Reprinted with permission from Detroiter – April 1997
By Jeff Dworack
Global Commercial Credit
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:
Protection from unexpected customer defaults due to a broad range of insolvencies, or protracted default. The policy is designed to help exporters eliminate the potential for loss on their overseas open credit customers. When exposures are large, or terms are long, this protection can eliminate the devastating impact on working capital and reserves that results from credit defaults.
Securing a more competitive market position. The ability to offer aggressive open credit terms can enhance the exporters’ ability to meet a customer’s needs. As competition in the global marketplace heats up, more and more companies are demanding open credit. By utilizing credit insurance to hedge the risk of loss, exporters can extend open credit that will permit foreign customers to more easily purchase the quantity of product or service that they truly desire. Further, by eliminating the need for letters of credit, exporters help their customers keep their working capital lines of credit available for other uses. In competitive bid situations, it may make the difference between securing the contract and losing the business.
Allowing exporters the ability to pledge export receivables and insured purchase orders as collateral for working capital financing. By eliminating the risk of loss, the exporter can create a “riskless” asset that can be included in the borrowing base along with domestic receivables.
Export credit insurance has truly proven to be one of today’s greatest hidden keys to global growth and export success. If you are in search of more working capital, and pledge your accounts receivable as collateral against your working capital line of credit, and make sales to overseas accounts, you may want to read on.
In this traditional arrangement of exchanging cash 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 behind limiting 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, and increase 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 off of 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 useful percentage.
For example, a company with $10 million of pledged receivables is currently allowed to advance 80%, providing $8 million in available working capital. Assume additional growth opportunities require additional $3 million. By insuring the receivables against unexpected customer insolvency’s and protracted default, the advance rate can safely be increased to 85%. This provides an additional $500,000 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 $3 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 everyone.
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 $3 million of additional capital reinvested in the business at a 30% return on funds employed yields an incremental return of $900,000, from a premium investment of approximately $100,000. 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. Overall, you may find that credit insurance is the ideal solution to a number of very common dilemma’s.
Review a Related Case Scenario: Borrowing Enhancement