Any time you provide a product or service to a client and later invoice them for payment, you undertake a risk that you won’t be paid. Effective credit risk management is imperative to the success of your business.
What is Meant by Credit Risk?
When you invoice clients at a later date after providing goods or services, you take a risk that the client will not pay on time or default on payment. This can disrupt your cash flow and reduce your profit.
Taking a risk by extending credit is not necessarily a bad thing. By doing so, you can encourage a client to spend more with your company or stand apart from competitors who don’t offer credit. But you should extend credit only when you have effectively assessed a potential client’s creditworthiness.
Businesses that are considered high-risk include those that are relatively new, those that have no credit history or those that have poor credit ratings. In addition, certain industries are considered high-risk for financial failure. Visit our Sector Risk page to get up-to-date analysis of credit risks by industry.
What Are the Different Types of Credit Risk?
Typically, credit risk falls into three categories:
- Credit default risk refers to the chance that a client will not pay your invoice. Any time you provide goods or services and invoice for them later, you undertake a credit default risk.
- Concentration risk refers to extending a high amount of credit to one large client or to a group of clients whose invoices represent a significant part of your revenue. A high concentration risk exposes you to losses that could significantly impact your cash flow management.
- Country risk refers to the exposure your business takes when doing business internationally. Country-specific credit risks are affected by fluctuations in currency exchange rates, economic or political instability, the potential for trade sanctions or embargo, or other issues. These are all factors that can negatively impact the business environment and cash flow in and out of the country where you do business and play an important international risk management.
What Factors are Used to Assess Credit Risk?
Before you do business with a new client, you want to be confident in their ability to pay what they owe on time, every time. When assessing clients’ or potential clients’ credit risk, there are several important factors to consider.
- Financial health and flexibility: Businesses that demonstrate financial soundness, adequate capital, and a record of being able to raise capital as needed are usually lower risk. Signs of stress in a business’s past (especially recent) financial performance, including cash shortages, poor sales growth, declining revenues, closed locations, missed payments, and trouble raising capital may raise red flags for a higher-risk client.
- Payment history: By running a business credit report, you can uncover a client’s ability to pay invoices based on its payment history and public records. Financial data like annual sales, invoice activity and credit limits over several years, legal judgements and collections activities, and a business credit score are also part of the report and offer insights into how low- or high-risk a client may be for non-payments.
- Business stability and diversity: Examining a client or potential client’s revenue stability, liquidity, debt-to-equity ratio, profit margins, and return on investments (ROIs) can offer important insights about its stability and likelihood to pay on time. A business with a diverse revenue stream, customer base, geography, and industry classification may be better able to weather fluctuations.
- Industry risks: A potential client facing significant industry risks is also more likely to be a greater credit risk. Looking at industry-specific regulations and policies, economic trends and volatility affecting that industry, the level of competition in that industry, the growth rate of the industry, and its importance to the overall growth of the economy are important points to consider.
- Country risks: Economic, political, and business risks unique to a specific country which might result in unexpected investment losses are an important consideration when assessing an international client’s credit risk.
- Business news: Looking up a potential client can offer helpful insights on stability and risk. If the business is winning awards, opening new locations, hiring, receiving lots of complimentary customer reviews, and is the subject of other positive news and accolades, it is more likely to be stable and low risk. If there are investigations, negative reviews or news articles, layoffs and closures, and other negative news being reported, the business is likely a risky prospect.
What is Credit Risk Management?
Business credit risk management is the actionable plan you use to guard against late payments or defaults. It helps protect your business’s cash flow and improves performance. Business credit risk management is a continuous process of identifying risks, evaluating their potential for loss and strategically guarding against the risks of extending credit. Because risk management is proactive, it helps reduce the possibility of a default and its impact on your organization.
Why is Credit Risk Management Important?
Credit risk management is important because any business you choose to begin a relationship with or extend credit to poses risks to your business by default. If a client abruptly closes or is unable to pay a significant debt (or a series of smaller ones), your business loses revenue and may face damaging financial challenges that keep you from paying your debts or functioning at your normal level of efficiency. Effective risk management protects your business against defaults and bad debt.