Credit risk: what is it and how do you manage it?
Estimated reading time: 4 minutes
Credit risk is the risk of financial loss a company may suffer when a client isn’t capable of meeting his or her obligations related to invoices., Well thought-out credit risk management is essential to avoid not being paid (on time) and to ensure a good cash flow and the financial health of your company.
What is credit risk?
Credit risk refers to the risk of financial loss as a result of any party failing to comply with certain terms and conditions of a contract. It means there is a chance (a risk) that you, as a supplier of goods or services, will not receive a client’s payment (on time). For suppliers, this usually means cash flow interruption and increased costs of collection.
Credit risk usually occurs because of a client’s inadequate income or business failure. More rarely, credit risk occurs deliberately, when a client refuses to meet its obligations, despite having adequate income.
Types of credit risk
Credit risk usually is split up in three different types: credit default risk, concentration risk and country risk. Each type has its own specifications and requires its own approach.
Credit default risk means that a client is unlikely to meet its payment obligations (in full), or that it takes a client more than 90 days to pay his or her invoice. It is therefore the most common type of credit risk. An interesting fact? This form of credit risk not only occurs in companies, banks also often experience this problem. Think of people who can no longer repay their loans.
Concentration risk, on the other hand, is associated with payments needed from a single counterparty, sector or country. The risk arises from the observation that more concentrated client portfolios are less diverse and therefore the returns on the underlying assets are more correlated. It has the potential to produce large enough losses to threaten a company’s core operations.
Ultimately, we speak of country risk when there is a risk of loss arising from doing business in countries that are sensitive to situational changes that adversely affect profits or value assets. Although this risk is sometimes referred to as “political risk”, we prefer the more general term of “country risk”, referring to risks that affect everyone within or involved with a particular country. Nevertheless, this type of risk is prominently associated with the country’s macroeconomic performance and its political stability.
Credit risk analysis
The best way to estimate in advance whether or not your invoices will be paid is to calculate the credit risk – to analyze it. This credit risk analysis will give you an idea of your client’s ability to pay the due amount. In other words, it measures their credit worthiness.
A popular method for the analysis of credit risks is using the five C’s:
- The first C stands for character, i.e. the character or reputation of the client, which examines to what extent the client is known as a good or bad payer.
- Capital – or leverage – comes second and is only interesting for banks. As a company, you can therefore skip this entire step. Capital is involved when a client chooses to take a loan without investing capital, expecting the final profit to be greater than the additional interest costs to the bank.
- The third C refers to a client’s capacity to pay their invoices. It looks at the volatility of the client’s income: Does it remain stable and sufficient enough to be able to pay invoices?
- Another C is the client’s conditions, namely the working conditions in which the client is active: What is his or her main activity?
- Ultimately, collateral must be considered, whatever pledge the client uses to ensure paying the invoice. Think about the client’s office building or warehouse stock, for example.
Credit risk management
The survival of a company depends on the way in which the credit risk is managed. But traditional methods of credit risk management are often very time-consuming, which means that the risks are often not assessed on time or sometimes not assessed at all. At iController, we therefore rely on artificial intelligence (AI).
The iController software collects customer interactions, after which AI automatically analyses the credit risk and provides bite-sized recommendations. Are you curious about the difference AI can make for your company? Quickly request your free demo.
Is your credit risk management going fine, but are you looking for other ways to secure your cash flow? Then read our blog about DSO – Days Sales Outstanding.