Credit Risk Management
By Michael C. Dennis, MBA, CBF

Credit risk can be defined as the risk of financial loss resulting from the failure of the debtor to honor part or all of its obligations to pay creditors' invoices as they come due. The goal of credit management is to optimize the company's sales and profits by keeping both credit risk and payment delinquencies within acceptable limits. Sound credit management involves finding the right balance in the risk/reward relationship between sales and bad-debt losses.

There are a number of ways to actively manage credit risk. Your options include:

• Avoiding risk. This can be accomplished by refusing to extend credit to high-risk accounts. However, in most companies this is not a viable option since so many customers could be classified as high risk that refusing to sell to them would reduce sales to unacceptable levels.

• Controlling risk. This option involves developing a comprehensive plan to reduce credit risk in the company's accounts base, then implementing that plan, and monitoring the credit department's efforts to carry out the plan.

• Accepting risk. A few companies simply accept the risks associated with doing business with customers identified as high risk. These tend to be companies trying to gain market share, companies with high profit margins, companies with excess inventory, and companies with adequate reserves for the bad debt losses that are almost certain to accompany this policy.

• Transferring credit risk. An example of transferring credit risk would involve purchasing credit insurance. Other examples of transferring credit risk include flooring or factoring of the company's accounts receivable.