What is Credit Risk Management?
Many suppliers and manufacturers sell goods and services on business credit, also known as trade credit, invoicing customers for payment at a later date. Business credit risk management helps suppliers make those direct lending decisions based upon their customers’ financial health, which can indicate their ability to pay on time. Extending the appropriate amount of credit (known as a credit limit) to qualified buyers may reduce the risk of late payments or defaults, both of which can expose the vendor to financial challenges.
Business credit is an important financing tool for any company that chooses to buy directly from a supplier (especially when it wants to make ongoing purchases). Credit risk management is the practice of determining creditworthiness – assessing new and returning customers for risk of late or nonpayment. It’s important that suppliers perform their due diligence to manage the risks that come with extending business credit. After all, if a customer doesn’t pay, the balance to collections or be written off as bad debt, neither of which is desirable.
Understanding a Business’s Risk Profile
Access to accurate business data is crucial when assessing credit risk. Suppliers require customers to provide their business information as part of the credit application. Suppliers also often supplement the customer’s self-reported information by consulting business credit bureaus to familiarize themselves with a new customer. Here are some of the indicators that can be used to understand the level of risk associated with extending credit to a business:
1. Trade References: Vendors, banks, landlords, and other partners can report payment experiences to business credit bureaus. Trade references may highlight late payments or defaults on previous business debts and are valuable sources of information for suppliers to consider before extending trade credit. Trade references are a part of a business credit bureau’s credit report; however, self-reported trade references are typically required in a credit application. Companies know their customers are only going to submit positive references in the credit application, but it’s important to have these positive references to balance any detrimental references that may have been reported to a bureau.
2. Bank and Financial Information: All thorough credit applications will require bank information to confirm the relationship between the bank and the applicant. In addition, most credit applications ask for financial statements (though some don’t, for smaller lines of credit). According to the Credit Research Foundation, credit managers know that small businesses are more likely to submit financial statements prepared by the company’s management rather than ones audited by a CPA.
3. Internet Research: It’s highly likely a credit manager will perform a general web search on a new credit applicant. If the search reveals a local publication reporting that the applicant won an award or expanded their business, that works in the applicant’s favor. Other types of headlines, such as frequent management changes or recently shuttered stores, can signal trouble about the applicants’ financial health and ability to pay.
4. Business Credit Scores and Ratings: Business credit bureaus consider many factors when calculating a company’s credit scores and ratings. Statistical models compare a company’s performance to similar businesses in the same industry or region. The use of predictive analytics can reveal whether a business is underperforming or presents a higher financial risk. Applying these scores and ratings allows a company to minimize independent research and more quickly understand the risks associated with doing business with another firm.
Of course, trade references, public information, or business credit scores and ratings can also reveal encouraging information about a company. Either way, credit professionals should set credit limits based upon their confidence in a customer’s ability to pay. Of course, trade references, financial documents, or business credit scores and ratings can also reveal encouraging information about a company. Either way, business owners should set credit limits based upon their confidence in a customer’s ability to pay.
How to Make Business Credit Decisions
At a minimum, vendors need answers to two main questions before extending credit to another business:
- How likely is the business to default on a loan? This speaks to the company’s overall financial stability. If a business’s risk profile indicates that it’s financially stressed, credit managers may not want to extend any amount of trade credit for fear of taking on a bad business debt. Businesses that seem to be on a sound financial footing may be better candidates.
- How much trade credit should you extend? Even profitable businesses face upper limits on what they can afford to borrow on a revolving basis. Once a decision has been made to extend funds, the lending company determines a reasonable credit limit and repayment schedule based on its credit policy. Both aspects must align with the borrower’s ability to pay. Suppliers take a variety of approaches when setting trade credit limits. The dollar amount can be based upon a percentage of a borrower’s net worth, or the vendor may simply match what other businesses have lent and recouped.
Business Credit Management Solutions
There are a multitude of resources that help companies manage business credit risk. Major credit bureaus such as Dun & Bradstreet provide easy access to in-depth data and analytics that determine creditworthiness. Dun & Bradstreet provides business credit scores, ratings, and research to help companies manage credit risk. Its more comprehensive business credit reports feature multiple types of scores for risk assessment, as well as a recommended credit limit. Reports can be purchased individually or as part of a subscription (subscription solutions offer additional capabilities, such continual account monitoring and notification alerts that let you know when there are changes to a customer’s credit scores and ratings).
Companies that process a large volume of credit applications typically manage their accounts using more sophisticated credit risk management software and solutions. These types of solutions offer automated decisioning using credit scorecards, custom credit scores (based on the supplier’s risk tolerance), integrated online credit applications, and the ability to support international credit customers.
Business credit risk management is essential for making sound lending decisions and protecting cash flow. While it’s impossible to eliminate all risk, the wealth of data and risk management tools available to businesses can help them guard against outstanding bad debts and defaults.