ICPA Analysis: Factoring and credit insurance
Factoring and credit insurance: hand in hand to help businesses
Peter Laurie answers some commonly asked questions about factoring and credit insurance
Businesses looking to raise finance often have more options than they think. One option that is growing in popularity is factoring. Factoring companies weigh up the risks before agreeing a deal - this is where credit insurance comes into play. In instances where a business wants to factor their debt but the debtor’s credit rating is poor, a factoring company will need to insure the debt before they release the funds.
Q: What is credit insurance?
Credit insurance is an insurance policy that provides a business with protection against the failure of a customer (‘the buyer’) to pay them for the products and services they have delivered because their customer has become insolvent.
Q: Who uses credit insurance?
Credit insurance is suited to all manner of companies, regardless of whether they are trading nationally or internationally, and in all sectors from manufacturing to services. In terms of size they can also be anything from annual turnovers of £250,000 right through to the turnovers of the largest multinationals.
Q: When and why would a company consider using credit insurance?
On average, companies are estimated to have 40% of their current assets in the form of trade debtors. It is estimated that up to 50% of all failures concern customers that were previously considered to be both long standing and prompt paying. The cost of bad debt can be very significant. For example, if a company is operating on a 5% profit margin, a £10,000 bad debt would require £200,000 of additional sales to compensate for the lost ground. Double the debt and it is easy to see why businesses can be brought to the brink of collapse. Unless, of course, they are covered by credit insurance.
A further reason why businesses should consider using Credit Insurance is because a bad debt often causes a company to reduce the amount of credit it extends to its customers. Again in simple terms, it is easy to see how this potentially exposes that business to its competitors, leaving it in a potentially much weaker competitive position.
Q: How can credit insurance improve/support business?
The fundamental purpose of credit insurance is to protect a business against customer insolvency. Credit insurance provides an early warning signal that a customer is in financial difficulty, allowing a company time to withdraw from the relationship on a structured basis, reducing exposure gradually. Credit insurance assists companies with targeting their sales effort, focusing on profitable buyers and markets, and avoiding financially weak customers or politically unstable export territories. It also positively impacts on their balance sheet by reducing a company’s bad debt provision, thereby releasing tied-up capital that can be invested elsewhere.
The ‘security’ which credit insurance provides, gives a company the confidence to tackle new markets and take-on new customers, safe in the knowledge that if anything happens beyond their control, then they’re covered. It can also be used to provide greater security – in essence a guarantee – to a lender for trade or export finance, and thereby provide greater access to finance.
Q: How does credit insurance work?
How it works is simple: a company asks for a credit limit on each of the customers with whom they trade above an agreed level. Below this level – referred to as a ‘Limit of Discretion’ or ‘Discretionary Limit’ – they do not need to ask for a credit limit. Instead, they can use their own sources of financial status information and trading experience to justify the trade credit that they extend. Provided they trade within the set parameters and abide by the terms and conditions of the policy, they will be covered (up to the limit of cover agreed)
Q: How much does it all cost?
The cost of a policy is usually calculated as a percentage of a company’s turnover, and will depend on its trading history, turnover, business sector and customers on which they need cover. The range is from less than 0.1% of turnover to more than one percent. Typically, a company will pay between 0.3 and 0.7.
Q: Are there some companies that are uninsurable?
Only those where the analysis of the business and/or the sector they serve/the businesses with which they trade suggest that the risk cannot be justified.
Q: Is this a bonanza time for Credit Insurers in terms of new business?
Obviously, in the current environment, the opportunity for ‘new’ business has perhaps never been greater. What is important is that Insurers will look after their existing clients first. That is not to say that new business isn’t being encouraged in the market. If you or your client would like to fully understand the options available, contact Peter on firstname.lastname@example.org or call 020 7535 7000.
Peter Laurie, Factoring Advisory Service
This article is taken from “Accounting Practice” the ICPA quarterly magazine. Dedicated to supporting and promoting the needs of the general practitioner. You can find us at www.icpa.org.uk or email email@example.com or by ‘phone on 0800-074-2896