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 Bad Debt Reserves:

✔   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 against 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