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Typically, companies will choose one of four strategies to reduce their exposure to credit risk. These include such things as self-insurance, factoring, letters of credit, and trade credit insurance.
1. Self-insurance is when a business sets aside funds to cover potential losses from credit risk.
2. Factoring is the process of selling an account receivable to a third party for a discounted rate.
3. Letters of credit are used to guarantee payment.
4. Trade credit insurance is a form of insurance that covers losses due to non-payment by customers.
These four methods are the most commonly used options for mitigating credit risk. Each method has its own advantages and disadvantages and businesses must choose the one that best suits their needs. Self-insurance is the simplest and most economical option, but it does not provide as much protection as other methods. Factoring and letters of credit provide more protection but can be expensive. Trade credit insurance provides the most protection but also carries the highest cost.