We know that with receivables, there is always a risk that an entity may not be able to collect the amount receivable. This risk is called the credit risk. To minimize the loss due to default, companies often obtain some form of security in the form of collateral. Term collateral refers to some asset that an entity accepts as a security from the other party. Collateral is seized and sold to make up for the loss suffered by the company if the debtor defaults in paying the amount due to the company.
Based on the presence or absence of such collaterals, receivables are classified into two categories.
- Secured receivables
- Unsecured receivables
A receivable that is backed up by some collateral is known as secured receivable. In case of default by the debtor, collateral is seized and sold to make up for the credit loss.
By obtaining collateral from debtors, companies minimize their credit risk. However, insisting on obtaining collateral may limit the sales as the customers may prefer the company’s competitors who are offering credit sales without obtaining security.
Preferably, companies should try to obtain collaterals where the credit risk is high based on the customer’s credit history. In addition, for high value loans and receivables, companies should obtain collaterals and secure their receivables to minimize significant credit losses in future.
A receivable that is NOT backed up by some collateral is known as unsecured receivable. In case of default by the debtor, the company either suffers the loss or files a lawsuit against the debtor to recover the amount due.
Generally, trade receivables are unsecured as the company offers credit sales to customers that are well known, and the company is doing business with these customers for some time. Credit sales are offered to customers based on good creditworthiness. If a customer has a history of defaulting or not paying the amounts due on time, the company should either stop doing business with that customer on credit, or minimize its risk by demanding collateral to secure its receivables.