Anticipating the worst-case scenarios you may face, starting with the client or customer insolvency, is part of good credit risk management. Without proper credit risk analysis and protection, the situation can quickly become dangerous should the risks materialise.
Read below what credit risk is, what a credit risk assessment is, how to conduct a credit risk assessment and what the best practices for credit risk mitigation are.
What is Credit Risk?
The definition of credit risk: the risk of defaulting on a debt that may arise as a result of the borrower not making the required payments. It is essentially a risk to consider as part of business risk management if you are selling on credit terms.
In simple terms, credit risk happens in a situation where the client faces insolvency and is no longer able to pay their debts, especially with suppliers.
Main Trade Credit Risks
Risk of client insolvency and bankruptcy
Business insolvency can arise from a variety of factors, from poor cash flow management to business failure (and the domino effect of insolvency) or overspending. Therefore, it is essential to perform accurate credit risk assessments to protect your business from insolvency.
A client can file for bankruptcy when they become insolvent, which is a legal debt restructuring process aimed at helping a company pay its debts and keep its business afloat.
Depending on the country, bankruptcy proceedings can take various forms and consist of different stages:
- internal restructuring,
- appointing a receiver,
- debt renegotiations with creditors, etc.
As part of this procedure, you can legally demand payment of a commercial debt, sometimes even if it is not yet due. The ultimate goal is to avoid the final liquidation of the company, which occurs when its assets are no longer sufficient to pay off all debts.
Moral hazard: the case of a fraudulent or dishonest client
There are also cases that are more difficult to predict within the credit risk analysis. For example, you have granted a trade loan to a client who wants to hide key elements of their commercial or financial situation. Their accounts are fake and do not reflect their ability to pay when payment is due. This is most often the work of management or the executive team, who are the only people in a position to disguise the true picture of accounting and present it in a better light.
Accounting manipulation can even go as far as bankruptcy fraud: it allows managers to structure the liquidation of a company through fraudulent operations (concealing assets, fictitious or devastating increase in liabilities, etc.). Sometimes legal bankruptcy can be “strategic”. The goal is to reduce the company’s debt or exit from existing contracts, for instance, with suppliers whose debts have not yet been settled.
Fraud is also sometimes perpetrated by third parties, as in the case of the “bogus supplier” scam: a hacker uses the payment period granted to your customer under trade credit to steal your identity and replace their bank details with yours.
In other cases, the transaction itself is hacked, often when the payment method is not secure. Increasingly sophisticated cyber fraud technologies make this type of fraud more frequent and more difficult to prevent.
What to Do in Case of Customer Insolvency
In the event of client insolvency, you will rely more on the law than on your contract. Your credit risk management strategy must be based on detailed knowledge of the country’s applicable legislation.
First and foremost, you need to know your position as a supplier in terms of debt repayment – other creditors generally include employees, banks, tax authorities etc.
Some creditors may also negotiate a preferential right to payment (preferential creditor) or secure their loan through collateral (collateralised creditor).
Commercial law is often complex and varies greatly from country to country. You should get information about the legal process options to exercise your rights and restore credit before any bankruptcy procedures.
Small businesses often don’t have the internal resources to manage bad debts when they are facing difficulties. Our country risk reports provide you with detailed knowledge of local practices and can provide you with clues for effective credit risk assessments.
How to Protect Your Business from Credit Risk
Prevention is better than cure – prevention is, as always, the main recommendation. Regular credit risk analysis is key. That’s why you should establish a strong and balanced credit risk management process in your company before embarking on trade credit and monitor your cash flow.
Knowing your customer is key: make sure you’ve assessed your customer’s creditworthiness and agree on clear and appropriate invoice payment terms. You can also develop good internal credit risk mitigation processes to avoid and recover late payments.
One of the best practices is to set credit limits for your client: the amount of credit you grant should not exceed a certain threshold. Common methods of calculating customer credit limits include:
- Fixing a percentage of the client’s net worth (their assets minus liabilities), usually around 10%
- Using your customer’s past trade credit references (which can usually be found in their credit report) and choose the median value in their credit history
- Assessment of the actual needs of your client.
Another option to mitigate credit risk is to ensure you always have a cash buffer to use in case of an emergency, such as a contingency fund (for a rainy day).
However, credit risk management is sometimes not enough to protect your business. With high insolvency indicators, trade credit insurance or trade finance insurance (or accounts receivable insurance) remains the most reliable way to protect your cash flow from insolvency risk and significantly limit the damage from such unpredictable credit risk incidents.