Credit risk

What it means

Credit risk is the risk that a debtor, customer or other counterparty will not meet a payment obligation on time or at all. For an ordinary company it is mainly the risk that a customer will not pay an invoice; for a bank, that a loan will not be repaid. It also covers advances paid to a supplier that then fails to deliver.

The risk has two components: the probability that the debtor will not pay, which depends on its creditworthiness, and the size of the loss, which depends on how much the company is exposed and what security it holds. A large receivable from a single customer with an unclear financial position is a concentration of risk.

Credit risk cannot be eliminated entirely, but it can be managed: through the choice of partners, limits, security, insurance or selling receivables. Good management means losses are predictable and the company can absorb them without endangering its own liquidity.

How it works in practice

For new customers we recommend a business partner check: registers, the tax debtors list, published financial statements, enforcement proceedings and payment history. On that basis a credit limit and payment terms are set, with advances or prepayment for risky partners.

A regular tool is receivables ageing, which shows who pays late and how the picture is changing. For larger volumes, trade credit insurance or non-recourse factoring help by transferring the risk to an insurer or factoring company.

In the accounts credit risk appears as impairment allowances on doubtful receivables. For tax these are recognised only under statutory conditions, for instance according to how long a receivable is overdue. At year-end we therefore assess receivables individually and by age.

What to watch out for

The most common mistake is concentration: one big customer accounts for most revenue and receivables, and its payment problems then threaten the whole company. With such dependence, insurance, shorter payment terms or actively spreading sales across more customers make sense.

The second mistake is ignoring warning signs: a customer who used to pay on time starts paying late, asks for deferral or instalments, or changes bank accounts. Reacting early, for example by stopping deliveries or asking for security, is cheaper than collecting after a bankruptcy.