The importance of credit risk management

It is crucial for all businesses to understand credit risk management and how to protect their business from potential financial setbacks.

Here we look at what credit risk management is, why it's important, and offer some advice on how to manage your business credit risk effectively. 

What is credit risk management?

Credit risk management is the process of reviewing criteria to build an accurate picture of another firm’s financial stability including payment behaviour and affordability, in order to set realistic payment terms. A detailed look can also provide knowledge about past debts, their repayment, length of the commitment, and so on. Put simply, it is about obtaining an overall picture of an individual or businesses creditworthiness, which can help a company avoid getting into debt trouble. 

Effective credit risk management usually involves:

• Conducting credit checks on new and existing customers/clients
• Managing customer credit limits
• Reviewing your business's debtors regularly
• Having a clear collections policy in place

Why is it important?

Failure to have a robust credit risk management process in place can cause a serious impact on a company’s capital. If your customers don't pay you, then your business will struggle to meet its own financial obligations. This can quickly lead to cash flow problems and in some instances, insolvency. Credit risk management is essential to guard against irresponsible or untrusted customers. 

Credit risk management is especially important for SMEs because they are less likely to have the resources to recover from a major financial setback. That is why effective credit risk management is key for any SME. It can help protect your business from potential financial disaster.

Also, if you don't have a good credit risk management strategy in place, you could be missing out on potential sales opportunities as some customers may only be willing to do business with you if they're confident that you can pay them on time. Having a good credit risk management strategy can also help you to save money as it may help you to negotiate better terms with your suppliers.

Good credit risk management can help to protect your business's reputation as customers, suppliers and other businesses will have more confidence in working with you if they know that you have a good system in place for managing your credit risk.

In order to avoid any unwelcome situations, a solid credit risk management process should be applied. At the start of any new business relationship, the supplier should look at certain key figures; these include looking at the customer’s overall profit, the existence of any detrimental data and any signs of cashflow issues.

Profit is the primary indicator which will demonstrate how well a business is preforming and its likelihood to stay trading. Secondly, look at cash flow. Poor cashflow in a business points towards mismanagement of funds in and out of the business and could result in the inability for a customer to settle invoices efficiently. It is also important to look at directors and shareholders, as recent changes to structure can indicate that the business is in a period of transition and that caution should be applied.

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