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 percent, 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 percent. 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 percent to .3 percent 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 percent 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. …