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 Factoring: 

• Immediate access to ccash
• 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 aginst 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 or slow payment
• Enhances efficiency of a company's internal credit department with fast credit limit requests and ongoing buyer monitoring
• Allows exporterrs to offer safe, open 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