I received a call in early December from a client who wanted my feedback on a new sales terms arrangement they were discussing with one of their customers for this new year. 
Our client is a mid-sized manufacturer of a unique plastic resin that is included in the subsequent manufacturing of all kinds of plastic products. One of those products includes plastic gowns worn by medical professionals while attending to patients in hospitals, especially those who might be sick with COVID-19.  
The customer has been purchasing from our client for about three years and they have seen their end customers, such as local hospitals, request significantly more and more gowns. Naturally, this in turn has resulted in more orders of the plastic resin to our client. 
Until the pandemic, orders were coming in monthly at around $30K – $50K, which were in line with the $50K credit limit. At the same time, payments were consistently coming in between 5-14 days after the net 30-day due date, which was not particularly worrisome. 
However, as the pandemic started to get rolling, orders increased two and three-fold, resulting in sales going way past the assigned credit limit. In addition, payments started to become considerably past due, reaching the 60-day point from the due date. 
Our client began to become concerned and so finally they and their customer tried to figure out a way for purchases to be made more safely and payments more timely. They looked into trying to obtain credit insurance or an accounts receivable put option, but those products had restrictions that didn’t apply to their needs and didn’t address cash flow. They also looked into non-recourse factoring, but unfortunately there too, it was difficult to locate a non-recourse factor for this particular transaction.
So, they decided to create their own insurance-rebate plan with each purchase that works like this:

If the customer makes a purchase, for example, of $100K, the actual invoice will contain an additional line item called “invoice insurance” of 10%, bringing the total invoice value to $110K. Upon receiving payment, the invoice insurance of $10K will be put aside and kept separate. As each purchase is made, 10% invoice insurance will be charged and again, upon receipt, be kept separately. Gradually, over the months, this invoice insurance amount will grow and by the end of the year, it will reach a significant amount. At that point, the client and customer will renegotiate what to do with this accumulated invoice insurance amount, which includes:

  • Leaving it there at that level as a way of insuring against the possibility the customer may default on future payments. 
  • Rebating the entire amount, with or without an interest, and continuing business without an invoice insurance requirement. 
  • Making modifications to the insurance-rebate structure that will accommodate changes in orders, the economy and other factors.

Although this kind of arrangement was a completely new approach to me, following below are the comments and advice that I gave to the client for your consideration: 

  • I applauded their creative strategy to try and make a difficult situation into a win-win-win arrangement for all parties involved. That is, the client (creditor) tried to structure sales more securely so that the customer was able to purchase more. This in turn would support the ability of the customer to manufacture the protective gowns and fulfill the demand from their local hospitals.
  • I encouraged my client to try and have their customer first pay off the current balance owed so they would be starting the new year with a clean slate. 
  • I advised my client to try and not exceed a $100K credit limit per month, or $150K for an A/R balance. I also strongly suggested that a 45-day payment term be adhered to. Since the customer’s end users were hospitals, which can tend to be slow payers, I felt the 10% invoice insurance amount would not accumulate and keep pace with what might be a ballooning A/R balance. 
  • I explained there will be a gap of several months before the accumulated invoice insurance amount would reach a level where it would sufficiently protect them against a payment default of the A/R balance. My client understood the risk but felt it was best to balance their ability to accommodate their customer, develop a long-term relationship, and minimize the impact that could result from a loss. 

This pandemic has probably brought out other kinds of creative and unique strategies to accommodate a customer’s needs. Some, like the one above, may not work for many credit managers and their companies. For others, this might just be another recipe to include in their own credit risk management cookbook.

This article was edited by Steven Gan.

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