As often discussed in credit management circles, a sale isn’t a sale until the seller receives payment for the goods or services. How does a seller get paid? For short term sales, two of the most common forms of payment are a letter of credit or extending credit / open account. While both accomplish the same objective, there are significant differences between the options. The letter of is more secure for the seller, because the risk of default has been reduced, but can limit sales. Extending credit (open account) to the buyer increases the seller’s risk of non-payment, but because it’s advantageous to the buyer, can used as tool to facilitate sales. What if the seller could extend credit to buyers to generate sales while limiting risk of non-payment? The solution is credit insurance. Let’s look at both payment options in more detail.
What is a Letter of Credit?
A commercial letter of credit is a document sent from the buyer’s bank that guarantees the buyer’s payment to a seller will be received on time and in the correct amount. If the buyer is unable to make a payment due to the seller, the bank issuing the letter of credit will be required to make payment. In a volatile global economy, where there a longer transit times, less knowledge of the buyer, there are advantages to selling on L/C.
Seller advantages:
- Buyer is assured payment
- Terms of the sale are negotiated in the letter of credit document
- Funds are transferred from the issuing bank to the seller’s bank
While there are advantages to the seller, there are disadvantages to the letter of credit itself and for the buyer.
Disadvantages:
- Seller – It can be challenging to negotiate the key terms
- Seller – Transactions details can be missed leaving room for error
- Buyer – Letters of credit can be costly. The buyer bears the brunt of the fees which typically range from 75 bps in developed countries to 150 bps or more in underdeveloped countries
- Buyer – Letters of credit tie up the buyer’s working capital. The bank will require the buyer to set aside the funds as a condition of issuing the letter of credit. This either reduces their borrowing capabilities or access to cash.
Letters of credit are an effective payment method assuring the seller is paid for goods or services. However, the benefits generally accrue to the seller, while there are a number of disadvantages for the buyer.
What is Credit Insurance?
Credit insurance is an insurance policy that protects the insured (seller) from non-payment. It allows the seller to extend credit (open account) to the buyer while reducing the risk of not being paid for their products or services. Credit insurance can be a win-win for both the buyer and seller.
Seller advantage:
- Sell more. Extending credit makes it easier for your customers to buy your products. Financing is critical aspect of any sale. If your customer can get a better deal which includes credit from your competitor, you are at risk of losing the sale and your customer.
- Credit insurers are very good at determining credit worthy buyers and credit limit to extend. If they make the wrong credit decision, the insured can file a claim for non-payment. That’s a huge benefit often overlooked when evaluating credit insurance options.
Buyer advantage:
- Reduced borrowing costs
- Improved working capital
The following graphically shows impact of the terms of sale on buyer’s willingness to buy:
Conclusion
Financing is a critical component of any sales transaction. Ideally, the seller would like to sell on secured basis, but for most cases this isn’t realistic. Companies are increasingly recognizing that credit insurance is a valuable tool in their overall enterprise risk strategy. They can extend credit to facilitate sales, and also reduce enterprise risk by protecting one of the largest assets on their balance sheet.
Since 2004, Securitas Global Risk Solutions, LLC (“Securitas”) has helped clients develop credit and political risk transfer solutions that provide value on numerous levels. As an independent trade credit and political risk insurance brokerage, Securitas is focused on developing comprehensive solutions that meet the needs of clients, ensuring a complete understanding of policy wording and delivering excellent responsive service.
