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Credit Risk Management

What Is Credit Risk Management?

Many businesses extend credit to their customers. All credit comes with a certain amount of risk.

How the business analyzes, projects, and plans for that risk is credit risk management.

Not all customers are able, nor do they prefer, to pay in cash. Credit, which is the purchase of goods and services on the promise of payment at a later time, gives them more flexibility.

Most businesses will extend credit in some fashion to at least some of their customers. By extending credit, the business expands the form of payment options available to customers, and in doing so, increases the range of potential customers available to engage with the business.

Credit is also a good business practice because it extends goodwill and builds trust with customers.

In the perfect world, all customers will pay their outstanding bills on time and in full. In reality, this does not always happen. Some customers will not fulfill their payment obligations.

Businesses must have an effective process for managing the inherent risk that comes with the extension of credit. An effective credit risk management process helps the business maintain the viability of its credit policies and keep failed payments to a minimum.

In What Context Is Credit Risk Management Used?

Evaluating credit risk is an essential element of any credit management process. Any business that extends credit to its customers will have adopted such a process.

The credit management process will consist of credit policies that provide guidance to customers and the business for how credit is to be extended and managed. In implementing those policies, the managing director will determine a customer’s credit rating before credit is extended.

The business will also take a number of other factors into consideration when calculating the terms of credit extended to a customer, such as the strength of the product being sold and the financial strength of the customer. Determining the customer’s credit worthiness is where risk calculation is considered.

How Is Credit Risk Determined?

Credit risk is calculated to measure the borrower's ability to repay the debt according to the original terms provided by the business to the customer when the transaction occurs.

The terms of credit will also be defined in large part by the customer’s credit risk, or credit worthiness.

The business will make a determination about the customer’s credit worthiness before credit is extended.

Businesses will consult the credit reporting agencies to gain the necessary information to evaluate the customer’s credit risk. Payment performance, financial statements, and purchase patterns are factored into the overall evaluation.

To evaluate a customer’s credit risk, a business will typically look at what are referred to as the Five C’s:

  • Credit history, as reported by the credit reporting agencies, reveals the customer’s past patterns of behavior concerning the repayment of credit.

  • Capacity to repay refers to the customer’s ability to repay the credit that will be extended. This is based on a number of factors including income, assets, employment status, liabilities, and debt-to-income ratio.

  • Capital is a reference to the savings and other liquid assets that the customer owns which could be applied to the outstanding debt.

  • Collateral refers to any sort of asset owned by the customer which could be provided as security against default. An example would be a house on a mortgage loan or the vehicle in an auto loan.

  • Conditions of credit are a catch-all term that includes any circumstances that the business feels might have an impact on the customer’s ability to repay, such as the job market or how the customer intends to use the credit.

Many businesses also use credit risk models to determine a customer’s credit risk. These risk models employ various computerized statistical methods and information to project the potential credit risk of a customer.


Why Is Credit Risk Management Important?

Most businesses extend credit to at least some of their customers. Credit confers many benefits to the business and its customers, but it also carries risk.

Any business that extends credit must have comprehensive credit management policies and it must properly manage credit risk.

Managing credit risk helps businesses minimize their exposure to unreliable customers and to failed payments. It allows businesses to avoid spending too much money on collections processes, and it helps avoid uncollected payments or bad debt.

All business need cash to operate on a daily basis. Minimizing credit risk and bad debt helps ensure a healthy cash flow for the business, which ensures that it will remain competitive.

A healthy credit risk management process also helps some businesses, especially lending institutions, more effectively utilize interest rates on loans that are issued to customers.

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