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Understanding credit risk management and why it matters

Oct 31, 2018 Walt Wojciechowski

Understanding credit risk management and why it matters

Credit stands out as one of the most vital resources for any business, regardless of size or the specific nature of industries to which companies belong. On a macroeconomic scale, a company's credit - specifically its business credit rating, as issued by Dun & Bradstreet and similar agencies - can serve as a primary benchmark of its high standing within an industry, as valuable as evidence of its annual revenue, stock price and overall valuation. Business credit's importance on a more immediate, micro scale is not particularly different, representing factors ranging from a company's record of fiscal responsibility to its ability to offer financing to its loyal customers. 

"Every business should follow certain best practices for credit risk management."

The undeniably big and multifaceted role credit plays for a business is also what makes it so important to protect from the various risks the company can encounter in the course of its operations, whether from vendors who abuse your trust by not paying back invoices or individual customers who become seriously delinquent.

Here, we'll take a closer look at the numerous hazards risks an organization may run into, and how to deal with them - as well as credit risk management strategies for mitigating the likelihood of their occurrence in the first place. 

Credit risks posed by individuals 
While not nearly as potentially troublesome as credit risks posed by other businesses, it is still worth examining the hazards that delinquent individual loan recipients can pose. For small businesses, in particular, even just a few past-due customers can be devastating if such specific issues aren't dealt with promptly. Credit scores and reports, of course, are the most basic method for determining the credit risks of single borrowers or loan applicants, with FICO and its numerous variants arguably being the most popular and rubrics like the Big Three's VantageSCORE also finding fairly common use. In some cases, a brief perusal of these scoring models and an individual's credit report may be all that is necessary to determine whether someone is creditworthy or not.

Understanding credit risk management and why it mattersIndividuals can still pose notable credit risks to businesses and financial institutions.

However, the limitations of conventional credit reporting and scoring can also prevent your business from bringing in certain customers - namely, those with reasonable finances who simply don't show up to any significant degree - or at all - when you search for their FICO information. More than 25 million individuals in the U.S. alone are either underbanked or unbanked, according to the most recent study on the subject conducted by the Federal Deposit Insurance Corporation, and many more are credit-invisible.

Because they lack any significant number of banking or credit accounts (or have none whatsoever), they likely won't show up or will have a minuscule score due to the credit bureaus not knowing much about them. Such individuals may nonetheless hold steady jobs and pay their bills on time, and if an underbanked or credit-invisible applicant shows up to your business applying for credit of some sort, they could well deserve it and you simply don't know it. To ensure identification of genuine high-risk applicants and avoid letting worthy ones slip through your fingers, it'll be worthwhile to use a blend of traditional and alternative credit measurements.

Presence of risk shouldn't scare companies away from extending credit 
Entering the realm of business credit risk management and assessment is a considerably more complex affair, but much more important to the well-being of your company. As a leading statement, however, it's worth noting that none of the cautionary practices noted here should discourage your business from offering trade credit altogether. As Dun & Bradstreet point out, providing trade credit as an option to your buyers can motivate them to spend more than they ordinarily would, and also draw new purchasers into your customer base. This is especially advantageous in certain business environments, particularly those where longer-term capital budgets are becoming more common and companies expect to be able to pay off certain obligations a year or two in the future, but not immediately.

Looking at the right data is key 
According to D&B, certain data points carry particularly significant weight in assessing a business's credit risk. Credit scores and ratings from all of the major corporate credit bureaus are the first and most easily accessed type of information you should pull up, followed by any public records. These include but are by no means limited to tax filings, commercial building permit applications, quarterly earnings reports and even any news stories pertinent to a given company, if they apply to the firm's finances or business practices. (The latter can be particularly relevant, because if a company's problems are sizable enough to elude the ability of its PR representatives to contain them, there's a reasonable likelihood this organization won't be the most reputable.)

"Using data from a variety of sources will greatly assist credit risk management processes."

Beyond that, large-scale examinations of industry trends can also help with risk assessments: Compare the progress of the firm to which you're considering extending an offer of trade credit to average companies in the same field or geographical area. Trade references from peers of yours in the industry, as well as past creditors, can shed further light on your prospective borrowers.

Last but certainly not least, you should be confident in the general status of your business relationship with any company that could be receiving trade credit from you, as The Risk Management Association points out - simply put, know your buyers and feel comfortable with them. If you don't feel good about a company's payback prospects from the get-go, you should verify this suspicion rather than immediately going from your gut, but having such reservations in the first place is not infrequently an ill augury of trouble somewhere down the line. 

Understanding credit risk management and why it mattersAvoiding credit risks is only possible with the right information.

Circumventing challenges to risk assessment
There are few guarantees in any avenue or process of modern business, and credit risk management is no different. According to SAS, flawed or incomplete risk models could lead to the analysis of a risky borrower as a safe prospect, and in turn lead to unpaid invoices that linger on your books for months or more. Relying on any sort of manual reporting methods can also be considerably problematic, leading to loss of information, incorrect analysis and a surplus of pressure on the IT resources of your organization. 

With the right tools, however, you can protect yourself significantly. Microbilt offers a comprehensive suite of credit risk management solutions for suppliers and other companies, across all industries, seeking to reduce their chances of taking on problematic buyers and business partners who fail to meet terms of loan agreements. Contact us to learn more about our bank account verification, fraud risk monitoring, compliance verification and other risk mitigation services.