The UK is facing some of the toughest economic conditions since the financial crisis.
The value of the pound has fallen, and the country is likely to enter a recession. For some sectors, the recession has already hit.
Worst of all, insolvencies are set to hit record levels.
It’s therefore a good time for businesses to review their credit risk exposure. This will help them avoid losing money to clients that are unable to pay invoices.
This article explains the basics of credit risk exposure, including what it is, how to reduce it and how to calculate it.
What is credit risk exposure?
Credit risk exposure is a measurement of the maximum potential loss that a creditor could experience if a debtor company defaults on its payments.
Businesses extending credit to customers need to calculate their credit exposure so that they understand the level of risk they are working with.
Most businesses provide credit in some form. For example, if you only invoice your client once a job is complete, you are effectively providing them with credit.
If a customer can’t pay an invoice and they become insolvent, you are unlikely to get that money back. Knowing your credit risk exposure is important because it allows you to understand the likelihood of that happening.
Types of credit risk
There are several different types of credit risk. Default risk is the most common among businesses, but it’s worth knowing the others too.
This is a measurement of how likely it is that a customer will default on their debts to the creditor. If this happens it usually means that the customer's business is insolvent.
High credit default risk can be caused by a number of factors. The most common are poor financial health, increased competition and recession.
Concentration risk default
This is a measurement of risk based on the level of diversity in a company’s customer base. If a firm gets too much of its revenue from a single business, market or country it will have a high risk of concentration default.
Country default risk
This is a measurement of risk based on the country that a business is based in. If its home country has high political instability or poor economic conditions then it could impact the company’s performance and even put its future at risk.
This is when the business or a parent company breaks down due to legal or regulatory issues.
How to control credit exposure
There are many ways to reduce credit risk to your business. Some involve measures to make your business more efficient. Others require good risk management; in other words, taking precautions to manage risk and ensure the companies you work with are financially sound.
Perform credit checks
One of the best ways to manage your risk exposure is to understand your client’s financial position before you begin working with them.
A good way to do this is to use a credit referencing agency. They will provide you with data and tools to run credit checks on potential clients. Red Flag Alert will allow you to perform credit checks on global and UK companies, with a database of 15 million companies.
You can set your own credit risk tolerance and only work with companies that meet those requirements.
Once you’ve started working with clients, it’s a good idea to regularly monitor their financial health. This way you’ll know if it starts to deteriorate, giving you time to take action.
Red Flag Alert allows you to set up monitoring alerts that automatically warn you as soon as a customer’s financial position drops below an acceptable threshold.
Conduct KYC and customer due diligence checks
If you work in regulated sectors like finance you are required by law to verify the identity of your customers before you begin working with them by completing customer due diligence checks. You may also need to get a proof of address and check international databases to see if they are a politically exposed person or on a list of sanctioned individuals.
But doing this doesn’t just protect you from the regulator. It also ensures that your clients are who they say they are, and aren’t committing fraud.
Set credit limits
Decide how much risk your business can accept and then use this to set credit limits. If a business exceeds this level you can ask for further guarantees or even refuse to work with them.
Credit insurance allows you to receive a payout if a debtor is no longer able to pay.
Understandably, credit insurers will analyse the financial condition of your customers before offering you a policy.
Find new clients
If you are concerned about the risk profile of your customer base, then consider finding more clients. During a recession, you may need to pivot your strategy to focus on ideal customer profiles that are in attractive, financially healthy sectors. This way, if one customer defaults you’ve lost a smaller proportion of your overall revenues.
Make sure your credit agreements are as favourable as possible. Reduce payment terms, ask for payment upfront, agree just-in-time stock delivery and use retention of title clauses.
If a client becomes a financial risk it may make sense to mitigate this by increasing your margin with them, either by raising prices or decreasing costs.
How to calculate credit risk
To calculate a customer’s credit risk, you should consider the five Cs. They are:
- Credit history
- Capacity to repay
- Associated collateral
- The credit conditions
A common equation for working out credit risk is:
Default probability X exposure X loss rate
The default probability is the probability that the debtor will default on a payment. Exposure is the amount that you will be owed by the customer at any one time. Loss rate is the amount of money that you cannot recover should a customer default.
Manage credit risk and limits with Red Flag Alert
Red Flag Alert gives you a vital early warning system, allowing you to spot financial risk amongst clients. Our insolvency risk score allows you to protect your business by taking pre-emptive action and making your credit control processes proactive.
Red Flag Alert offers:
- Financial health on businesses in almost every country in the world.
- Detailed rating system that is predictive of future problems.
- Sophisticated scorecards that include a wide range of weighted factors.
- Information integrated into your CRM.
- Monitoring updates provided in real time.
- Helps you fulfil regulatory requirements like AML and GDPR.