Tools to Manage Credit Risk

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  • Tools to Manage Credit Risk

    1. 1. Tools to Manage Credit Risk May 2009
    2. 2. Topics of Interest <ul><ul><li>Open Account Terms </li></ul></ul><ul><ul><li>Cash in Advance / Cash with Order </li></ul></ul><ul><ul><li>Irrevocable Standby Letter of Credit </li></ul></ul><ul><ul><li>Documentary Letter of Credit </li></ul></ul><ul><ul><li>Credit Insurance </li></ul></ul><ul><ul><li>Certificate of Deposit </li></ul></ul><ul><ul><li>Payment Guarantee </li></ul></ul><ul><ul><li>Purchase Money Security Interest </li></ul></ul>1
    3. 3. Open Account Terms <ul><li>Definition </li></ul><ul><li>Seller makes shipment and awaits payment direct from buyer based on prescribed repayment terms established by seller. </li></ul><ul><li>Applications </li></ul><ul><li>Buyer has acceptable credit rating. </li></ul><ul><li>Buyer is usually established customer…well known to seller. </li></ul><ul><li>Orders are relatively small…profit margin sufficient to support risk. </li></ul><ul><li>Advantages </li></ul><ul><li>Provides seller a competitive advantage. </li></ul><ul><li>Limits documentation necessary to make the sale. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Risk that buyer may not be willing or have means to make payment. </li></ul><ul><li>If buyer files bankruptcy, seller takes a low priority in recovery as claim is usually regarded as unsecured. </li></ul><ul><li>Seller does not have guarantee that buyer will make payments in a timely manner, thus jeopardizing seller’s liquidity. </li></ul>2
    4. 4. Cash in Advance / Cash with Order <ul><li>Definition </li></ul><ul><li>Calls for payment before or at the time of the transaction and does not ordinarily offer any discount. </li></ul><ul><li>Applications </li></ul><ul><li>Buyer has unacceptable credit rating. </li></ul><ul><li>Advantages </li></ul><ul><li>Seller assumes little or no risk. </li></ul><ul><li>Positive impact on seller’s liquidity. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Most severe terms from the standpoint of the buyer. </li></ul><ul><li>Seller may give up competitive advantage. </li></ul>3
    5. 5. Irrevocable Standby Letter of Credit <ul><li>Definition </li></ul><ul><li>Promise by a financial institution (typically, a bank) to pay the buyer’s obligation in the event of a buyer default. </li></ul><ul><li>Applications </li></ul><ul><li>Buyer has unacceptable credit rating. </li></ul><ul><li>Substitution of bank credit for that of the customers. A-B policy dictates that banks should be rated AA- or higher to issue an irrevocable standby letter of credit. </li></ul><ul><li>Seller invoices normally and does not call the L/C unless buyer fails to pay timely. </li></ul><ul><li>Advantages </li></ul><ul><li>Most secure method of mitigating credit risk. </li></ul><ul><li>Assures payment in the event of a customer default. </li></ul><ul><li>Seller does not have to obtain relief from automatic stay in event of a bankruptcy. </li></ul><ul><li>In the event of a preference action, courts generally do not view drawdown as a preference. </li></ul><ul><li>Can be modified only with the consent of the seller. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Seller may give up competitive advantage by asking for a standby L/C. </li></ul><ul><li>In some cases, costs associated with L/C may have to be paid by seller. </li></ul><ul><li>Documents must be carefully prepared and reviewed by A-B Legal. </li></ul>4
    6. 6. Documentary Letter of Credit <ul><li>Definition </li></ul><ul><li>Promise by a financial institution (typically, a bank) to pay the customer obligation upon satisfaction of selling and delivery terms, submission of confirming documents and seller’s demand for payment through the L/C. </li></ul><ul><li>Applications </li></ul><ul><li>Buyer usually has unacceptable credit rating. </li></ul><ul><li>Substitution of bank credit for that of the customers. Since Documentary Letters of Credit are a lower risk instrument, A-B policy dictates that banks should be rated “A” or higher to issue a Documentary Letter of Credit. </li></ul><ul><li>Mode of payment when selling to an unknown or high risk customer. </li></ul><ul><li>Advantages </li></ul><ul><li>Assures payment to seller provided seller complies with the terms of the L/C. </li></ul><ul><li>Seller does not have to obtain relief from automatic stay in event of a bankruptcy. </li></ul><ul><li>In the event of a preference action, courts generally do not view drawdown as a preference. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Seller may give up competitive advantage by asking for a Documentary L/C. </li></ul><ul><li>Documents must be carefully prepared and reviewed by A-B Legal. </li></ul><ul><li>If L/C is revocable, it is subject to modification without consent of seller. </li></ul>5
    7. 7. Credit Insurance <ul><li>Definition </li></ul><ul><li>Insurance policy that a creditor can purchase from a financial institution. Insurance policy may provide protection to the policyholder from A/R losses following a customer bankruptcy or payment default. </li></ul><ul><li>Applications </li></ul><ul><li>Buyer has weak credit rating or minimal credit information available. </li></ul><ul><li>Substitution of insurance company credit for that of the customers. </li></ul><ul><li>Advantages </li></ul><ul><li>May provide protection to seller in event of a sudden bankruptcy of customer. </li></ul><ul><li>Credit protection may be obtained without contacting customer. </li></ul><ul><li>Provides information about the ongoing creditworthiness of a covered customer. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Loopholes in insurance policy may subject buyer to risk of non-payment of claim. </li></ul><ul><li>Policy holder usually has to pay deductible before making claims on policy. </li></ul><ul><li>Various conditions in policy regarding communication with insurance company and documentation of claims may be difficult to adhere to. </li></ul><ul><li>Policy usually allows insurance company to reduce or cancel coverage on a customer with very short notice. </li></ul><ul><li>Only covers a customer’s inability to pay, not unwillingness to pay. </li></ul><ul><li>Catastrophic credit losses may not be covered because of cap on liability amount. </li></ul><ul><li>Small losses also may not be covered because the insurance company may not consider them as qualifying towards the deductible. </li></ul>6
    8. 8. Certificate of Deposit <ul><li>Definition </li></ul><ul><li>A CD issued by customer’s bank in the name of the creditor, or creditor may hold the customer’s deposit to reduce the risk of non-payment on a credit sale. </li></ul><ul><li>Applications </li></ul><ul><li>Buyer has unacceptable credit rating. </li></ul><ul><li>Advantages </li></ul><ul><li>Cash is available for the seller to drawdown in the event of non-payment by buyer. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Seller may give up competitive advantage due to ill will created by tying up customer’s funds. </li></ul><ul><li>In the event of bankruptcy, the creditor would need to obtain relief from the automatic stay imposed by the courts to drawdown funds. </li></ul>7
    9. 9. Payment Guarantee <ul><li>Definition </li></ul><ul><li>Customer’s obligation to creditor is guaranteed by a third party (individual or other business entity). </li></ul><ul><li>Applications </li></ul><ul><li>When the financial position of the customer is not strong enough to warrant open credit terms. </li></ul><ul><li>Customer order exceeds pre-defined credit limit. </li></ul><ul><li>Advantages </li></ul><ul><li>Facilitates the shipment of goods based on credit standing of a third party </li></ul><ul><li>Guarantee may be used by seller to force the customer to pay by threatening to pursue guarantor. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Guarantor may not have sufficient assets to back all guaranteed claims. </li></ul><ul><li>Seller may be forced to initiate legal action to enforce payment guarantee. </li></ul>8
    10. 10. Purchase Money Security Interest <ul><li>Definition </li></ul><ul><li>Goods are shipped to the buyer and title passes, but the seller perfects a lien against the goods and proceeds from the sale of the goods through UCC filing. </li></ul><ul><li>The seller must execute a security agreement describing the goods and the lien must be perfected via timely filing of the UCC documentation and notification of the PMSI to pre-existing lien holders of the customer’s inventory. </li></ul><ul><li>Applications </li></ul><ul><li>When financial position of the customer is not strong enough for open credit terms. </li></ul><ul><li>Advantages </li></ul><ul><li>Supplier receives a first priority security interest and lien in and to the goods financed by the customer’s credit regardless of whether other creditors have filed financing statements prior to the purchase money creditor. </li></ul><ul><li>If customer goes bankrupt, the PMSI creditor is given a priority in the inventory over unsecured creditors. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Documents must be carefully prepared and care must be exercised in filing UCC statements and advising other creditors in order to assure a perfected security interest. </li></ul><ul><li>To foreclose on collateral in the event of a bankruptcy, creditor has to seek relief from automatic stay. </li></ul><ul><li>Record keeping and tracking of inventory is very cumbersome. </li></ul>9
    11. 11. Conclusion <ul><ul><li>Credit protection allows for prudent management of credit risk. </li></ul></ul><ul><ul><li>Best protection is cash in advance or cash with order. </li></ul></ul><ul><ul><li>Next best is Irrevocable Standby Letter of Credit from an “AA-” or above rated bank followed by a Documentary Letter of Credit. </li></ul></ul><ul><ul><li>Credit insurance is not a good tool for protection of credit risk because of several loopholes in policy language, including the insurance company’s ability to reduce or cancel credit limits on any customer at any time. </li></ul></ul><ul><ul><li>Payment guarantees from individuals also cannot be considered a good protection tool unless they are backed by collateral. </li></ul></ul><ul><ul><li>Open credit with a high limit should only be granted to known and reliable customers who pay in a timely manner. </li></ul></ul><ul><ul><li>Credit terms should not normally exceed Net 30 days unless specifically approved by Treasury. </li></ul></ul>10

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