Risk of credit: What it is and how to evaluate it in your business!

Credit risk is a key variable that can have a significant impact on any company's finances. But what exactly is credit risk, and how can you assess it within the context of your business?

In this simplified guide, we'll unravel the mysteries behind credit risk analysis and show you how you can use it to ensure the financial health of your business.

What is Credit Risk?

Simply put, credit risk is the likelihood that a customer, business partner, or debtor will default on their financial obligations—that is, default on a debt or loan they've contracted with your company. This can occur, for example, when you sell products or services on credit and the customer fails to make payments as agreed.

In the financial landscape, credit risk assessment is a common and crucial practice. Financial institutions, such as banks, investors, and credit agencies, rely on credit risk assessment to make informed lending and investment decisions.

This analysis allows them to determine the likelihood of a borrower or bond issuer defaulting on its financial obligations, which is essential to ensuring stability and security in financial markets.

How does a credit risk analysis work?

Credit risk analysis is a vital process for companies that grant credit to customers or business partners.

While specific criteria may vary between institutions, there are some universal factors you should consider when assessing credit risk:

1. Credit History: The debtor's credit history is one of the key factors. It includes information on past payments, outstanding debts, and any history of default. A good credit history generally indicates lower risk.

2. Payment Capacity: Assess the debtor's ability to meet financial obligations. This includes analyzing their income, cash flow, and whether they have sufficient resources to repay the debt.

3. Existing Debts: Check if the debtor already has other debts. Too much debt can increase the risk of default, as it can strain your finances.

4. Financial Stability: Consider the debtor's financial stability. This involves analyzing their employment or business situation, track record of stability, and any signs of financial instability.

5. Assets as Collateral: In some situations, it is possible to require assets as collateral, such as real estate or vehicles, to reduce credit risk.

6. Purpose of Credit: Understand the purpose of credit. If it's for investments that can generate financial returns, it may be less risky than credit for everyday expenses.

7. Terms and Conditions: Review the terms and conditions of the credit agreement. This includes the interest rate, repayment terms, and any late payment penalties.

8. Continuous Monitoring: Credit risk analysis isn't static. It's important to continually monitor the debtor's financial situation throughout the business relationship.

In short, even though credit risk analysis criteria vary between companies, these universal factors can help you get a basic understanding of what to consider when assessing the risks of dealing with a client. This analysis is crucial for making informed financial decisions and protecting your company's interests.

For a more in-depth understanding of credit risk and management strategies, we recommend consulting the website Serasa Experian.

To simplify: know the C's of Credit Risk

As you can see, there are many analysis points to determine credit risk. But to simplify, remember that all the risk analysis points we mentioned arise from the C's of credit risk.

The C's of credit risk serve to summarize everything that should be evaluated in a credit risk analysis. Here are the C's:

1. Character: Character assessment assesses the debtor's integrity and trustworthiness. This involves analyzing the customer's financial history, their market reputation, and verifying past transactions.
2. Capacity: Capacity refers to the debtor's ability to meet payment obligations. This involves assessing the credit applicant's financial condition and their ability to generate income to repay the debt.
3. Capital: Capital refers to the net worth of the client company and its partners. This encompasses all assets and liabilities that make up the credit applicant's equity.
4. Collateral: Collateral involves guarantees offered by the debtor in exchange for credit, such as assets, equipment, real estate, and other assets that can be liquidated in the event of default.
5. Conditions: The terms are based on the customer's current financial situation, their expectations, and potential for improvement or decline. This takes into account external factors that may affect the debtor's ability to pay, such as general economic conditions and market changes.

These five factors form a comprehensive framework for assessing a customer's credit risk and making informed decisions about extending credit to your business.

How to Calculate Credit Risk

You can calculate credit risk by assigning scores to customers in each of the 5 C's: character, capacity, capital, collateral, and terms. Assign a score from 1 to 5 for each category, with 1 being the worst and 5 being the best. Add these scores together and use this score to decide whether or not to offer credit to the customer.

Check out a practical example

Imagine you have an online store and a customer made a large purchase but wants to pay in installments. You discover that they have a poor payment history with other stores (character), your income is low (capacity), your company has few assets (capital), he has no guarantees or assets that can be used as collateral and the market is facing an economic crisis (unfavorable conditions). Based on this, you may decide to offer a payment plan with more restrictions or even refuse credit.

The Importance of Assessing Credit Risk

Assessing credit risk is essential for any company, regardless of size or industry. Here are some reasons why it's important:

1. Financial Protection: Assessing credit risk helps protect your finances. It prevents you from granting credit to customers who may default, harming your cash flow and profitability.
2. Informed Decision Making: By understanding and assessing credit risk, you can make more informed credit decisions. This means you can choose to provide credit to low-risk customers while taking extra precautions with high-risk ones.
3. Sustainable Business Relations: Proper credit risk management contributes to sustainable business relationships. Customers who pay on time are more likely to continue doing business with you and recommend you to others.