Credit risk glossary: 10 key terms explained

Often used interchangeably with credit risk, default risk is more specific: it’s a type of credit risk and refers to the likelihood that a buyer may fail to pay its debt as agreed, while credit risk also covers concentration risk and sovereign/country risk.

Concentration risk arises when a large share of a company’s receivables or revenue depends on a small number of customers, sectors or markets. Concentration risk can also arise when different customers are exposed to the same economic conditions, meaning that a single event could affect several customers simultaneously.

Sovereign risk is the possibility that a government won’t be able to meet its financial obligations. Country risk is broader, covering political, economic or regulatory changes in a particular country that could affect a buyer’s ability to pay. Sector risk, meanwhile, refers to potential losses due to vulnerabilities associated with a particular industry, such as declining demand or rising raw material costs.

Probability of default is the likelihood that a buyer will fail to meet its payment obligations within a specific timeframe. Usually expressed as a percentage, PD is a key measure used to assess credit risk and inform decisions about extending credit.

Creditworthiness is a customer’s ability and willingness to make payment. Assessing creditworthiness involves examining factors like financial health, payment history and business outlook – an essential step in managing credit risk.

Payment terms, also known as credit terms, are the conditions establishing when and how a customer must pay for goods or services. These may include payment deadlines and penalties for late payment. A business remains exposed to credit risk until it has received payment.

Portfolio diversification is a credit risk management strategy that involves spreading risk across multiple customers, industries or markets to reduce concentration risk.

Overdue receivables are the amounts owed to a company by its customers that remain unpaid after their agreed due dates. Accounts receivable includes both overdue and current receivables, the latter referring to payments that are not yet past due.

Risk mitigation refers to measures businesses take to reduce their exposure to potential financial losses. These can include assessing a buyer’s creditworthiness, setting credit limits, diversifying the customer portfolio and using trade credit insurance (TCI) to protect against non-payment.

Bankruptcy is a formal legal process involving a buyer that is unable to meet its financial obligations. For a supplier, a customer’s bankruptcy may result in financial losses if the outstanding debt can’t be fully recovered. Assessing the likelihood of bankruptcy is therefore an important part of managing credit risk.