How to Increase Cash Flow by Insuring Foreign Receivables
Businesses that are exporting have more to worry about than their local business risks. In many companies, the accounts receivable portfolio is the biggest current asset on their books. It can account for as much as 40 percent of their asset portfolio.
Making sales on credit doesn’t come risk-free. Customers can default on their obligations for any number of reasons. However, will a business simply limit its customers to those who can pay upfront? Not if they want to grow and serve a growing market.
For example, most B2B companies operate on credit terms with their suppliers. This article highlights these risks and how you can hedge them by insuring foreign receivables. This is done through trade credit insurance or accounts receivable insurance.
Risks of Foreign Transactions
Introducing export services expands your business's reach, but cross-border trade can hurt your business if it isn’t well managed. Credit sales across borders have even higher associated risks, like government policies and currency fluctuations. Below are common risks and how they affect your foreign revenue collection.
1. Regulatory or Economic Risks
All countries have some level of regulatory or economic risk. It is critical to understand different trade policies in the countries you wish to venture into beforehand. Some countries have strong values, customs, and social regulations that could affect your ability to sell in those countries.
In addition, there are macroeconomic factors that could affect your company’s ability to sell in another country. In some countries, domestic products are preferred over imports. Taxation and who bears the tax burden is another factor of economics. Others include import or export policies and tariff changes.
2. Currency Risk
Anyone dabbling in foreign trade should understand how currency exchange rates affect the business. This is especially true if you're offering trade credit to other countries. Foreign exchange risk refers to the risk a business incurs in the event of a fluctuation in the currency value.
All businesses face some currency risk and can be affected if the currency becomes volatile. However, exporting businesses face very direct risks in this area. For exporters, you could lose earnings if you sell goods at a specific price and your home currency weakens compared with your customer's currency.
Let's say you have a business in the US and want to sell to a customer in Great Britain. So you invoice them £250,000 with payment terms of 30 days. In that time, the USD becomes weaker against the GBP. When your £250,000 comes in and you need to convert it to USD, you'll get less USD for the same number of pounds.
Because of these risks, you should also have a foreign exchange policy before venturing into cross-border trade.
3. Credit Risk
Credit risk, also called counterparty risk, is the risk of not being able to collect on an account receivable. Just like your local clients, foreign clients may be unable or unwilling to pay for supplies for various reasons:
Going bankrupt or closing down the business
Facing cash-flow problems
With foreign companies, credit risk increases because you have limited information on the company’s status. Additionally, your rights and remedies if the buyer defaults vary according to the country’s laws and regulations. As a result, collecting nonpayment can become very difficult and expensive.
There are several ways to reduce your credit risk when dealing with foreign customers. They include:
Full or partial upfront payment – asking for payment before services are rendered eliminates or reduces nonpayment risk. However, you must have negotiation leverage to justify this demand. Small businesses or new exporters may not have the clout to take this approach.
Letters of credit – the customer’s bank agrees to pay a certain amount to your bank once the contract terms have been satisfied. The customer’s bank generally sets aside this money, restricting the customer’s working capital. This process can be time-consuming and expensive.
A standby letter of credit – is a secondary source of payment if the customer defaults; however, it is not intended to be a payment contract.
Credit insurance – the business takes a policy that will pay should the foreign customer default for reasons allowed in the policy.
Factoring – the AR debt is sold to a third party who becomes responsible for collecting. The business, however, sells this debt at a discount and hence won’t realize the full revenue anticipated.
Insuring foreign receivables is generally the easiest and most cost effective option as it takes care of most eventualities that lead to customers defaulting.
4. Shipping Risks
Logistics can be complicated when you're dealing with exporting. They include:
the extended shipping period – days may be counted from the date the customer receives the product, not the date of shipping
risk of breakage, vandalism, theft or piracy or losses of other kinds
impounding or seizure at the destination port
Working with a forwarding agent can help you navigate various logistical requirements. In addition, they will tell you what your responsibilities are. Before shipping, you must agree with the customer what their responsibilities are.
5. Political Risks
Many kinds of political risks can affect foreign trading transactions. The most apparent risks include war, protracted civil unrest, and major terrorist attacks in the customer's country. Other risks include:
Expropriation – the foreign country arbitrarily nationalizes or confiscates assets without following due process or compensating business owners, e.g., when Cuban president Fidel Castro seized US-owned sugar plantations in Cuba.
Embargoes – the imposition of an embargo on a foreign country makes a trade with that country difficult or impossible. If you had an outstanding AR, chances of recovery are slim.
Environmental factors – earthquakes, hurricanes, storms, and floods in the destination country affecting your customer’s business.
Trade sanctions – sanctions are often used as political tools for countries to punish each other. For example, when the US recently barred American companies from doing business with Huawei in China. Sanctions are more limited in scope than embargoes and include visa bans, freezing assets, and prohibition of dealings, among others.
Apart from these, the political actions of world leaders can affect trade in several ways. For example, after Brexit, the value of the GBP dropped, as did the Euro. Both currencies took long to recover and remain on shaky ground because the decision hasn't come into effect.
How Accounts Receivable Insurance Can Help Businesses Conduct Foreign Trade
Any business that offers products and services on credit terms should consider taking trade credit insurance. As demonstrated, exporters face even higher risks and therefore, should consider the insurance options available before venturing into selling their products and services overseas.
Below are some advantages of getting AR insurance on your foreign receivables:
Controlling credit/financial risk –it is customary to evaluate a potential customer’s creditworthiness before giving credit. However, companies may develop unanticipated financial problems before your debt is settled.
Improving cash flow – businesses must have adequate cash to ensure day-to-day running. Foreign accounts take longer to pay because the payment period often doesn’t include shipping time. Insurance can help you get your cash should foreign clients default on their payments.
Monitoring customer’s creditworthiness – If you have trade credit insurance, you can use your insurer’s resources to check the creditworthiness of customers. The insurer’s data is more extensive, as are their networks. Their analysts can advise you on whether a potential client is creditworthy.
Improved revenue and competitive advantage – with insurance, your business may be able to offer competitive credit terms to secure more clients. You can take more risks because you’re protected, and this results in more revenue for the business
Borrowing against your AR – accounts receivable are a recognized business asset against which you can borrow. However, most lenders will exclude lending against foreign AR unless the AR is insured. By insuring your AR, most lenders will advance up to 90% of the AR value, meaning you will have more money to grow your business.
There are different kinds of AR insurance, and their terms are also different. If you’re looking into insuring foreign receivables, get at least three quotes from reputable insurers who deal with foreign ARs. Below are the kinds of risks typically covered in most AR insurance policies:
AR Insurance and Covered Risks
Almost all insurers cover the risk of customers’ insolvency. The policies may have specific events which qualify to be considered as an insolvency. For example, court-ordered liquidations or bankruptcy declared in a court of law.
Policies also typically protect from protracted default, which means the buyer fails to pay on the due date and after extensions from the seller. Exporters are also generally covered from political risks, such as failure to pay because of confiscation expropriation, embargo, currency inconvertibility or regulatory acts. These are acts by the government or another public authority.
Provisions, Limits, and Exclusions of Coverage
AR insurance policies indemnify your business against credit losses from nonpayment of debts. An indemnity may be triggered by a sale made or loss occurring during the policy term. There is no standard policy, which means different insurers can have their own policies. You can have a policy for just one debtor or your entire AR portfolio.
The insurance typically has a right to recover losses by subrogation against the buyer. Subrogation means that the insurer gets the right to try and recover the amount from the buyer after compensating you for the loss.
Trade credit insurance premiums are often calculated as a percentage of the business’s revenue or turnover. This percentage is determined by your credit terms, the creditworthiness of your customers and loss history, among others.
Because insurance is taken at the beginning of the year, the revenue is an estimate. You should report the actual income to the insurer. The insurer then adjusts the premium upwards or downwards according to the difference.
Additionally, trade credit insurance may undertake to cover a portion of every unpaid debt, say 80 or 90%. The balance is to be paid by the policyholder and is called coinsurance or self-insured retention.
AR policies have a waiting period or the amount of time from the date of loss before the claim is payable. This waiting period is enforced to ensure that the seller makes sufficient efforts to collect on the payment and fails.
Exclusions and Limits
Most AR insurance policies have exclusions. This means that you cannot claim on AR losses related to these circumstances. Some of them include:
Unresolved disputes between buyer and seller
Shipments made to a buyer that was delinquent or insolvent at the inception of the policy
Dishonest actions of the policyholder
Breach of sales contracts by the policyholder
Insurers can also establish credit limits and credit terms for each buyer which the policyholder should stick to. You cannot extend buyers credit beyond the specified credit limit – rather, you can, but the remainder of the credit is uninsured.
If a customer is unable to pay, the insurer will only pay up to the indemnified portion of the customer's credit limit. There's also a maximum policy limit, which is the most an insurer will pay for all AR losses within the policy period.
Insuring foreign receivables is not just a smart move; it should be the only move if you're venturing into an unknown overseas market. Your credit risks increase exponentially when you're dealing with customers from other countries because variables increase exponentially.
In time, you may be able to demand upfront payment and therefore reduce foreign trading risks to a minimum. Trade credit insurance offers you a chance to grow the business beyond national bounds without many of the associated risks of nonpayment. In turn, you may be able to offer more favorable terms to secure even more business.