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Managing Credit Risk for Business Owners: A Comprehensive Guide

Ann Marie Smith

5/1/2024

As the owner of a small manufacturing company, John watched one of his biggest customers suddenly close its doors. The customer had been a long-time account but left John with $250,000 worth of debt. John was not able to pay his suppliers, resulting in late fees, and he nearly missed payroll for his employees. He had to take out a loan to cover the costs and put on hold a new project he was planning to launch.

At that moment, John fully realized the importance of credit risk management. If he had pulled a business credit report on his customer, he might have seen the warning signs of financial distress and been proactive in mitigating his risks.

Unfortunately, this type of situation happens more frequently than you might think. According to the U.S. Chamber of Commerce, nearly 600,000 businesses close every year. The number of bankruptcies has skyrocketed since the pandemic, rising by 40% in 2023 and continuing to escalate another 22% so far in 2024.

Many other businesses are struggling and they might not show any outward signs of trouble unless you look for them. Credit risk management and analysis are crucial to protect your business and make better decisions about extending trade credit to your customers.

What is Credit Risk Management?

Credit risk management includes the steps businesses put in place to protect themselves from losses in case of a customer’s inability to pay their bills. Credit risk management and analysis actively monitor credit risk, keeping a close eye on a customer’s financial health.

The Benefits of Credit Risk Management and Analysis

Effective credit risk management produces significant benefits for business owners, including:

Reducing Bad Debt

Evaluating customers before granting credit helps minimize the risk of non-payment or having to write off bad debt. This evaluation can also help business owners set credit limits or take other steps to limit their exposure.

Improving Cash Flow and Working Capital

According to SCORE, the number one reason businesses fail is lack of cash flow. If you do not have enough cash coming in to pay your bills, it puts you at severe risk. With a steady flow of payments incoming, however, you have the working capital you need to pay your employees and suppliers or fund new initiatives.

Improving Decision Making

Pulling a business credit report on customers can uncover the information you need to be more strategic about extending credit and mitigating your risk. You check out a customer’s financial health and payment history, evaluating your risk.

Compliance

Depending on your industry, you may be required to meet certain credit risk management standards. Failing to meet them might result in penalties and fines. Companies may also have specific risk thresholds and performance obligations they must meet.

Competitive Advantage

Effective credit risk management can be a competitive advantage. When you are confident you will get paid by your customers, you are more able to make investments and grow your business.

There is another consideration as well. When your business demonstrates financial discipline and you can present a healthy financial posture, you increase your ability to get credit from your suppliers or access additional capital through loans or investors.

What Are the Key Components of Credit Risk Management?

Five key components make up a credit risk management framework:

  1. Identify risk
  2. Measure and evaluate risk
  3. Mitigate risk
  4. Reporting and monitoring risk
  5. Risk governance

Identifying Risk

The first step of credit risk management is to identify the sources of potential risk to which your business is exposed. This involves considering the credit risk factors that could impact your entire customer portfolio as well as assessing the creditworthiness of individual customers.

Identifying Portfolio-Level Credit Risks

Business owners should take a comprehensive view to uncover the various risk factors that could affect their financial health. These include:

  • Economic environmental risks, such as industry disruptions or economic downturns
  • Market risk, such as new competitors or shifting customer behavior
  • Legal risks, such as changes to laws or regulations
  • Credit risks, such as customers' ability to pay

Assessing Individual Customer Credit Risk

It is also crucial to evaluate the creditworthiness of each customer before extending trade credit. This typically involves analyzing a customer’s business credit report to look at:

  • Overall customer risk scores
  • Credit and payment history
  • The customer’s ability to pay
  • Any outstanding liens, judgments, or bankruptcies

A rigorous approach to vetting new and existing customers enables you to make more informed decisions about credit limits, payment terms, and exposure. This customer-level risk assessment strengthens your larger portfolio risk management efforts.

Measuring and Evaluating Risk

When reviewing this information, business owners need to assess the potential impact of these credit risks. Commercial delinquency rates have trended higher over the past few quarters and are currently at their highest level since 2015, so business owners need to evaluate risk carefully—prioritizing customer-level risk in terms of the impact on the overall portfolio risk.

For example, if a particular customer defaults or does not pay their bill on time, what is the effect on your business? If it materially impacts your ability to operate, pay your employees, or get credit from your suppliers, you need to give it careful consideration.

Mitigating Risk

There are multiple strategies for mitigating risk. At the customer level, you can employ strategies such as:

  • Setting appropriate credit limits based on risk and exposure
  • Requiring down payments or progress payments
  • Adjusting payment terms for higher-risk customers
  • Asking for payment immediately upon delivery.

You might have different policies based on your evaluation. New customers with limited credit history or first-time customers, for example, might be asked to put down a deposit before work begins. Those with poor credit might be required to pay on net 15 rather than net 30.

Reporting and Monitoring Risk

An effective credit risk management framework is ongoing. By regularly tracking and reviewing credit performance, you can look for warning signs of trouble and adjust policies or practices based on what you see.

In a business credit report, warning signs might include:

  • An increase in late payments, missed payments, or accounts sent to collections
  • Increasing debt levels
  • Negative public records, such as liens or judgments
  • Drops in business credit scores
  • Changes in business size, such as staff reductions or layoffs
  • Significant changes to trade credit
  • Decreases in recommended credit limits
  • Changes in the financial health of parent companies

Risk Governance

Risk governance policies set the credit risk management framework policies for your business, based on your acceptable risk tolerance. Companies should follow their policies consistently to minimize potential losses.

Key aspects of credit risk governance include:

  • Clear roles and responsibilities: A well-defined structure should outline the requirements and who is responsible for credit risk assessment, approval, and monitoring.
  • Risk appetite: Your business should quantify the amount of credit risk you are willing to take on before it impacts your operations.
  • Policies and procedures: There should also be standards for credit risk assessment, underwriting, and portfolio management to ensure consistency.
  • Independence and expertise: While it may be more difficult in small businesses, best practices would include having the credit risk management function independent from sales to provide an objective evaluation.
  • Communication and reporting:  Regular reporting on credit risk exposure and trends is essential. Things can—and do—change quickly.

How often should credit policies be reviewed and updated? It is really up to you how often you review your policies. Most companies do at least an annual review as part of a portfolio review. Some businesses choose to update their credit policies more often, especially in fast-changing industries or in light of changes in the economy or money supply.

It is also a good idea to consider your policies and make any appropriate adjustments when you see regulatory changes that may impact your collection policies or ability to manage your credit risk management.

Other conditions that might trigger reviews and possible updates to your policies include:

  • Changes in your business or investment strategy
  • New competitors or pricing concerns
  • Increasing defaults or delinquencies
  • Changes in customer behavior impacting financial stability
  • Shifts in the broader economy or industry

What Are Your Six Options for Dealing with Credit Risk?

Any time you are lending money or making decisions about trade credit, you have six specific options:

  1. Risk acceptance: Acknowledge the credit risk and deal with any impact when it occurs.
  2. Risk avoidance: Avoid risk by not granting credit to a customer.
  3. Risk challenge: Take steps to interrupt or stop risk before it escalates.
  4. Risk prioritization: Identify high-priority risks and monitor them more carefully.
  5. Risk control: Define clear policies to evaluate risk and the actions to take when issues occur.
  6. Risk transference: Handoff risk to third parties, such as factoring or selling collectibles.

Which option is right for your business will depend on a variety of factors, such as economic conditions, your risk tolerance, and your current cash flow and working capital.

Business Credit Reports: Central to Effective Credit Risk Management

Business credit reports provide essential information about customers to help you make better decisions. The data in these reports is compiled from various sources to create an overall risk score.

You need to get permission to pull someone’s personal credit report. For a business, however, you do not need approval. You can pull a business credit report on any company whenever you want. Credit reports will provide information such as:

  • Payment history
  • Account details for various accounts
  • Outstanding debt
  • Days beyond payment terms (DBT)
  • Public records, including liens, judgments, and bankruptcies
  • Company information
  • Credit utilization

Business credit reports help verify business identity to ensure you are working with a legitimate business. Business fraud is increasing, so it is best practice to make sure you are dealing with the right party. Estimates from the Association of Certified Fraud Examiners (ACFE) show the average business loses about five percent of its total revenue to fraud each year. Details about the company’s owners, directors, and family tree can help you verify business owners.

Three agencies provide business credit reports:

  • Experian
  • Dun & Bradstreet
  • Equifax

Each company uses slightly different sources and provides different information, so you will want to review samples to decide which report is best for your needs. With Command Credit, you can pull business credit reports from any or all of these providers. You do not need to sign up for a long-term subscription or monitoring services with Command Credit. You can pull business credit reports on demand at any time. Simply verify the business, enter your payment details, and pull reports instantly.

View available business credit reports on-demand or contact the team at Command Credit for more information. 

Frequently Asked Questions — FAQs

What Is the first step in initiating credit risk management?

The first step is to thoroughly evaluate your customer base and identify potential sources of credit risk. Due diligence for new and existing customers to assess their creditworthiness and financial stability can help identify warning signs of potential problems.

Can technology eliminate credit risk for businesses?

While technology can streamline and improve your credit risk management, it cannot eliminate risk. An effective credit risk management framework requires a combination of tools and sound policies tailored to your business needs.

How do financial institutions assess credit risk?

Financial institutions utilize a comprehensive framework to analyze factors like credit history, financial statements, collateral, industry outlook, and management experience. They pull business credit reports to quantify default likelihood and its potential impact on their broader portfolio.

Should you want to meet regulatory requirements for credit risk?

At a minimum, you want to meet any regulatory requirements regarding credit. However, you may want to take additional steps to protect your business—whether it’s a requirement or not.

How do I set appropriate credit limits for my customers?

A thorough evaluation of s customer's creditworthiness, payment history, and business credit scores can help you decide on credit limits to keep your risk exposure in line with your policies. Some business credit reports also provide credit limit recommendations.

Get business credit reports from Command Credit as part of your credit risk management framework.