Accounts receivable is a ubiquitous challenge for a diverse range of businesses spanning many industries. If you were to compare a small and large business that were otherwise very similar, you would begin to see differences in their accounts receivable risks. Small companies — say, around $1 million in revenue — without insurance to cover their accounts receivable (A/R) risks sometimes use factoring to help manage those risks.
Factoring is really just selling your receivable to a third party to transfer the risk of nonpayment and receive payment quickly. Consider this scenario: you have $100,000 in one receivable and payment terms are 45 days, but your client pays in 70 days. If you want to get paid now and eliminate that risk of not getting paid, you go to a factoring firm. They give you 88 percent of that receivable today.
For those choosing factoring, there are two options: recourse and non-recourse factoring:
- Recourse factoring is not an attractive option for many businesses. Essentially, the lender can return the receivable to the company if they are not able to collect from the customer.
- Non-recourse factoring is a better option and a true sale. The lender actually buys the receivable and notifies the customer that they are factoring.
Factoring is particularly useful for transferring risk and accelerating cash flow in one action. The problem is that factoring tends to be very expensive, as the example above illustrates. And the smaller the company, the more expensive it is.
A/R insurance, on the other hand, offers not just risk transfer, but also lower costs and access to a risk management and loss control partner (a.k.a. your insurer). You can decrease your expenses dramatically with insurance for a full portfolio of receivables. With factoring, the discount in the gross invoice value, when converted into an interest rate, translates into an APR between 8 and 35 percent interest on a loan that is in place for 12 months. If you throw a claim in there, it very much shows the cost-benefit.
You can rely on the insurance carrier to do the due diligence. For example, the carriers will get credit scores on every one of your customers to assess the probability of default. This type of information can be extremely valuable to your business.
While large companies have risk managers and controllers to manage accounts receivable, small companies may not. That’s why small businesses in particular can benefit from finding the right insurance partners. It provides them access to a team of risk management and finance experts. Even if an insurer says “no” to insuring a particular risk, that denial provides useful information in assessing how much risk a small company is assuming.