Reprinted
with permission from Business Credit - June 1997
By Vic Sandy & Jeff Dworack
Global Commercial Credit
In the traditional
arrangement of exchanging goods and services today for
the promise of cash tomorrow, we all realize there are
many inherent risks, not the least of which is unexpected
customer defaults. The risk of an unexpected customer
default is a driving reason why lenders limit advances
on pledged receivables. Prudent lending practices dictate
that lenders extend themselves only to a certain point,
since the potential for default in the receivable base
can place an undue repayment burden on the borrower.
Obviously, this limits the amount of working capital
available from a given group of accounts.
Many companies
in periods of rapid growth, or faced with new revenue
opportunities need access to additional working capital.
The traditional approach has been to secure additional
assets or provide personal guarantees. For some, these
options are not feasible or desirable.
A more cost
effective alternative is to hedge the risk in pledged
receivables, allowing a safe increase in the advance
rate. A financial instrument known as accounts receivable
insurance, which is commonly used in Europe, and has
been available in the United States for over 100 years,
can be used to transfer the risk of unexpected credit
losses from the company's books. By eliminating this
potential for loss, it is possible to more fully leverage
the pledged receivables and increase advance rates by
a beneficial percentage.
As an example,
a company with $15 million of pledged receivables is
currently allowed to advance 80%, providing $12 million
in available working capital. Assume additional growth
opportunities require an additional $4 million. By insuring
the receivables against unexpected customer insolvencies
and protracted default, the advance rate can safely
be increased to 85%. This provides an additional $750,000
of working capital. As the receivables turn, say six
times for this example, that increased availability
provides additional working capital at every turn, resulting
in $4.5 million in additional funds accessible to the
company. Further, by guaranteeing payment on the receivables,
the lender enjoys the benefit of advancing against a
"riskless asset". This approach is a win-win
opportunity for the company and their lender.
A typical
credit insurance program costs 1/10% to 3/10% of covered
annual sales for a domestic receivables policy, and
slightly more for export programs. The return on additional
funds employed in the business assures the company a
sizable return on the initial investment. In the preceding
example, the $4.5 million of additional capital reinvested
in the business at a 30% return on funds employed yields
as incremental return of $1,350,000, from a premium
investment of approximately $150,000. Additionally,
the policy allows the company to replace reserves with
a tax deductible premium that places a firm guarantee
of payment on the accounts, and eliminates the need
for excess reserves.
The end result
is an immediate increase in working capital, increased
sales, and increased future sales revenue, while the
company preserves remaining assets for future financing
needs.
Exporting
on Open Credit Terms
For many
companies, the overseas market place represents their
best growth opportunity. As barriers fall, and the world
truly becomes a much smaller place, foreign competitors
are looking to the United States as a growth opportunity
for their companies, as well. This growth potential
abroad, and competitive pressures to secure market share,
are two key forces pushing more and more companies into
the export arena. For decades European companies have
relied on export credit insurance to hedge the risk
of selling into other countries on open credit terms.
While gaining in popularity and use in the United States,
this financial instrument is still widely unknown. Export
credit insurance has two basic components - commercial
risk protection and political risk protection.
These
programs provide the exporter with several tangible
financial benefits including:
