Tag Archive for: credit risk management

How to reduce your credit risk

14-10-2019 | Marco Lassche |

It is nice to sell your products at a good price. But what if you have delivered goods to your customer, and he is not able to pay? In this article we give you over 15 options, how to reduce your credit risk.

Although a company that you do business with can look very successful and credit worthy from the outside, there are many examples of unexpected bankruptcies.
Credit risk is the probability that your company incurs a financial loss as your counterparty (customer/supplier), cannot meet its contractual obligations.

In this article we give you guidance, how to control and cover your credit risk. We focus on the sales perspective, however it is also applicable on the purchases side; a prepayment to a supplier causes also credit risk.

Ways to control your credit risk:
  • Make a credit check on your counterparty before onboarding, and make sure to keep doing this during the whole relationship. Credit rating agencies like Creditsafe, Graydon, Dunn & Bradstreet make their business out of running credit checks on companies. They also have good tools (risk alerts), to follow the credit worthiness of your counterparty.
  • Transfer your credit risk and insure your counterparty risk to a credit insurer (Atradius, Euler, Coface). In case you trade with unstable countries, do not forget to insure the political risk. If insurance of your counterparty is not possible, this might be already a warning. However it can also be a just established subsidiary, being part of a bigger credit worthy parent.
  • Bank guarantee: the bank of your customer will ensure the payment if the customer is unable to.
  • Execute the exchange (payment vs. property of goods) with your counterparty at the same time or use a trustable intermediary.
Options with the bank:
–    Direct Collection
–    Letter of Credit (LC)In a direct collection as well as in a LC you handover agreed documents to the bank. The biggest difference between direct collection and Letter of Credit: In a collection the bank pays you only, when the customer paid to the bank. In an LC the bank of the buyer pays you when the agreed documents are delivered by the seller. So for goods that are not easily sold to another counterparty, we would advise to go for a LC.Other options

  • Use an escrow account of the warehouse.
    The warehouse releases the goods to the buyer, when they received the payment, and forward the payment to the seller.
  • In case of transport of the goods by ocean freight you can use the shipper to be the intermediary.
    When your sold goods are transported by sea, you can give the release to the shipper to handover the Bill of Lading (property document) to the buyer. Normally this is done after payment of the buyer.
  • Use factoring. You sell your debtor at a discount to a factoring company. Make sure that you cannot be liable for non-payment (non-recourse basis).
  • Ask for a parent guarantee if the counterparty that you trade with is part of a big parent company. This parent guarantee can also be used to get an insurance at your credit insurer.
  • Diversification. Try to limit credit exposure on one customer, one region (concentration ratio’s). Ensure that a non-payment of one not covered counterparty will not put you in any liquidity squeeze and put your company at stake.
  • Give collection responsibility to the sales team. A trader works mainly for its sales bonus. In my opinion, to be eligible for the bonus, the whole order to cash cycle should be fulfilled. What if you give already bonus to a sale, but the invoice is not paid. So give the trader also the responsibility for collection. In this way he will be more critical with onboarding his customers, agreeing on payment terms and fight for the invoice to get paid.
  • Create your own financial buffer; an umbrella for rainy days.
  • Limit the number of payment terms for your customers, and make sure that you keep them within the Terms & Conditions of insurance company.
  • Determine who within the company has the responsibility for the credit risk management and setting the credit limits. Most of the time this is a collaboration between treasury, sales and controlling team, and final responsibility at CFO.

As said, running a business hardly goes without credit risk, but there are a lot of tools that can help you to limit it to an extent that is acceptable.

Please feel free to contact me if you need any further information or assistance in setting up a framework to control your credit risk.

 

 

Marco Lassche 

Founder and Owner of at Bedrijfskostenexpert
Treasurer and Project Manager at Van Caem Klerks Group
treasuryXL Ambassador

Managing treasury risk: Credit Risk (Part V)

| 23-2-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my fifth article I will focus on credit risk. Many companies have very significant credit needs and this needs to be formally addressed with a credit analysis procedure in place. In my former articles I dealt with risk management, interest rate risk, foreign exchange risk and commodity risk. See the complete list at the end of today’s article.

Credit Risk

Credit Risk occurs when there is a risk of default from money that has been lent to a borrower, or funds that have been invested.
The risk can be caused by:

  • Trade credit extend to a client, who does not pay
  • Inability to make a payment on a loan
  • A company going bankrupt
  • An insurance company not paying under a policy
  • A bank becoming insolvent
  • A company not paying wages to employees
  • A government defaulting

Main categories

The main categories of credit risk are:

Default risk
Counterparty risk
Sovereign risk
Legal risk
Concentration risk

Default risk:
occurs due to the default on monies owed either from lending or investment. The counterparty could be unable to repay. Sometimes they could also be unwilling to repay. The default risk is therefore on 100% of the outstanding balance, unless some form of recovery (be it full or partial) was possible.

Counterparty risk:
occurs when counterparties have to perform an action on a contractual commitment.
This can happen at both the time of settlement and also before settlement, but after entering a contract. Since the start of the financial crisis settlement risk is a major factor for banks. If at settlement a counterparty fails to meet its obligation, this can potentially lead to large losses and, eventually, to a systemic risk as you are therefore unable to meet your own obligations. A default before settlement can be alleviated by substituting a new contract though this could occur at prices far less favourable.

Sovereign risk:
entails the political, legal and regulatory exposures arising from international trade and cross border transactions. It can relate to a government failing in its obligation to repay or to new laws that prohibit free movement of funds – exchange control. Any contracts entered into with nondomestic counterparties should be analysed for the embedded sovereign risks and potential political instability.

Legal risk:
can occur if the counterparty is not legally allowed to enter into certain trades – especially derivative trades. We see in the media stories of companies that have experienced difficulties with derivatives leading to losses and court cases are started to either enforce or negate the contract. Also special purpose vehicles are formed purely to enter into certain transactions like securitisation issues. These are companies with no staff, fixed abode, or assets other than the underlying collateral of the issue.

Concentration risk:
arises from lack of diversification. Too many loans from 1 or 2 banks, too many products purchased from 1 or 2 suppliers, too much revenue generated by 1 or 2 customers. This risk is a bit of a paradox as many companies become successful through concentrating their resources in key niche areas, whilst having to diversify their underlying risk at the same time.

Measures

There are, of course, measures that can be undertaken to identify and minimize these potential losses.

The first approach is counterparty ratings. Certain criteria can be examined – credit rating agencies, examination of financial statements, good knowledge of the counterparty, political, geographical (are they situated next to a volcano?) and legal status.

Notional exposure reveals the full amount outstanding with a counterparty – all the money that could potentially be lost.

Aggregate exposure netts the exposure with a counterparty between monies to be received and monies to be paid.

Clear picture of the replacement costs – the costs involved to replace the existing transaction with a new counterparty.

Techniques of measurement

Measurement of credit risk requires quantitative techniques to measure and model the risks.  An example would be Basel III that places a regulatory framework on banks to ensure adequate capital ratios. Eventually the techniques being used will trickle down to commercial companies. This should result in the creation of risk tools that are more sophisticated and improvements of the techniques used to report and measure risk.

However, as the financial crisis has clearly shown, over-reliance on sophisticated computer models appeared to lead to false comfort with the results generated by the modelling systems. This was caused by underestimating the risks in new financial products and the great assumption that is always prevalent in economic theory – people behave rationally at all times! Any model is a snapshot of the world and can only contain a few variables that are perceived as critical. All others are discarded to ensure that the model can work quickly and efficiently.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Managing treasury risk: Foreign exchange risk

Managing treasury risk: Commodity Risk