Trading on credit terms carries an ever-present underlying risk for those trading overseas – from customer insolvency and default to economic and political upheavals. Many companies generally accept this as the essential price for expansion and for accessing new markets. However, by seeking to maximise these opportunities, many are taking wholly unnecessary gambles.
In my opinion, every company should give greater thought to the level of trading risk they take on and how they can manage it more effectively by adopting a holistic approach to credit risk management:
The Risks of Trading on Credit
Companies should continually monitor the economic and political factors which influence insolvency statistics and company payment behavior.
The global economy
The world economy is showing signs of recovery, with growth of as much as 4.1% predicted for 2004. There are also increasing signs that recovery is gathering momentum in the United States – the world’s greatest growth driver – where the economy grew by 3.1% in the second quarter of 2003.
The local economic climate
The single currency and the pragmatic approach of the European Central Bank (ECB) have provided a relatively stable framework for intra-community trade. However, recovery in the region has been hampered by the solidity of the Euro against the Dollar and Sterling which has affected investment and the region’s competitiveness at a time when domestic demand is also weak. Company solvency has remained shaky with the bankruptcy rate continuing to rise in 2003. Only sluggish growth is likely in 2003, with slow recovery in 2004. Economic trends in the region have continued to vary widely by country with economies such as Germany, France and Italy faring particularly badly, while Spain and Greece have continued to out-perform.
The political situation
The ability of a customer to honour their financial commitments can be influenced by political factors such as wars, revolutions, rioting, currency crises and exchange controls. The war in Iraq (and before it, the campaign in Afghanistan) has led to a worrying period of political uncertainty in the Middle East, while the fall-out continues to affect the United States and its allies. The situation in Iraq itself is volatile, hindering economic reconstruction and the return of Iraqi oil to the market while the War on Terror has further exacerbated anti-Western sentiment among Arab populations, leading to political instability in countries.
The level of risk associated with individual companies also depends on the climate in their industry sector. For example, the US’s War on Terror has had a negative effect on fuel (particularly oil supply); airlines; and holiday companies (the SARS epidemic has also affected consumption for tour operators in Asia and Canada).
While electrical components virtually stagnated last year, there has now been a moderate upturn, underpinned by increasing demand in Asia. Sales are particularly strong for opto-electronics (used in telecommunications), flash memories and digital signal processors.
The Consequences of Non-Payment
In the manufacturing sector, the sales ledger typically represents at least 40% of current assets; in the service industries, it can be as high as 90%. Non-payment therefore represents a real threat to the survival of any company. Even if the business survives, the consequences of even one bad debt can still be devastating and include:
Cash flow problems: Bad debt affects a business’s ability to cover overheads, buy essential materials and meet its own payment obligations.
Opportunity cost: A company may find itself having to utilise a high proportion of its turnover to finance late payment or bad debt, money which could have been re-invested in the business.
Administration cost: Extra statements, debt collection and legal action – solicitors’ letters or the small claims court, for example – all cost time and money, whether handled in-house or by outside services. Not to mention the valuable management time involved.
Constraint on business growth: A company which experiences a high instance of bad debt is often forced to curtail the credit limits it offers customers, leaving itself in an increasingly poor competitive position.
Managing the Risk
Companies can protect themselves against the risk of bad debt in a number of different ways:
Payment in advance: Insist that funds have been cleared by the bank before releasing goods. Given the widespread reliance on credit for business transactions, it is doubtful that such a company could attract any customers at all.
Guarantees and Documentary Credits: Decreasing in use, especially in developed markets and often not cost-effective, this is where a company receives a third party guarantee or undertaking – traditionally provided by a bank – that payment will be made.
Self-insurance: Many companies choose to set aside bad debt provision or a specific reserve to cover bad debts. However, it is arguable whether this is an efficient use of working capital or has any effect on the risk of non-payment.
Credit insurance: Offers protection against extended late payment or non-payment due to the insolvency of the debtor or external political factors. Credit insurance is a way of spreading risk and not an opportunity for a company to recoup its losses. Indemnity values typically range between 80-95%, depending on the policy and the quality of the risk.
In the second part of this article we will examine the types of Credit Insurance and how one administers Credit Insurance Cover.