Why Businesses Need Credit Risk Management

Back when "forward contracts" were used between the wool markets of England and the Italian merchant societies, there were stipulations that cash loans would be repaid in wool through credit. From this medieval time until current businesses have to rely on investment and many owners don't have the cash to capitalize a new venture or underwrite new products. However, ever since the early days there has always been risk associated with making credit available. Accounts can be paid late or go into default. In order to reduce this risk it is important for business owners to use credit risk management.

The mistakes of extending credit to others are real and can be very costly. For example, XYZ Ltd in India approaches ABC Company in the United States to buy ten million in computer chips for a new project. While this is a good deal, both companies also need to be careful. Neither company knows much about each other and has no history together. There is no way to know if a contract is honored and if the bills will be paid on time.

At this point, ABC Company has two choices. Either they can require a cash down payment with the balance due upon delivery of the product or they can use credit. Cash transactions are a safe option because ABC can keep the deposit and sell the chips to someone else if XYZ Ltd doesn't pay. However, cash transactions aren't the routine in the business world. Credit is what most businesses use because of the benefits. Since XYZ Ltd is going to sell a finished product and get more for the chips there is a profit to be made. The best option for XYZ is to use these profits in order to pay their suppliers rather than cash up front.

Making a Sound Decision

ABC Company is likely to agree to extend credit to XYZ. Often there will be a down payment with a term of "net 30" or "net 60" required upon delivery of the product. As the creditor, ABC Company isn't going to need interest on the account, but may choose to charge interest if a late payment is made.

However, ABC Company needs to determine the risk involved before they extend credit to XYZ. The best way to do this is to get a credit report. This report contains financial and payment history information that is only available through a credit risk management agency and is vital in making a sound business decision.

A business credit report is only useful if it contains up-to-date and accurate information on the company as well as background information on shareholders, management and bank information. Basically, a credit report contains all the vital information needed to determine a company's financial strength.

No matter what type of business, everyone needs credit so it is important to have a good credit rating. This makes it easy for companies to get credit through a vendor. The credit rating allows both parties to benefit. ABC Company is sure that they are providing credit to someone who is trustworthy while XYZ Ltd gets the credit it needs.