Extending credit has become a normal part of trading in the business world. Companies today carry a credit risk when they extend credit to their customers and do not demand up front payment for products or services that they offer.
It has become expected that shipments of the items that they sell are received first or delivery of the product or service offered comes first, and the customer is billed later. Businesses often offer this service with terms of 30 or 90 days for payment. However the company is carrying a credit risk between delivery and payment. So how can this credit risk be minimised?
Minimising Credit Risk
Credit risk arises when there is uncertainty as to the other parties' ability to meet their obligations and the terms of the credit agreement. But this uncertainty can be reduced.
In assessing the credit risk to your business it is beneficial to consider these issues:
- Default probability
- Credit exposure
- Recovery rate
Default probability involves assessing the likelihood that your customer will default of its payment either over the life of the set agreement if it is a continual service or at a specific point.
Credit exposure involves assessing how large the outstanding obligation or payment will be in the event of a default. Recovery rate assesses what fraction of the exposure will be able to be recovered through settlement with the customer or bankruptcy proceedings.
There are many resources available however before it comes to this point. Using a debt collection agency is not an ideal way to mange the credit risk. If the money is recovered, it will not be before the debt management company has taken its share. Analysing the credit risk and managing the risk beforehand is essential.
Tools to Minimise Credit Risk
One way credit risk can be minimised is by the purchase of a simple but comprehensive credit report. CheckSURE offers full credit reports on all limited companies which provide a credit score and suggested credit limit for the company.
By purchasing a credit report and analysing the history of the company, financial information and county court judgements, you will have the information necessary to make an informed decision on extending credit.
This information can be particularly useful in establishing the terms of your agreement with them. For example a distributor selling to products to a troubled retailer could minimise the credit risk by tightening the terms of payment, to maybe 15 days. The distributor may even decide to demand payment in advance to reduce the exposure to risk and possible defaults on payment.
With the use of a credit report, even very small companies can lessen the credit risk. They are then less vulnerable to defaults and late payments that could severely affect their cash flow.