Sunday, December 20, 2009

A Comment on Risk

I heard a marketing presentation not long ago in which it was asserted that that “only three-tenths of 1% of invoices ultimately go unpaid”. The unspoken but implied conclusion was that buying invoices involves only minimal risk.

I asked for the source of the statistic quoted and was told that it came from the Credit Research Foundation. I contacted the CRF and obtained a copy of the quoted report, which is entitled “National Summary of Domestic Trade Receivables: 2008 Annual Bad-Debt Report”.

The top-line analysis is provided in two statements:

1) “Net bad-debt write-offs during 2008 totaled $30.00 per $100,000 of sales. This is a net change of $0.00 over 2007, and

2) Allowance for uncollectables during 2008 was 1.00% of receivables. This is an increase of .50% over 2007.”

(Not to be picky, but $30 per $100,000 is actually three one-hundredths of one percent, not three-tenths.)

A few observations:

• The number of respondents to this survey was 555. It is not clear how large a part of the overall economy this sample represents.

• The figures quoted in the summary statements above represent the median responses.

• While the write-off figure did not increase in 2008 over 2007, the allowance taken in 2008 was double that of 2007.

• In the case of the write-off figures, the upper-quartile break-point of the sample was at .19%, or about 6 times the median level.

• In the case of the allowance for uncollectables, the upper quartile break-point was at 3% of sales---100 times the level of the median write-off reported!

So you can choose to highlight the finding that the median write-off remained the same from one year to the next. Or you can take note that the expectation of losses, captured in the allowance figure, increased by 100%.

Or you can acknowledge that the upper-quartile, forward-looking statistic is 100 times the median backward-looking statistic.

The waters might not be as placid and shallow as they appear!

There’s another source of data that is more relevant to the operation of The Receivables Exchange. It is collected by The International Factoring Association. For 2008 this data represented the experience of 120 companies in the factoring business.

• The median write-off experience of that group in 2008 was .3% of gross invoices purchased, 10 times the median of the CRF sample. The average write-off experience was 1.3% of gross invoices purchased, more than 4 times the median.

• The IFA presents results broken down by size of respondent. The largest companies providing data; those with $100 million or more in gross receivables purchased; had the lowest loss experience, at .6% of invoices purchased. The smallest companies, buying less than $5 million per year, had an average loss experience of 2.5% of gross purchases.

• These figures, from companies actually involved in the industry, are far higher than those reported by the CRF. But more importantly, I think, these figures represent the experience of companies that KNOW the risks of buying invoices and take all of the normal precautions against losses.

I’ve detailed in other posts the ways in which the Exchange’s practices in qualifying Sellers, in obtaining security and in verifying invoices fall short of those in common use among buyers of individual invoices. (I've also pointed out some unusual benefits of the TRE process as well, however.)

I’ve argued that the TRE Buyers are exposed to incremental loss levels because of those shortcomings in risk mitigation.

It’s too soon to say what level of incremental return should be required by TRE Buyers to adequately offset the added risk.

It is not too soon to say, though, that the increment should be added to the IFA experience, not to the much lower CRE numbers.

And I would argue that the baseline point of the analysis should not be the experience of the largest companies but rather of the smallest, recognizing that the majority of TRE Sellers would not qualify for funding by the largest factoring companies.

We've all heard the one about the guy who drowned in a river that was only 6 inches deep, on average! Some statistics can be correct and irrelevant. Some can be correct and dangerous.

It's only coincidental that the first three letters of Treasuries, are TRE. We're not buying Treasuries here!

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