- Credit risk involves the potential financial loss from a borrower's inability to repay loans, making proper assessment crucial for business risk management.
- Insolvency and fraud, stemming from factors like poor cash flow management or accounting manipulation, pose significant credit risks that require early recognition and legal understanding.
- Effective credit risk mitigation strategies include regular analysis, setting credit limits, maintaining cash buffers, or partnering with trade credit insurance providers like Allianz Trade.
Summary
Key Takeaways
Anticipating the worst scenarios, starting with customer insolvency, is part of good credit risk management. And when risks materialise, 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.
What is credit risk?
Here’s 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 honour their debts, especially with suppliers.
The main trade credit risks
Customer insolvency risk and bankruptcy
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’s 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.
Bankruptcy proceedings can take many forms and include different phases: internal restructuring, appointment of an administrator, debt renegotiation with creditors, etc.
It’s within the framework of these proceedings that you can legally demand payment of a commercial debt, sometimes even if it’s 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.
Moral hazard: the case of a fraudulent or dishonest client
Now 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 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 don’t reflect their ability to pay when payment is due.
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. This means managers 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. This involves a hacker pretending to be one of your real suppliers in order to fake an invoice and divert the payment.
Or, the transaction itself can be hacked when the payment method isn’t secure. Increasingly sophisticated cyber fraud technologies are making this kind of scam more frequent and more difficult to prevent.
What to do in case of a customer insolvency
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. 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. We can provide you with in-depth knowledge of local practices, and can give you clues for effective credit risk assessments.
How to protect your business against credit risk
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.
How to protect your business against credit risk
Part of the global Allianz insurance group, Allianz Trade is trusted by over 62,000 clients around the world.
We have an unparalleled understanding of credit risk, with 83 million businesses monitored across all sectors in over 160 countries.
We’re market leaders, with an industry-respected AA Standard & Poor rating that characterises our financial strength and security.
We understand what companies want from trade credit insurance, and offer a solution tailored to the needs of your business.
Visit our trade credit insurance page to find out how we can help and request a quote online.
You might also be interested in…
What happens when your employees harm your company – and how can you prevent it?
What should I do to protect my company from embezzlement?
Let's talk...
For a free credit insurance consultation call our UK team, 09:00-17:00 Mon-Fri.
![People discussing on a coach](/en_GB/insights/protect-revenues/credit-risk-anticipating-the-worst/_jcr_content/root/parsys/wrapper_copy_copy_co_1267129581/wrapper/multi_column_grid/grid-0-par/image.img.82.3360.jpeg/1718879548551/aztrade-uk-seo-footer.jpeg)
Our expertise and commitment
Allianz Trade is the global leader in trade credit insurance and credit management, offering tailored solutions to mitigate the risks associated with bad debt, thereby ensuring the financial stability of businesses. Our products and services help companies with risk management, cash flow management, accounts receivables protection, Surety bonds, Business Fraud Insurance, debt collection processes and e-commerce credit insurance ensuring the financial resilience for our client’s businesses. Our expertise in risk mitigation and finance positions us as trusted advisors, enabling businesses aspiring for global success to expand into international markets with confidence.
Our business is built on supporting relationships between people and organisations, relationships that extend across frontiers of all kinds - geographical, financial, industrial, and more. We’re constantly aware that our work has an impact on the communities we serve and that we have a duty to help and support others. At Allianz Trade, we’re strongly committed to fairness for all without discrimination, among our own people and in our many relationships with those outside our business.