Loss of receivables can have serious consequences for a company if it poses a threat to the company’s liquidity. Below, we’ll explain what loss of receivables means and how you can protect your business against it.

What’s in this article?

• What is loss of receivables?
  
• What causes loss of receivables?
  
• How can loss of receivables affect a company?
  
• How can you protect yourself against loss of receivables?
  
• How can you insure yourself against loss of receivables?
  

What is loss of receivables?

Loss of receivables occurs when a debtor fails to fulfill their obligations to a service provider and does not pay an invoice on time. If the customer refuses to pay or is insolvent, the company requesting payment does not receive its money and incurs losses. In business transactions, the service provider bears the risk of payment default if no measures have been taken to protect against loss of receivables prior to a business relationship.

How can loss of receivables affect a company?

Loss of receivables can threaten a company’s liquidity and lead to cash flow difficulties, which can consequently leave the company unable to meet its own financial obligations on time or even at all.

Small and midsize enterprises (SMEs) are especially dependent on the payment practices of their customers, since working capital (i.e., the capital available for day-to-day operations) tends to be very quickly stretched to its limits. In the worst case, multiple losses of receivables that hit an otherwise healthy company in a short period of time can overextend liquidity management and even lead to insolvency.

It is essential to ensure that this does not happen in the first place and that the company’s own liquidity is not put at risk. Therefore, every company should identify any cash flow issues at an early stage and take precautions against the risk of payment defaults.

How can you protect yourself against loss of receivables?

It is important to adopt early measures to protect against payment defaults. Conducting a thorough review of your receivables management processes and making them more efficient overall will help to prevent loss of receivables. For example, adopting the following practices in your receivables management process will help your customers pay their invoices on time:

• Invoice on time to ensure liquidity.
  
• Offer payment methods that make it easier for your customers to pay.
  
• Adopt advance payments for provision of services.
  
• Choose shorter payment terms that don’t put your own liquidity at risk.
  
• Offer payment incentives, such as cash discounts.
  

We also recommend using software to make the management of receivables and accounts receivable more efficient. This makes it easier for you to keep track of open invoices and to send dunning notices for missed payments more quickly and systematically.

How can losses of receivables be prevented?

There are also measures you can take to virtually eliminate potential payment defaults before a business relationship even begins. Here are the most important ones:

1. Credit check

Check the creditworthiness of potential business partners as well as their company records to minimize the risk of loss of receivables. The following sources are useful for assessing a company’s credit:

• SCHUFA
  
• Creditreform
  
• Commercial register
  
• IHK
  
• Federal Gazette
  

Credit checks can also be carried out by external payment service providers. When assessing creditworthiness, the previous payment history of a potential business partner is particularly important: how reliable is the company in question when it comes to settling outstanding payments? Have they ever gone through dunning processes, or even insolvency proceedings?

It is recommended that companies include in the contract terms that the trade partner agrees to undergo a credit check. This protects the service provider, which is especially advisable when companies are entering into larger contracts that would result in significant financial damage in the event of a loss of receivables. In such cases, a credit check should be performed before the contract is signed.

2. Factoring

Use factoring services to outsource your accounts receivable management: an external company handles all billing (invoicing, dunning, etc.) and assumes the risk of loss of receivables. This involves you selling your receivables to a factoring company. While you do have to pay factoring fees, it is then the factoring company that bears the risk of financial loss. The average cost of factoring is usually 1% of the volume of receivables. There are also costs for regular credit checks.

Factoring provides reliable protection for your company against cash shortages. In fact, the biggest advantage of factoring is the boost to liquidity: factoring companies transfer as much as 80% to 90% of the volume of receivables to the company in question as soon as the credit check has been completed. This increases liquidity and also provides financial flexibility for investments.

Another advantage: outsourcing some or all of your accounts receivable management allows you to focus more on your actual business. It also reduces your accounting staff costs, freeing up the cash for factoring fees.

3. Insurance

Take out insurance against loss of receivables. Trade credit insurance, for example, can cover payment defaults. We explain below what you’d need to keep in mind.

How can you insure yourself against loss of receivables?

Companies can take out trade credit insurance, which covers loss of receivables in the event that a debtor is unable or unwilling to pay. It provides compensation for losses of receivables up to the insured amount in the event that receivables cannot be collected. Before taking out trade credit insurance, companies should carefully check the coverage amount and the requirements that must be met for the insurance to cover a payment default.

Taking out trade credit insurance is particularly important in times of economic crisis. This is because in an economic recession, price increases and increased cost pressure lead to significantly more cases of loss of receivables. Even customers who have reliably settled their invoices in the past may increasingly find themselves unable to pay. Trade credit insurance can provide companies with some relief from this situation, and it can be taken out for both domestic and international trade.

Trade credit insurance not only protects against loss of receivables, but it also provides stability for the company’s own liquidity, which in turn improves its relationship with its business partners. Trade credit insurance therefore offers companies several advantages that may not be immediately obvious. However, companies should still weigh whether trade credit insurance is worthwhile for them, taking into account their industry and customer base in particular.

Is trade credit insurance worth it?

There is no simple answer to the question of how much trade credit insurance costs. There are several factors that determine the cost of insurance, primarily the trade partners of the company to be insured and the industry in which it operates. An insurance company determines the cost of insurance on the basis of the risks involved. The costs vary depending on the insurer and the amount of coverage.

In any case, the costs involved in taking out trade credit insurance will be significantly lower than the probable financial loss in the event of loss of receivables. Plus, the cost of credit insurance is tax-deductible as a business expense—so from a purely financial standpoint, trade credit insurance is usually worthwhile for a company.

However, when considering whether credit insurance is worthwhile, it is not just the cost that plays a role. The overall cost-benefit calculation is much more important for each company: what is the benefit of trade credit insurance, and what losses can it prevent for the company? Companies should therefore also consider the following:

Defaults are more common in some industries than in others, so trade credit insurance may be essential in some cases.
If your company is particularly reliant on receiving payments on time to cover ongoing costs, trade credit insurance that covers losses on receivables will ensure greater liquidity.

Ultimately, it also depends on the company’s individual risk tolerance whether it is prepared to shoulder a payment default itself (i.e., without insurance). You can also perform a risk analysis for your company, which usually provides a pretty clear view of whether trade credit insurance could protect your business from financial loss, or if it is not an absolute necessity. You should also consult an industry expert before deciding whether to take out trade credit insurance.