Credit Risk

Credit risk is the potential loss that may occur if a borrower defaults on their loan. The failure to pay could result in the creditor not receiving the total principal or interest owed. This scenario contributes to greater financial and operational risk for creditors. Banks and other financial institutions invest heavily in measuring this type of risk. Vendors that allow customers to accept goods and services on credit should do the same.

What Is Credit Risk Management?

This risk management process includes the identifying, quantifying, and managing of credit-related risk. It’s a proactive way to limit exposure to bad debt and protect your organization’s bottom line.

A sound risk management system considers all aspects of your business, from customer history and financials to market conditions. It should also be flexible enough to adapt to changes in your industry and the economy.

Risk management aims to maximize the chances of getting paid while minimizing exposure to bad debt. To do this, you need to understand your customers’ ability to pay. You also need to monitor changes in the marketplace and adjust your policies accordingly.

3 Main Types of Credit-Related RIsk

Each type of risk requires a different strategy to mitigate. Consider the three main types below:

Personal Risk: This is the risk that a borrower will default on their loan because of personal reasons. Job loss, illness, or divorce are some common reasons this might happen.
Business Risk: This is the risk that a borrower will default on their loan because of business or operational reasons. Examples include poor sales, natural disasters, or competition from other businesses.
Country Risk: This is the risk that a borrower will default on their loan because of political or economic conditions in the countries they service. War, inflation, or currency devaluation are common examples.

How To Conduct Credit Risk Management

Risk inevitably accompanies every kind of business. While managers cannot avoid it, they can take action to reduce risk and its impacts on business solvency and operations. Below are some of the common tactics financial professionals use:

Diversification: You can reduce your exposure to risk by lending to different types of borrowers. For example, you can diversify by business size, industry, and location.
Stress Testing: You can test your lending portfolio against various economic scenarios, such as a recession or interest rate hike. This can help you identify problem areas and take steps to mitigate losses.
Collateral: You can require risky borrowers to put up collateral, such as property or equipment. Doing so could help you recoup losses if they default on their bills.
Credit Insurance: You can require high-risk borrowers to purchase credit insurance. This can help you recoup some of your losses if that borrower does not settle their bills.
Credit Scoring: This is an excellent example of credit risk assessment that you can apply to each borrower. Scoring models can help you make better-informed lending decisions so that you can price credit appropriately.

How A/R Automation Complements Credit Risk Evaluation

A/R automation provides real-time data on customer financials and payment history. This information can help you conduct credit risk monitoring exercises and make more informed lending decisions. Your team can then take action to reduce exposure to bad debt. A/R software can also automate the credit scoring model and centralizes the key performance indicators that help you track financial performance. Book your demo with Gaviti to see how it works.