Bad debt protection or bad debt insurance is insurance that secures business owners from the financial loss that results when customers default on their invoice payments. It may also refer to instances where bad debt protection is used as an add-on service that is bolted to an invoice finance facility for protection against possible customer insolvency. Either way, bad debt protection helps to shield business owners from non-payment of invoices. It supplies them with a firm peace of mind since their chosen funder will cover them in such cases.
The full breakdown on bad debt protection
Numbers don’t lie. Annually, scores of businesses in the UK suffer from bad debt with their combined losses running into billions of dollars. For example, direct line for business reports that SMEs waived close to six billion pounds of debt between the year 2015 and 2016. On average, 20% of small business owners revealed to their funders that they had waived debts that amounted to more than thirty thousand pounds. A further 10% admitted they had lost hope and stopped seeking out customers who owed a total balance exceeding one hundred thousand pounds.
The bottom line is non-receipt of payments is a serious threat that sees more than 50% of small businesses failing to reach their five-year trading mark. Bad debt can stem from many factors on the customer’s side. The number one reason is usually insolvency. In some cases, long payment delays, or defaults also create a cash flow crisis that can cause a business to go belly up. Without sufficient working capital or bad debt insurance and no matter how profitable business may be, all it takes are a few substantial unpaid invoices to derail the whole operation off course.
Advantages of bad debt protection
Bad debt protection allows a business to hand over their bad debt risk to a finance provider and it offers the following advantages:
- It ensures businesses will not lose money from their coffers should bad debt come knocking on their door.
- In as little as 24 hours a business can have reliable bad debt protection with an option to backdate some debts.
- It gives businesses the guarantee they need when dealing with customers they are not entirely confident will honour payment terms.
- It provides reliable cover that eases a business owner’s worries, especially if the business has encountered bad debt before.
- In cases where a small client base corresponds to the largest portion of a business’ total sales, bad debt protection is a much-needed option.
- Businesses get help in evaluating the risk posed by their new and existing customers. Their factor or invoice discounting provider assists them by conducting credit checks and advising them on the customer approval process, thus lessening their vulnerability to bad debt.
- The process provides flexibility since businesses can opt to cover some customers but not others. Assessment of customers provides a considerable measure of assurance that gives businesses the firm footing they need to engage more customers and expand their operations without worrying about non-payments.
While bad debt protection helps to control risk, it can have a few downsides:
- Some factors or invoice discounting services do not offer non-recourse services.
- Those that do often have a steeper price that is usually a percentage point higher.
- Non-recourse factoring or invoice discounting is sometimes limited to low-risk customers. High-risk customers with poor credit history, for example, may not be approved.
- In some cases, providers stipulate they can only cover the business if the non-paying customer has gone bankrupt. Hence, non-recourse factoring or invoice discounting is not a fool-proof way to secure against non-payments of invoices.
What’s the procedure for non-payment?
The provider usually takes over at this point, ensuring the business owner doesn’t expend unnecessary effort negotiating with the customer. If the customer becomes insolvent, for example, the provider simply hashes it out with the insolvency practitioner. When all the required documents are in place, the matter is quickly settled, and the business can retain its profits and the money needed to keep the cogs in that business oiled and running smoothly.
Calculating the cost of bad debt protection
Many factors need to be applied in this calculation, primarily the type of provider, the period of cover and the level of finance involved. Typically, bad debt protection does not provide immediate cover after the factoring as the funder requires a specific timeframe to cement trust.
Usually, the provider covers at least 90% of the invoice. As an example, with a net invoice of £70,000 inclusive of VAT, £63,000 is paid for under the bad debt protection agreement while £14,000 of the VAT can be recovered from HMRC.
If an administration fee of £1680 is subtracted, the total recovered amount rounds off to £75,000.
Main characteristics of bad debt protection
- Businesses relieve themselves of bad debt risk
- It can cover all customers leaving a business with zero bad debt risk
- Provides an option to cover hand-picked customers or all of them
- Offers comprehensive credit checks on new and existing customers
- The provider takes care of all the processes involved with bad debt protection
- The provider takes over management in case of non-payment, saving the business a lot of resources
Four ways to protect your business from bad debt
- New clients should always have their credit history thoroughly assessed.
- Use your customer’s background and level of risk to establish a suitable credit limit.
- You can add bad debt protection as a product bolted to an invoice finance facility if you are using invoice finance to increase your working capital cycle.
- If your business sector involves many risks or you’re having payment difficulties with some of your customers, applying for credit insurance is a safe bet for you.