Credit Risk: What it is and Why it matters

When someone owes you money, you are exposed to Credit Risk – the risk of incurring a loss if the person will not return your money. When you are in business, you deal with many parties and have exposure to such a credit risk. You may have supplied goods, however, your customer enjoys a 30 day or 60 day credit period for payment (i.e. Account receivables). On the other hand, you may have given some advance to your suppliers, however, you still have to wait for your supplies. What if the business itself is about lending money such as is the case for banks and NBFCs? In that case, every loan transaction is exposed to credit risk.

Have you ever thought about these questions and had trouble evaluating risks associated with such decisions? A credit risk results in an interruption of cash flows and therefore increases costs for collection – high credit risk can also be fatal for the business. Therefore, understanding when, where and how much credit that applies to both businesses, and financial institutions. Mitigating a credit risk will begin with assessing a credit risk, and let us take you through that:

How does one assess credit risk?

As with any assessment, credit risk assessment also begins with collecting relevant data points about the other party. The collection of data is followed by an analysis to identify the potential risks and probability of such a risk materializing. A credit risk assessment has to be a continuous exercise and not a one-off to ensure its effectiveness. Therefore, the process of assessment whether data collection or analysis or decision thereof has to be standardized for the organization.

While many organizations use internal data on other parties to monitor credit risk, it is imperative to access external data and independent view on the other party for a complete credit risk management. External Data and Views could minimize internal biases and also bring in the market perspective. Popular ways of external credit risk assessment include financial ratios, credit scores, credit ratings or business information reports, let us go through some of these concepts.

Risk Assessments by Lenders

Lenders are most exposed to credit risks and therefore carry out thorough credit risk assessment on their prospective clients, generally referred to as a credit check. Lenders generally look at: Credit Scores (Personal) only for individual consumers and Business Credit Score and Credit Ratings for businesses and companies.

• Personal Credit Score: A credit score is a statistical number that evaluates a consumer's creditworthiness and is based on history of loans and repayments of the individual with any bank or NBFC across the country. Lenders use credit scores to evaluate the probability that an individual will repay his or her debts. Personal credit score ranges from 300 to 900, and the higher the score, the more financially trustworthy a person is considered to be. If a person's credit score is under 600, many home loan companies may not lend to him, based on this nationally recognized credit risk measure. A lenders credit analysis may take into account other factors such as available investments, collateral property, income or cash on hand.

• Business Credit Score: Credit bureaus like CRIF High Mark apart from Personal Credit score also hold the credit score for companies, known as Business Credit Score or Company Credit Score. Like individuals, business credit score represents the loans taken for the business and repayments on those loans. Lenders use these to decide the loan eligibility of a company for new loans or even enhancements of existing credit limits. Though the score range here is also 300-900, a score above 700 is generally considered good for businesses too, and can help business get higher loan amount, better interest rates and preferred tenure.

• Credit Ratings: Credit Rating is another indicator of the creditworthiness of a business or a company. Credit Ratings give an understanding of the ability of the company. While a credit score is calculated through an algorithm and only on past trends, a credit rating is calculated by a team of analysts through an in-depth analysis of company’s business, economic situation, potential of the sector, outlook of the management etc. These ratings are based on corporate financial instruments and usually denoted in alphabetical symbols such as AAA, AA etc. Higher the rating, lower is the probability of default.

Risk Assessments by Corporates

Whatever the nature of your business, there will almost certainly have been times when you’ve had to ask yourself questions such as “Who exactly am I dealing with?”, “Will they pay me and when?” or “How much can I supply to them and on what terms?”

Whether these risks relate to new or existing customers or even with suppliers, the only way to mitigate them is by having a clear, up-to-date insight into each business’s associated risks. To do that corporates can source data through a Business Information Report (also known as BIR)through an independent agency such as CRIF.

Corporates use the BIR as it provides an in-depth profile of a company, including financial statements, business trends, history of business, ownership details, operational information, and details on related firms and any special events that occurred in the past involving company management. CRIF also provides a risk indicator and an indicative credit limit to support business managers with their decision.

A Business Information Report is not limited only to domestic companies. If you are dealing with businesses from any other country, companies such as CRIF can help facilitate getting you a reliable and insightful freshly investigated business information report through its network across the globe. Lenders also use business information reports as a tool to assess credit risks originating from third parties especially while financing a company involved in cross-border transactions.

Now that you understand the basics of credit risk management, leverage the power of these proven tools to secure your business.  You can begin by checking your own or your business credit score here. Learn more about techniques in credit risk assessment here.