What is credit risk and how to anticipate the worst-case scenarios

Anticipating the worst scenarios, starting with customer insolvency, is part of good credit risk management. And when risks materialize, the situation can quickly become dangerous without the right credit risk analysis and protection in place. 

In this article, find out what credit risk is, how to conduct a credit risk assessment and the best credit risk mitigation processes to follow.

Here is a credit risk definition: a risk of default on a debt that may arise from a borrower failing to make required payments. It is an essential risk to take into account as part of business risk management if you sell on credit terms. 

Credit risk essentially boils down to one situation: when a client faces insolvency and is no longer able to honor their debts, especially with suppliers. 

Customer insolvency can originate from various factors from bad cash flow management to failure of clients (and the domino effect of insolvencies) or excessive expenditure. Therefore, it is necessary for you to make accurate credit risk assessments in order to protect your business against insolvency risk.

When a client becomes insolvent, they may file for bankruptcy, a legal process of debt restructuring whose goal is to help the company pay its debts and maintain their business. 

Depending on the country, bankruptcy proceedings can take many forms and include different phases: internal restructuring, appointment of an administrator, debt renegotiation with creditors, etc.

It is within the framework of these proceedings that you can legally demand payment of a commercial debt, sometimes even if it is not yet due.

The end goal is to avoid the final liquidation of the company, which occurs when its assets are no longer sufficient to pay off all its debts.

Now that you fully grasp the definition of credit risk, let’s have a look at cases that are more difficult to anticipate as part of your credit risk analysis. 

For example, you have granted a trade credit to a client who uses accounting dissimulation to hide key elements of their commercial or financial situation. Their accounts have been doctored and do not reflect their ability to pay when payment is due.

Naturally, this is often the work of the management or executive team, the only persons in a position to cook the books.

Accounting manipulation can go as far as bankruptcy fraud: it allows managers to structure the liquidation of the company through fraudulent operations (concealment of assets, a fictitious or ruinous increase in liabilities...). Sometimes, legal bankruptcy can be “strategic”.

The aim is to reduce the company's debt or get out of existing contracts, for example with suppliers not yet paid.

Fraud is also sometimes perpetrated by third parties, like in the case of “fake supplier” fraud: a hacker takes advantage of the payment period granted to your client within the framework of a trade credit to steal your identity and substitute their own bank details for yours.

Other times, the transaction itself is hacked, often when the payment method is not secure. Increasingly sophisticated cyber fraud technologies are making this kind of scam more frequent and more difficult to prevent (Learn more about business fraud protection).

In the case of a client insolvency, you will rely more on the law than on your contract. Your credit risk management strategy must be based on an in-depth knowledge of the country legislation in effect.

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 might also have negotiated a preferential right to payment (preferential creditor) or secured their loan through a collateral asset (secured creditor).

Commercial law is often complex and varies greatly from one country to another. You should get information about the possibilities of legal action to assert your rights and recover your credit prior to any bankruptcy proceedings.

Small businesses often do not have the internal resources to manage bad debt in the event of difficulties. Our country risk reports  provide you with in-depth knowledge of local practices, and can give you clues for effective credit risk assessments.

As the old saying goes, an ounce of prevention is worth a pound of cure. Regular credit risk analysis is key. You should therefore set up a strong and balanced credit risk assessment and management process within your company before engaging into trade credit, as well as keep track of your cash flow.

Knowing who you’re dealing with is key: make sure you start with credit risk analysis by evaluating your client’s creditworthiness and negotiating clear and appropriate invoice payment terms. You can also develop sound internal credit risk mitigation processes to avoid and recover overdue payments.

Setting up credit limits with your clients is another best practice: the amount of credit you grant should not go above a certain threshold. Common methods of calculation of customer credit limits include:

•  Fixing a percentage of the client’s net worth (its assets minus its liabilities), typically around 10%.
• Using your client’s former trade references (which can typically be found on their credit report) and chose a median value among their credit history.
•  Estimating your client’s real needs and not going further.

Another credit risk mitigation option is to ensure you always have a cash reserve to use in case of emergency, like a rainy-day fund.

However, credit risk management is sometimes not enough to protect your business. Trade credit insurance remains the most reliable to protect your cash flow from insolvency risk and considerably limit the damage of such unforeseeable credit risk incidents – including by getting compensation in case of bad debts.