What is Credit Risk?

Credit risk is the risk of loss due to a borrower not repaying a loan. More specifically, it refers to a lender’s risk of having its cash flows interrupted when a borrower does not pay principal or interest to it. Credit risk is considered to be higher when the borrower does not have sufficient cash flows to pay the creditor, or it does not have sufficient assets to liquidate make a payment. If the risk of nonpayment is higher, the lender is more likely to demand compensation in the form of a higher interest rate.

The credit being extended is usually in the form of either a loan or an account receivable. In the case of an unpaid loan, credit risk can result in the loss of both interest on the debt and unpaid principal, whereas in the case of an unpaid account receivable, there is no loss of interest. In both cases, the party granting credit may also incur incremental collection costs. Further, the party to whom cash is owed may suffer some degree of disruption in its cash flows, which may require expensive debt or equity to cover.

Credit risk is a lesser issue where the selling party's gross profit on a sale is quite high, since it is really only running the risk of loss on the relatively small proportion of an account receivable that is comprised of its own cost. Conversely, if gross margins are small, credit risk becomes a substantial issue, forcing sellers to engage in detailed credit analyses before allowing sales on credit.

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How to Assess Credit Risk

There are several ways in which to assess the credit risk posed by another party. Here are several options:

Review financials. A good starting place for a credit risk analysis is to read a firm’s financial statements to see if it has sufficient liquidity to remain in business, is well funded, and has a history of consistent profitability. A further financial investigation is to review its gross margin percentage on a trend line, to see if it is able to consistently maintain a reasonable profit; this is derived from being able to establish and hold reasonable price points, as well as by maintaining significant production efficiencies.
Review management. Another way to assess credit risk is to review the history of its senior management team. Ideally, this group should have a record of solid financial performance wherever they have worked, preferably having avoided bankruptcy situations. Any evidence in the business press of having made poor management decisions should be reviewed in detail.
Review the industry. A credit risk assessment can encompass the characteristics of the industry in which the business is located. Some industries are highly competitive, with low margins and a high dropout rate. They may also be nascent industries where there are too many competitors; a shakeout is likely, which will cause multiple businesses to go bankrupt. The result of a highly competitive industry will be readily apparent when the industry-wide return on capital and profits are low. Also, intense competition is more likely to result in highly variable earnings, especially when product replacement cycles are short.
Review a credit report. Another is to buy a credit report from a credit reporting agency that delves into the specific financial performance of the business. It notes any delayed payments, prior bankruptcies, and essentially any issue that might increase its credit risk. Depending on the type of report, it may also include a credit score, which is generated by the credit reporting agency.

Situations Where Credit Risk is Elevated

Credit risk is a particular problem when a large proportion of sales on credit are concentrated with a small number of customers, since the failure of any one of these customers could seriously impair the cash flows of the seller. A similar risk arises when there is a large proportion of sales on credit to customers within a particular country, and that country suffers disruptions that interfere with payments coming from that area. In essence, any concentration of sales increases credit risk. In these cases, proper risk management calls for the dispersal of sales to a a larger set of customers.

How to Mitigate Credit Risk

There are several ways to mitigate credit risk. A company that is contemplating the extension of credit to a customer can reduce its credit risk most directly by obtaining credit insurance on any invoices issued to the customer (and may even be able to bill the customer for the cost of the insurance). Another alternative is to require very short payment terms, so that credit risk will be present for a minimal period of time. A third option is to offload the risk onto a distributor by referring the customer to the distributor. A fourth option is to require a personal guarantee by someone who has substantial personal resources.

A lender that wants to reduce its credit risk can do so by increasing the interest rate on any loans issued, requiring substantial collateral, or requiring a variety of debt covenants that allow it to call the loan if they are breached, and to force the customer to pay off the debt before it is allowed to spend funds on other activities (such as paying dividends).

The Impact of Credit Risk on Interest Rates

A borrower’s credit risk is closely associated with the interest rate that it is charged on debt. This is because a lender will not be convinced to lend to a borrower with a high credit risk unless it is compensated with a greater return (in the form of interest). For example, a company with a dodgy credit history will only be able to issue bonds at a high interest rate, because prospective investors will otherwise have no interest in buying the bonds. Or, an individual with a sterling credit history will be able to obtain a mortgage at a low rate, because the lender perceives the individual to be more than capable of paying back the loan. Of course, if a borrower’s credit risk is simply too high, then lenders will not offer to lend to it at all, rather than charging a higher interest rate.

Credit Risk for Bonds

Credit risk also applies when purchasing bonds. There is a risk that the issuer of a bond will not pay back its face amount as of the maturity date. To guard against this, investors review the credit rating of a bond before purchasing it. A poor rating, such as BBB, is a strong indicator of a heightened risk of default, while a high rating, such as AAA, indicates a low risk of default. If you want to invest in a bond with a poor credit rating, then bid a price lower than the face amount of the bond, which will generate a higher effective interest rate. Or, if you want to avoid all credit risk, then only invest in bonds with very high credit ratings, though doing so will result in a low effective interest rate.