Making good credit decisions is fundamental to mitigating risk and protecting your business. If your customers cannot pay their bills on time, it can negatively affect cash flow and your ability to do business. The same goes for your suppliers. If they are struggling financially, they may not be able to deliver the materials and goods you need to run your business effectively.
As your business grows, credit risk management becomes more complex. Juggling different customers and different suppliers across different industries can be challenging. Without a robust credit risk management framework, your business is vulnerable to defaults, fraud, and other financial losses.
Credit risk management helps you safeguard your business, maintain financial stability, preserve trust with your partners, and manage your margins. So, let’s explore credit risk management, the best practices to minimize risk, and what we can learn from financial institutions that manage huge portfolios of loans.
What is Credit Risk Management?
Credit risk management is the process of identifying, assessing, and mitigating the risks that can arise when a customer fails to meet their financial obligations. These risks can take various forms, from customers defaulting on loans to suppliers being unable to deliver products due to financial distress.
The most common types of credit risk include:
- Default Risk: Borrowers are unable to make required payments on a loan or credit agreement.
- Counterparty Risk: This occurs when the other party in a transaction fails to meet contractual obligations, which is particularly common in financial markets.
- Concentration Risk: This risk arises from overexposure to a single party or industry. If that sector experiences financial difficulties, you can suffer considerable losses.
For businesses of all sizes, managing credit risk is crucial.
Whether you are dealing with large-scale contracts or everyday transactions, credit risk lurks in various business relationships. Businesses extending credit to customers can face severe financial strain if customers fail to pay invoices on time.
S&P Global forecasts credit defaults to hit 5% this year—historically high marks, so credit risk management is an essential practice for any company that extends or receives credit.
Why is Credit Risk Management Important?
If you extend credit to customers, credit risk management serves as the foundation for your financial stability and overall health. Without it, you are vulnerable to numerous threats that could derail your growth or, in the worst cases, lead to insolvency.
Here’s how:
Financial Stability
Your ability to weather financial storms largely depends on your risk management practices. Effective credit risk management can help you maintain liquidity and avoid cash flow disruptions caused by defaults or delayed payments.
Delinquency rates in 2024 are on the rise and at their highest point since 2015, according to the Federal Reserve. By understanding the creditworthiness of your customers and suppliers, you can make better decisions regarding who to do business with and under what terms.
Fraud Prevention
Credit risk management is a powerful tool for detecting and preventing fraud. With the rise of digital transactions and global business operations, companies must be vigilant about fraudulent activities. CFO Dive reports that payment fraud has hit more than half of all businesses; 53% of companies report they have been hit with up to six fraud cases within the past year, and half of those saw an impact of 30% or more of their total revenue.
Credit risk assessment processes can help you identify potential fraud or business identity theft and minimize exposure to such threats.
Reputation and Trust
Your reputation is invaluable in the business world.
Engaging in poor credit practices threatens your bottom line and your relationships with partners, investors, customers, and suppliers. Responsible credit risk management builds trust and long-term partnerships. Other businesses are more likely to collaborate with organizations that manage their risks prudently.
Best Practices in Credit Risk Management
Implementing an effective credit risk management framework is crucial for mitigating potential losses. Here are some best practices businesses can follow to protect themselves:
Developing a Risk Management Framework
Establishing a structured framework is the first step in controlling risk. This framework should include clear policies and procedures, such as defining acceptable levels of credit exposure and outlining the steps for evaluating creditworthiness. Importantly, the framework must align with your credit tolerance and strategic goals.
Clear Policies and Procedures
You should document how you assess, manage, and monitor credit risk. This includes specifying roles and responsibilities within your organization, creating escalation protocols for overdue accounts, and ensuring compliance with relevant regulations.
Terms and conditions should be consistent and transparent so that when you extend credit, customers understand the expectations. This helps avoid disputes down the road.
Alignment with Credit Tolerances
Your company’s credit tolerance should dictate how much risk you are willing to accept. This means understanding how much potential loss the company can handle without jeopardizing operations and setting limits accordingly.
A mistake companies make is not reviewing their risk tolerance over time. As economic conditions change, it is easy to fall out of compliance when you take on more credit risk. A shift in a large customer’s industry, for example, can change your overall exposure.
Data-Driven Decision Making
The most successful businesses are those that use data to inform their decisions. Data analytics allows you to assess and forecast credit risks more accurately. By using credit scores and other data found in business credit reports and consumer credit reports for small businesses or independent contractors, you can make better decisions.
Business Credit Reports
Business credit reports provide an overall credit score to help you assess risk. They also provide essential data on a company’s creditworthiness, enabling you to assess the likelihood of getting paid on time and in full.
Data analytics tools help track key credit-related metrics, such as:
Credit Ratings and Risk Scores
Business credit reports include an overall credit rating or risk score that provides a quick snapshot of a company’s creditworthiness.
These scores are typically calculated based on factors such as payment history, outstanding debt, and the number of inquiries made on the company’s credit. A low score can indicate a higher risk of default.
Days Sales Outstanding (DSO)
This metric measures the average number of days it takes for a company to collect payment after a sale has been made. A high DSO indicates that a business is taking longer to collect its receivables, which may signal cash flow problems or inefficiencies in its collections process. Tracking DSO through credit reports helps you to identify customers or suppliers that may be struggling with liquidity, thus raising potential credit risk concerns.
Credit Utilization Rates
Credit utilization refers to how much of a company’s available credit is being used at any given time. A high credit utilization rate might indicate that a business is overleveraging itself, potentially leading to financial instability. Monitoring this rate through business credit reports helps you understand how dependent their partners are on credit for day-to-day operations.
Payment Trends
Business credit reports provide detailed insights into a company's payment history and trends. This includes whether a business has a history of paying on time, late, or not at all. A pattern of late payments can be a warning sign, signaling potential cash flow problems or an unwillingness to meet obligations promptly.
Identifying a deteriorating credit score or worsening payment trends early gives you time to take corrective action, such as adjusting credit limits or renegotiating payment schedules to reduce the likelihood of a credit default.
Public Records and Legal Filings
Business credit reports also provide access to public records such as bankruptcies, liens, or judgments against a company. These legal filings are critical indicators of a business’s financial stability—or lack thereof. The presence of recent bankruptcies or legal disputes may signal that the business is in financial turmoil and could be a high-risk partner.
Industry Benchmarks
Some business credit reports offer insights to compare a partner's financial metrics against industry averages. This comparative analysis helps you understand how well your partners are performing relative to peers in the same industry.
For example, if a customer’s DSO is significantly higher than the industry average, it may indicate a growing credit risk that requires closer attention.
See all of the data you can get from business credit reports.
Continuous Monitoring
Risk is not a static concept. A company’s financial health may be strong when you extend credit, but it evolves over time. As market conditions change, you need to update your credit risk profiles regularly.
By continuously monitoring the financial status of clients and suppliers, you can quickly react to any changes that may indicate increased risk. A sudden dip in a customer’s financial health might signal the need to reassess their credit terms.
Strong Relationships
Maintaining strong relationships with customers and suppliers is another critical component of credit risk management.
When you have strong relationships, you can work together with customers or suppliers who may be struggling financially. You can often find solutions such as flexible payment terms to help customers recover while keeping the business relationship intact.
Strategies Financial Institutions Use to Manage Risk
Financial institutions are leaders in credit risk management and employ comprehensive strategies to mitigate risk. You can learn from these approaches and adapt them to your business.
Credit Scoring Models
Credit scoring models are used by financial institutions to assess a borrower’s likelihood of default. They analyze various factors, such as revenue, debt levels, credit history, and payment behavior to assign a score that predicts creditworthiness.
Risk Mitigation Tools
Banks and other financial institutions often use tools like collateral, guarantees, and insurance to reduce exposure to credit risk. Collateral provides security in case of default, while guarantees shift the risk to a third party.
Within your credit terms, you can require deposits, cash in advance, collateral, or personal guarantees for businesses you deem as higher risk.
Diversification
Financial institutions spread their risk by diversifying their loan portfolios. They avoid over-concentration in any single sector or geography, reducing the chances that an economic downturn in one area will impact their entire portfolio.
You can practice diversification by monitoring your industry-specific credit to avoid economic downturns that can hurt your credit portfolio.
Stress Testing and Scenario Analysis
Banks also use stress tests to assess how their portfolios would perform under various adverse scenarios, such as a sudden economic downturn. Scenario analysis helps them prepare for and mitigate the impact of these risks.
Businesses should also use these tools when evaluating their credit risk. Look at the direct impact on your cash flow, working capital, and bottom line in case a particular customer defaults or industry sectors suffer a significant financial downturn. Such stress testing can avoid serious problems in case of economic changes.
Building a Resilient Business
The success of businesses depends in large part on how well you manage and mitigate your risks. With a solid credit risk management strategy, you can navigate financial challenges and build a more resilient business.
Frequently Asked Questions—FAQs
What is credit risk management?
Credit risk management involves identifying, assessing, and mitigating risks associated with a borrower failing to meet financial obligations.
Why is credit risk management important?
Credit risk management is essential for maintaining financial stability, preventing fraud, and preserving a company’s reputation with stakeholders.
What strategies do financial institutions use to manage risk?
Financial institutions use credit scoring models, collateral, guarantees, insurance, and diversification to mitigate risk.
How do banks manage credit risk and interest rate risk?
Banks integrate both types of risks into their management processes, using stress testing, scenario analysis, and loan reviews.
What do model risk managers do at banks?
Model risk managers validate, update, and maintain the accuracy and compliance of credit risk models.
Command Credit provides business credit reports, consumer credit reports, background investigations, and fraud solutions to help you run your business more effectively. Contact Command Credit to learn more about credit risk management solutions or call us at (866) 703-2831.