Credit risk is the risk that you are not paid. When you make a sale, you expect to be paid. You have contractual terms, which you expect your customer will comply with. With regret, this is often not the case.
Credit risk is, however, not just about the risk that your customers fail to make payment on due date. It also arises in other parts of your business, as we shall see.
If a customer fails to meet an obligation or a payment on a loan or overdraft is delayed, then this is called being in arrears. Many firms go into arrears for a variety of reasons and often such amounts are eventually repaid with or without interest. At an extreme, there is a default and the amounts may or may not be lost.
To try to reduce the incidence of this, a credit assessment is undertaken of new and existing customers. In undertaking this work, their financial results will be reviewed and their credit rating considered. This might include, for example, taking information form a reputable credit rating agency. If full credit assessment is undertaken, then this will take into consideration the financial economic environment within which the customer operates. It will consider the following:
- The strength of the customer base
- The quality of the management
- The operational strengths of the business
- Its intellectual property
- The quality of its staff
- The history that the company has of financial success
- The market in which the company operates
- Its competitive pressures
- The impact of innovation on the likely success of the firm
Such issues will, of course, need to be considered, depending on the level of risk that the customer poses to the firm.
Credit risk also occurs in other areas. Failure of a major supplier can cause a company significant difficulty. Such suppliers might be providing a product which forms a major part of the company’s product offering. However, credit risk also occurs in the case of outsourced service providers. This would include software companies, lawyers and other suppliers. Increasingly, companies outsource more and more. The following is a list of a series of matters that might be outsourced, but of course, it is not likely to be complete.
The following services can be outsourced:
- Marketing
- Payroll
- Internal audit
- Debt recovery
- Legal and compliance
- Accounting
- Processing
- Systems development
- Systems administration
- Security
- Cleaning
- Logistics
- Warehousing
There is no limit to this anymore. Companies increasingly seek to focus on the areas where they add the greatest value and move the remainder to a firm that seeks to focus on delivery of this service as a specialist skill.
However, if the loss of such a supplier would be critical to the success of the company, then this will need to be factored in. Basically, all such firms should be credit assessed to ensure that their failure is properly assessed.
In such cases, the focus will be on the financial position of the firm, but another problem occurs. Smaller firms are generally private and consequently will either not have audited accounts or will have accounts that have been audited by what might be termed as smaller firms. Many such firms are advisors to the company concerned and provide advice on a range of other issues that might be considered to impact upon their objectivity.
In a private company, there is often a dominant individual who could remove all the available funds in the company without recourse to a third party. This position would not exist in a larger firm, which generally requires multiple layers of control. The consequence of this is that it may not be as possible to rely upon the accounts to the extent that the firm might wish to do so. Accordingly, in such cases, the company will often request details of the insurance that the company maintains, in part to mitigate this risk.
There is, in addition, credit insurance which will pay out and is generally based on a change in the rating of a counterparty. This might make sense for a major corporate credit exposure, but the cost would make it prohibitive in other cases.