Managing credit risk is an inherent part of doing business. Companies need to balance credit risk carefully in order to maximise their sales opportunities while remaining financially stable. Here, we explain what credit risk is, why it’s important and how it can be managed effectively.
What is credit risk?
Most businesses operate by enabling their customers to buy goods or services on credit and pay for them at a later date, which is defined by the payment terms of their agreement. However, this creates the risk that a borrower will not pay the amount owed – either in part or in full. The creditor may therefore lose the principal of their loan, or the interest attached to it. This risk is called ‘credit risk’.
Who is exposed to credit risk?
Any business that offers credit or loans to customers is exposed to credit risk. That includes trading businesses that provide goods or services, but it also includes banks, credit card providers, mortgage providers, utilities companies and bond purchasers, among others. Each of those lenders faces the risk that the borrower may default on their debt repayment.
Why is credit risk important?
It’s important for lenders to manage their credit risk because if customers don’t repay their credit, the lender loses money. If this loss occurs on a large enough scale, it can affect the lender’s cash flow. In turn, this could prevent the lender from reinvesting their money effectively – either in the business or their inventory. More damagingly, it could also mean that the company doesn’t have enough working capital to manage its day-to-day trading operations.
However, as we saw during the financial crisis – also known as the credit crunch – if a business’s credit risk exposure isn’t managed carefully, it can quickly lead to bankruptcy during a financial downturn.
Accurate credit risk management is particularly vital because of the interdependence of supply chains. If one part of the chain becomes insolvent and defaults on payments, this can cause a domino effect throughout the chain
The clearest example of this was seen during the financial crisis, when the endemic nature of credit risk was not accounted for sufficiently. As bankruptcy struck seemingly invincible financial organisations, government bailouts were needed to stem the contamination and protect the whole financial sector from widescale bankruptcy.
How is credit risk assessed?
Credit risk is assessed based on the borrower’s ability to repay a loan. There are different credit rating agencies for different types of credit risk. For example, consumer credit rating agencies are used to calculate an individual’s creditworthiness for a mortgage or bank loan. They take into account factors such as the applicant’s credit history, their financial security, their ability to make repayments, the conditions of the loan and the collateral associated with it.
Commercial credit rating agencies, like Moody’s, Fitch or Standard & Poor’s, provide credit ratings for business and countries, so investors can assess the risk involved in purchasing debt.
It’s important to know that ratings agencies calculate credit risk using different methods and scores, so one credit rating agency in the UK may provide a different score for a customer than their counterpart would. It’s also very difficult to transfer your credit rating with you if you move country, and so it’s likely you’ll have to build your credit rating afresh.
How does credit risk affect interest rates?
Generally, the higher the level of credit risk associated with a loan, the greater the likelihood of default. This means that a higher rate of interest will be charged in order to protect the lender’s income and capital. So, a mortgage applicant with a strong repayment history, credit rating and income flow will receive a better interest rate on their loan than an applicant with a mediocre credit history.
This applies to corporate debt too, as bond issuers with a low credit score need to provide investors with a high rate of return in order to encourage them to purchase their bonds, despite the greater risk involved.
How do you manage credit risk?
Credit risk management is an important function within any business, because it enables the business to maximise sales while carefully managing its risk exposure. There are a number of considerations involved, centred around deciding which customers to do business with and under what credit terms. The credit terms will include agreements about the credit limit, interest rate and repayment conditions, among other things.
Due diligence is a key part of credit risk management. It involves everything from running a credit rating check on a customer through to conducting a director search, analysing financial statements, assessing trade payment data and even researching the customer’s reputation within their supply chain.
Depending on the size and capability of the organisation, credit risk managers may use outsourced solutions to assess credit risk. External credit rating agencies offer more sophisticated resources for analysing creditworthiness, and can draw on data from thousands of borrowers and lenders to assess how creditworthy a prospect is.
It’s important to remember that in today’s fast-moving business environment, a company’s financial health can change rapidly. So, it’s vital to monitor existing customers regularly, as well as new prospects. Not only can a company’s credit score decrease, it can also improve – offering new opportunities to optimise your business relationship.