Risk is an unavoidable part of doing business and is usually necessary in some form to grow your business. However, taking unnecessary and uncalculated risks can be one of the best ways to endanger your business.
Risk takes many forms and some are more important to avoid than others. Credit risk is almost always best avoided and is one of the biggest risks currently facing UK businesses. As insolvencies and total amount of bad debt in the UK economy continue to rise and margins continue to shrink most directors are worried about the effects of credit risk on their businesses.
Fortunately, credit risk is something that can be managed and there are simple steps companies can take to include credit risk management into their day to day processes. In this article we will look at what credit risk is and how it can be managed.
What is Credit Risk Management?
Credit risk management is where a company uses technology and procedures to assess the credit risk of any potential customers and monitor existing debtors , with the purpose of avoiding credit turning into bad debt.
What is Credit Risk?
Simply put, credit risk is the risk of credit you have offered to a business turning into bad debt. Bad debt is caused by a debtor going insolvent and there not being enough funds, after liquidation, to pay back some or all of the money owed to creditors; leaving them to absorb the loss and suffer the associated negative consequences.
Under UK insolvency law there is a strict hierarchy as to the order in which creditors are paid. This is:
- Secured creditors with a fixed charge – usually financial institutions
- Preferred creditor – such as HMRC and employees
- Secured creditors with a floating charge – usually financial institutions
- Unsecured creditors – usually trade creditors
As an insolvent company, by definition, does not have enough assets to pay its debts there are usually very little to no funds left to pay unsecured creditors, which means most companies will get nothing.
Given current high cost and low margins this can be devastating. In fact, a company that receives a bad debt is three times more likely to go insolvent than one who has not.
This is why credit risk is so necessary to manage.
What to look for:
There are many warning signs that a company may be financially unstable and therefore a credit risk. Below we will look at some key warnings:
- County Court Judgements (CCJs) – CCJs are seen as one of the best indicators of credit risk. A CCJ is a recognition by the courts that a debt is outstanding and is a formal, but not legal, demand it be paid. For a CCJ to be issued, the debt must be significantly late and heavily suggests that the company can not afford to pay it. The likelihood is that if a company can not afford that debt it could not afford any credit you might extend.
- Bad debt – If a company has recently suffered a bad debt there is a good chance that their cashflow has been interrupted and they may be suffering. It is also useful to look at the amount of the bad debt, as if it was for a very small amount the company may be able to absorb it without problem and any credit risk from the bad debt is negated.
- Creditor days – Creditor days are how many days, on average, after the agreed payment date that a company pays its debts. A company with a high number of creditor days may be struggling financially and present a credit risk. Even if a company is financially strong if it has a large number of creditor days, the likelihood of them paying any debt owed to you late is high and they may not be an ideal customer.
- Declining profits – A company that is seeing its profits falling year on year may be on the downwards spiral to insolvency. These companies should be considered a credit risk
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How to manage Credit Risk
As previously mentioned, the best way to manage credit risk is to combine technology and process.
Red Flag Alert is a business data tool that will give you and your staff everything you need to effectively assess how you manage credit risk.
Before offering credit to any customer they can be searched in Red Flag Alert and a full report into their financial health is available. Key risk factors can be assessed and a decision as to their credit risk can be made. If they are deemed a risk then credit should not be offered and bad debt can be avoided. Red Flag Alert has a unique rating system that puts companies in clearly defined categories of credit risk to help you make a decision.
It is also necessary to monitor your debtors for any adverse events that suggest that they may be heading towards insolvency. If this is the case then you can make active efforts to recover any money owed prior to their collapse. You are also able to see if a repeat customer is struggling and have time to find a replacement prior to any interruption in your cash flow.
Finally, staff must be trained as to what credit risk is, why it needs to be managed and how to manage it. If staff understand why the risk needs to be avoided, that it is beneficial to a company to not make a ‘sale’ that turns into a loss and how to spot credit risk then managing credit risk will become a natural part of your business process. There are 5 Steps for managing credit risk which are important for any business to apply to their own processes, this won't only protect your business but will optimise operations and improve revenue.
A View of Red Flag Alert's Portfolio Manager and the Events Monitored
How Red Flag Alert can help
Red Flag Alert offers everything you need to manage credit risk:
- Records on over 15 million UK companies and over 350 million international companies
- Detailed and easy to understand company reports that contain a full picture of a company’s financial situation
- Unique and clear rating system that lets you know the level of risk attached to a company
- Fully downloadable reports
- Fully customizable monitoring system that gives real time alerts on up to 89 different events, so you are always the first to know if a debt is at risk of going bad
- Search function with over 100 filters that let you prospect for only the lowest risk, most financially stable companies
- Portfolio Management with Real Time Alerts
Red Flag Alert is the industry expert in spotting early warning signs of business distress, our award winning platform uses an algorithm based on over 15 years of insolvency data to be an industry leader in spotting credit risk.
If you are worried about the financial health of one of your customers and want to see how Red Flag Alert’s company financial risk assessment tool can help your business stay informed with customer's problems in advance, why not Try Red Flag Alert today?