Managing Customer Credit Risk

Default arising from customer credit risk is inherently guaranteed across all industries, however taking certain steps can minimize this risk. You are bound to face customers that either file for bankruptcy, or are slow payers that can dampen your cash; especially if you have substantial cost associated with servicing that same customer. Keeping your Days Sales Outstanding ratio (DOS) as low as possible will translate into your business always having the adequate funds to keep the operations going.

The DOS ratio simply measures your ability to convert accounts receivable into cash. The lower the ratio, the quicker you are at getting cash in the door. On the other hand, a high DOS ratio translates into your business having a higher risk of customer default on their debt. First of all refrain from automatically granting every customer credit on account. Establish a strict credit policy that is both effective, and adaptable. The first line of defense is the Credit Application, which should be a robust and rigorous process.

Every customer credit approval process should include credit references from existing vendors that the customer has, recent financial statements, recent tax return, as well as included language about late fees and finance charges. In addition, it should spell out the amount of credit the customer is approved for, and payment terms. A common mistake businesses make is that they let a customer purchase beyond their approved credit amount, this is a mistake as it undermines the entire credit application approval process, in addition your customer now will not take your credit limit amount serious.

As a business owner you need to understand when it’s time to cut your losses, selling more, or continuing to provide services to a delinquent customer does not increase your chances of collecting on already past due invoices, it only drives you deeper in the hole. Concerted effort needs to be placed on collecting outstanding invoices. One of the best methods that always worked for me is analyzing outstanding accounts receivable on a weekly basis, as well as keeping in constant communication with each of my customers on where their balances stood, as well as ascertaining payment expected date.

Keeping in constant communication with your customer is crucial, as this will signal to your customer that you are keeping an eye on your receivables. Not keeping in constant communication with your customers however signals that you are in no rush to collect on outstanding invoices. Giving early payment discounts, or charging late fees is a proper way to encourage a customer to pay their invoice early, and prior to the due date. Common discounts given are 2%/10, which essentially mean that you will give a customer a discount of 2% on an outstanding invoice, only if paid within 10 days from the date of the invoice.

The Importance of Credit Risk Management for Banking

The importance of credit risk management for banking is tremendous. Banks and other financial institutions are often faced with risks that are mostly of financial nature. These institutions must balance risks as well as returns. For a bank to have a large consumer base, it must offer loan products that are reasonable enough. However, if the interest rates in loan products are too low, the bank will suffer from losses. In terms of equity, a bank must have substantial amount of capital on its reserve, but not too much that it misses the investment revenue, and not too little that it leads itself to financial instability and to the risk of regulatory non-compliance.

Credit risk management, in finance terms, refers to the process of risk assessment that comes in an investment. Risk often comes in investing and in the allocation of capital. The risks must be assessed so as to derive a sound investment decision. Likewise, the assessment of risk is also crucial in coming up with the position to balance risks and returns.

Banks are constantly faced with risks. There are certain risks in the process of granting loans to certain clients. There can be more risks involved if the loan is extended to unworthy debtors. Certain risks may also come when banks offer securities and other forms of investments.

The risk of losses that result in the default of payment of the debtors is a kind of risk that must be expected. Because of the exposure of banks to many risks, it is only reasonable for a bank to keep substantial amount of capital to protect its solvency and to maintain its economic stability. The second Basel Accords provides statements of its rules regarding the regulation of the bank’s capital allocation in connection with the level of risks the bank is exposed to. The greater the bank is exposed to risks, the greater the amount of capital must be when it comes to its reserves, so as to maintain its solvency and stability. To determine the risks that come with lending and investment practices, banks must assess the risks. Credit risk management must play its role then to help banks be in compliance with Basel II Accord and other regulatory bodies.

To manage and assess the risks faced by banks, it is important to make certain estimates, conduct monitoring, and perform reviews of the performance of the bank. However, because banks are into lending and investing practices, it is relevant to make reviews on loans and to scrutinize and analyse portfolios. Loan reviews and portfolio analysis are crucial then in determining the credit and investment risks.

The complexity and emergence of various securities and derivatives is a factor banks must be active in managing the risks. The credit risk management system used by many banks today has complexity; however, it can help in the assessment of risks by analysing the credits and determining the probability of defaults and risks of losses.

Credit risk management for banking is a very useful system, especially if the risks are in line with the survival of banks in the business world.