Risk is an inherent part of any business activity being carried out. The reward is directly proportional to the amount of risk taken. It is the part of the parcel and no business is immune to risks. In the most basic sense of things, risk can be understood as the uncertainty around a business.
Even the recession-proof businesses are prone to some level of risk, given the current pandemic situation it is very much evident. Risk cannot be eliminated from a business activity but it can be managed and brought down to minimal levels that have very little influence. Enterprises should focus on the concept of calculated risk.
What is Credit Risk?
Credit risk can be explained as the risk of default that arises when the borrowing party fails to meet its contractual obligations. Not being able to repay the loan amount in the specified time frame is counted as a breach of the contractual agreement between the borrower and the lender. It is the probability of loss that can occur when borrowers fail to repay the loan amount.
Credit risk is multi-faceted and can be categorised into three types. The three types of credit risks include default risk, concentration risk, institutional or sovereign risk. All three types entail different types of defaults on the loan amount. At the core of it all lies the failure to meet the obligations of the debt contract, the underlying reason behind this failure to repay differentiates the types of credit risks stated here.
Reducing credit risk
Managing credit risk in the contemporary landscape is a complex process as it involves multiple variables that might influence the business. In addition to this, the globalised economy faces repercussions from all across the globe. Credit risk managers have a crucial role to play in the banking and finance sector.
A career in this domain is highly rewarding given the growing demand for the skills possessed by credit risk managers. Credit risk certification can help you kick-start your career in this domain. The most rudimentary step in credit risk reduction is evaluating the borrower’s creditworthiness. Let’s dig deeper into how credit managers assess the creditworthiness of the borrower.
Conducting Due Diligence
Knowing your customer is the key to reducing credit risk, especially for companies in the banking and finance industry. You must obtain important relevant information about your customers before doing business with them. This will help you identify a genuine customer. You must ask for their historical financial data, the purpose of the loan and their business registration documents.
Credit risk managers also use the CIBIL score to evaluate the creditworthiness of the borrower. A good CIBIL score can easily help the borrower to obtain a loan as it shows a positive financial track record. A thorough due diligence process also includes conducting a reference check and using industry contacts to find out about the financial standing of the person or organisation seeking funds.
Establishing Credit Limits
Establishing credit limits for borrowers help a great deal to reduce credit risk. Setting credit limits work on similar principles of diversification, at the core of setting credit limits lays the idea of limiting exposure from any one party. To establish a credit limit for a party you need to examine their previous financial records.
You can check out some common financial indicators like sales, net profit, gross profit, working capital ratio, liquidity ratio, etc. In addition to this, you also need to analyse the key economic indicators and conduct industry analysis. This will give you a comprehensive understanding of the prospects of that business and also help to find out the optimum credit limit for the borrower in question.