Many businesses offer credit terms to customers in an attempt to maximize their sales opportunities and remain competitive. However, it can be a risky business. If a customer does not pay as agreed, the business is left with a balance that cannot be collected. Therefore, businesses must take proactive steps to protect themselves from credit risks and reduce the likelihood of uncollected balances. If a customer does not pay late—or at all—cash flow can become stretched, but this is a trade-off for increased sales.
Considering how important this is, we thought it would be useful to put together a brief discussion on assessing and managing credit risk. If this is something that you’re interested in learning more about, read on as we break down everything you need to know about credit risk.
What Is Credit Risk?
When trading on credit terms there is always a possibility that a customer won’t pay in full or on time, becoming delinquent on their debt. If this happens, a business might not receive the money they are expecting, which can impact cash flow and prevent them from meeting other commitments such as paying suppliers, VAT, and PAYE. If enough customers become delinquent, it can lead to severe cash flow problems, one of the biggest causes of business failure.
How Is Credit Risk Assessed?
To assess the level of risk your business is exposed to, you need to think about a number of factors. However, the creditworthiness of your immediate customers may be the most important consideration. Here’s what you need to take into consideration when assessing creditworthiness:
- Character: The customer’s track record for making payments in a timely manner.
- Capacity: The customer’s financial capacity to pay.
- Capital: The capital that your customer has at their disposal.
- Collateral: The customer’s assets that can be liquidated to settle the potential debt if they cannot pay off their debt.
- Conditions: External factors that can affect the customer’s ability to settle their debt.
How Can Credit Risk Be Managed?
There’s more than one way to manage credit risk. Now, it’s best to consider all your options as some of these methods may work better than the others depending on your specific financial situation.
A credit management system is a great way to keep your business out of trouble, manage your cash flow, and reduce the chances of late payments. A good credit management system covers everything that happens between order and payment.
Credit insurance protects businesses against the risk of bad debt by guaranteeing cash flow when a debtor becomes insolvent or defaults on payments. Credit insurance can be purchased as a standalone product, and it can also be incorporated into an invoice finance facility, which will issue and pay out the full value of invoices within 24 hours.
We hope this article proves to be useful when it comes to furthering your understanding of credit risk. While it may seem complicated at first, this article should be enough to give you good foundational knowledge that will help you in better navigating risk. Be sure to keep all of this information in mind so that you can make the most informed decisions for your business.
BarettStacey Accounting is a friendly, approachable team of accountants and bookkeepers in Bristol, offering quality financial services to help businesses stay on top of their finances. If you are looking for accounting and bookkeeping services, reach out to us today!