Credit risk is the lender’s probability of loss due to the borrower’s failure to meet obligations or make payments on any type of debt in accordance with agreed terms. It is the largest source of risk that most, if not all banking institutions face.
Businesses also find themselves in the same situation as banks when it comes to extending credit to their customers. They need to figure out the risk of non-payment when selling to other businesses. They also need to know whether they can rely on their suppliers to fill their orders so that they don’t disappoint their own customers.
Here’s the problem: receivables are not always paid on time. As a result, budget allocations may stagger and cash flow is tight - limiting available financial resources to cover a company’s expenses and potentially resulting in serious financial losses. These and limited financial management know-how are the reasons why banks are cautious in extending credit to SME.
This is why credit risk management needs to be made a vital discipline by all business entities.
Credit Risk Management
Credit risk management is the practice of reducing financial losses by holding credit risk exposure within acceptable parameters.
For instance, if you are a garment manufacturer that sells through retail outlets, you will find that few retailers will purchase your merchandise outright with cash upon delivery. To generate sales, you will need to offer selected customer-retailers 30, 60 or 90 days' credit depending on the prevailing practice in the industry
There is no problem if your customer pays. After deducting the costs and expenses, the profit can be used to buy new equipment or machinery, invest in company property or to expand. On the other hand, there are customers who are unable to pay on time despite repeated demands. These payment delays will translate to delays in paying your own suppliers and your ability to promptly deliver on your other customers’ orders. All these factors will negatively affect your own business’ credit rating and creditworthiness.
To minimize your credit risk,
- Get to know your customer, starting from the overall company down to the key people running it. Don’t just extend credit to anyone who asks.
- Define your credit policy and strictly set out payment terms.
- Encourage timely payment by regularly sending invoices and indicating penalty charges. At the same time, make sure that invoices are done right to avoid excuses and delaying tactics due to some error in your invoice.
If the other party refuses to pay despite repeated demands, then seeking legal services could be another option to ensure collection of the obligated compensation.
Why do you need to know your credit profile?
A credit profile contains necessary information you need about your company’s credit history including additional information on strategic plans you have for your company given certain expectations about the industry you’re in. It is used by banks and other lending institutions to determine your company’s creditworthiness and ability to repay debts. Internal funds, loans or borrowing from your friends and family will not always be enough for working capital let alone to expand your business.
As a business owner, establishing a good credit profile may not be at the top of your priority list. There are other important factors you need to focus on to get the business going. As your company grows, you need to consider establishing a good credit profile especially when you decide to apply for a business loan.
Did you know that you can also benefit from knowing a client’s credit profile? Knowing your company and your client’s credit profile also means –
- Helping you make sound business decisions with confidence
- Setting or extending credit terms that more accurately fit your needs
- Determining whether you can make a credit decision concerning new customers or if further investigation is needed
- Passing on potential customers whose corporate profiles reveal late payments or delinquencies
- Offering first-time customers a suitable line of credit
- Choosing reliable suppliers and partners
- Preserving and expanding business-to-business relationships by understanding changes in management and business condition
- Finding out if a supplier or partner is undergoing financial stress
- Avoiding surprises from current customers when you review them for credit increases
Marketing introduces and promotes your company’s product or service to potential customers. It is the heart of your business success and many aspects of your business will rely on successful marketing.
When it comes to Marketing (in relation to managing your company’s credit risks), it’s not as simple as offering promos, creating ads and employing social media. You need to target a specific demographic which is appropriate for your product. You’ll then have to further filter your marketing leads down to companies who are credit worthy and deserving of additional marketing expense to successfully acquire them as customers. Companies who have a checkered credit history will always be a challenge to identify. An objective credit rating of your prospective and even your existing customers will mitigate losses due to non-payment.
Maintaining good business relationships might require you to extend payment terms to long-time and well-paying customers. While this is an effective strategy, make sure you weigh all the pros and cons before deciding on extending a client’s credit limit or payment terms. A credit report will help you effectively decide.
Supply Chain Management
Supply chain is the network created among various companies to source raw materials, produce, handle, and/or distribute a specific product.
Remember the garments manufacturing business example above? To create a product, there is a need to source raw materials such as fabric, needles, threads, zippers, and garters from other companies. You will also hire designers, cutters, and seamsters/seamstresses to carry out the process. Thereafter, the manufacturing process will start and progress until it produces a finished product, ready for distribution.
The main goal of the supply chain is to deliver a finished product to consumers in the most cost-effective way possible. The reality is most manufacturers these days source their products from other companies around the world. At present, a supply chain risk is recognized in today’s economy as a major threat to business continuity.
Any changes or disruptions in the chain could affect your business, often in a negative way. Still, this does not mean there is nothing you can do about it. To maintain business continuity, you can –
- Have alternative or secondary suppliers that offer materials at a low cost
- Employ reliable power grids and transportation facilities to minimize delay
- Have close proximity to raw materials to minimize transportation costs and threats
- Invest in newer technologies to reduce the need to source other materials from various companies
- Stockpile raw materials to prevent shortages
- Build healthy, collaborative relationships with various suppliers
These steps could entail additional costs for the company. In the long run and considering the risks associated with the supply chain, the benefits will outweigh the costs.
How CreditBPO can help
Companies need to evaluate their suppliers and customers in an effective way in order to mitigate operational and credit risk. Banks, leasing and financing companies, franchisors, lending cooperatives, insurance companies and big corporations realize the value of a reliable and consistent credit rating platform that will give them adequate information on the creditworthiness of their partners. CreditBPO provides that information through the CreditBPO Rating Report.= Being an SME does not mean you can dismiss information or methodologies that bigger companies develop as best practice. Your company's own CreditBPO Rating Report will allow you to be informed of your business’ credit rating and how banks might assess you as a potential or existing borrower. Through the credit report, you will know your cash conversion cycles, be able to plan increases in cashflow and be guided by actionable recommendations generated by CreditBPO’s Rating algorithm. This will allow you to exercise good financial and strategic management that will inevitably grow your business.