benefits:
1. Affordable risk protection. Accounts receivable insurance premiums average out to between 1% and 2% of receivables covered, and while deductibles are low, these policies typically cover only 90% of the unpaid amount due. That's the “bad” news; the good news is that you will no longer have to deal with your late-paying customer, and it will be your insurer that will undertake the effort and cost of trying to collect the bill (keeping whatever it recovers).
2. Flexibility. If you’re concerned about concentrated risk, you can instead purchase account receivable insurance on an “a la carte” basis, e.g., a single transaction, a single customer, or a group of major customers.
3. Better terms for customers. Fortified by the policy protection and credit insights of your insurer, you’ll be positioned to make better offers to potential customers. For example, you’ll be able to extend larger trade credit lines to customers without requiring them to buy letters of credit. Issued by banks, LOCs have been used for centuries to guarantee payments, especially across borders. Since they’re purchased separately for each transaction, this is usually more expensive and labor intensive than using account receivable insurance.
4. Reduced borrowing cost. This is where the CFOs who are trying to optimize their capital and leverage get excited. Negotiating with bankers becomes much easier when they see that 90% of your receivables are guaranteed by an insurance company. Potential line items on your balance sheet of unsecured trade credit to companies of questionable creditworthiness have much less of an effect on borrowing costs. We’ve seen the assurance accounts receivable policies provide bankers lead to loan agreements of higher amounts with lower rates.
Some clients ask how accounts receivable insurance differs from factoring, an age-old source of financing for manufacturers. In a classic factoring arrangement, you sell unpaid invoices at a discount to raise immediate cash. But you haven’t escaped credit risk, because if your customer defaults, you have to pay back the factoring company. These days, some companies offer non-recourse factoring that covers losses if the buyer defaults, but many of our clients find it more efficient to buy accounts receivable insurance and negotiate financing separately.
We work with many firms and investment funds that are highly sophisticated about optimizing their balance sheets. But we’re often surprised that many are unaware of how useful account receivable insurance can be. That’s a potential missed opportunity. These policies can be a valuable asset in every owner and operator’s financial tool kit.
Jon Gilbert leads the mergers and acquisitions practice at the New York-based insurance brokerage Crystal & Company.
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