A credit risk is determined by the amount of a financial loss that occurs when a borrower is not able to pay his creditor when the payment is due. Credit Risk Management is a technique to help a firm’s profitability stay consistent and strong by reducing the company’s vulnerability to delayed payments or those that are defaulted on. A business wants to strike the correct balance with the amount of risk it is willing to take on. An optimum goal is for a company to eliminate high risk, manage medium risk, and ready to take on all the low risk opportunities it can find. Here are some of the practices to follow in managing credit risk.

Before approving a new customer for credit, steps should be taken to verify a client’s financials and credit worthiness. A credit check is the simplest means to verify such information. A credit report with determine if a customer had credit issues in the past and if credit protection is needed. The customer’s balance sheet will show where the customer stands in being able to provide enough cash to be able to support the new debt.

By asking a customer for a deposit, you are safeguarding the debt by at least that amount. Furthermore, a customer who is willing to put down a 25 – 30% deposit on their order is not likely to walk away from paying the remainder of the bill.

Credit risk can be minimized by requiring a security interest, or collateral, on some part of a debtor’s assets. Ownership of these assets reverts to the creditor if the debtor defaults. In that way the credit risk is reduced when those assets are sold and the amount received for them is applied to the defaulted amount. An important practice that needs to be followed when doing this is to make sure there are no encumbrances attached to the asset being used for collateral. The creditor will not be able to use them if someone else can claim them.

Sometimes just saying “No” to a potential debtor is the best solution to reducing credit risk. If there is any indication that the customer isn’t going to pay, it is best not to offer any credit terms. Furthermore a commercial creditor is not obligated to explain any of the decision-making process; even when a “no credit” is the final result.

A letter of credit is usually issued by a bank and it takes on the debt liability of the client. So if the customer defaults on the issued credit, the bank or issuing agent of the letter of credit is responsible for the debt and has to pay the creditor. That institution then goes after the customer. You, as creditor, eliminated the credit risk in this case.

Credit default is widespread throughout all industries. Whether a business concentrates on one way of reducing credit risk or uses all of them, it is important that the company determines its best chances of receiving full payment for its sales.