What is credit insurance?

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Business may run on credit, but when things go wrong and a customer pays late or goes bust a small business can find themseleves in real trouble.

For this reason credit insurance can be vital. But its not just about keeping afloat in the face of bad debt. It can make for better relationships with banks, suppliers and customers.

Trade credit, which involves supplying goods and services on a deferred payment basis giving the customer time to pay, is a common practice. It has indeed become an important strategic or competitive tool: the amount of credit extended by a company to its customers appears as a current asset on the balance sheet and is therefore a component of net working capital.

A recent study by the Credit Management Research Centre (CMRC) at the University of Leeds for credit insurance company Euler Hermes Trade, found that debtors tend to represent up to 35 per cent of companies total assets.

But enforcing credit terms can be a problem, especially for small firms, which can be
particularly vulnerable as they may have a comparatively small customer base. Trade credit as a means of short term financing still comes with a cost attached. Firms in all countries suffer from slow paying customers, and a third of them think its an ongoing problem.

To protect their cash flow and provide liquidity, companies often delay their own payment to suppliers, offer a discount for prompt payment or ask for payment on delivery. Just over two-thirds of companies also claim that they would withhold
supplies from a slow paying account.

Prior to those extreme methods, companies organise their credit policy more and more effectively, for example by implementing written credit conditions, agreement on payment terms before sales in writing. Some 90 per cent of companies handle their credit management activities internally, but when payment default occurs and internal efforts fail, over 80 per cent in the Leeds survey outsourced the debt collection.

One answer to many of the problems that arise is credit insurance. Clemens von Weichs, CEO of Euler Hermes, says: "One of the key findings of the study is that credit insurance enhances companies business relationships which contribute to the overall effectiveness of the credit management department."

Professor Nick Wilson, director of CMRC, adds: "A significant financial impact is generated through higher levels of repeat business, lower levels of customer queries and disputes, more profitable sales, DSO (days sales outstanding) flexibility and on-time payments, lower levels of bad debt and incidences of fraud and lower overall average costs of credit management. Credit insured firms also have access to lower cost and better quality credit information and market intelligence. This saves money on credit reference information and market research".

The study looked at more than 2,000 businesses in 10 European economies and showed overall that in terms of credit operating costs as a percentage of sales volume, on average 1.38 per cent of a companys annual turnover could be saved by the existence of a credit insurance policy.

By having a policy in place, similar findings can also be seen in terms of bad debt write-off as a percentage of sales, average credit salaries, average expenditure on credit information and levels of fraud. In addition, raising finance through loans was also more likely to be cheaper for credit insured firms, with an average interest rate of almost half a percentage point lower for insured firms than for non-insured companies.

When it comes to suppliers, the systems and procedures that arise from having a policy mean that a credit insured company is a better risk. The Leeds study showed that credit insured firms received more favourable credit periods – on average up to seven days longer. The preferential terms gained from suppliers, the ability to take extended trade credit, the transaction discounts achieved and the smaller and more stable supplier base all contribute to the operational stability of a business.

Better banking relationships arise as a result of securing trade debts by credit insurance. This manifests itself in terms of longer and more stable banking relationships, with better access to short-term finance and loan capital and a lower average cost of bank capital.

The research showed that credit insured firms were more customer focused than non insured: 84 per cent of credit insured firms view customer relationship management as important or very important as opposed to 79 per cent for non insured. They offered credit to customers and managed the granting of credit to them more effectively than non-insured firms. And they were more willing to adapt credit terms to gain business, helping to foster better customer relations.

Von Weichs says: "The CMRC gave evidence for what we and other professionals assume: among all the credit management measures that companies can view to face bad debts issues, credit insurance helps companies efficiently to protect their current and future cash flow and net profits.

"Credit insured firms have less cash tied up in stocks and customer debt as a result of disciplined working capital management. This not only represents a financial saving but means that the firm is less vulnerable to insolvency through over trading combined with poor cash management."