Credit sales are a common feature of the modern trade. Offering credit sales means that businesses are willing to assume some credit risk to increase their sales. We do not live in a perfect world and there will be some defaults. However, the companies still sell the goods or services on credit as they believe that the benefits of increased sales outweigh the credit risks involved. Having said that, credit risk cannot be ignored, and businesses must manage their credit risks to avoid significant credit losses.
What is credit risk? It is a risk that an entity may not be able to recover its receivables, either the principal, interest, or any other form of contractual payment when they are due to be received. It will not be beneficial practice for a business if it is earning lots of revenue by credit sales but is not able to recover its receivables. Therefore, businesses must manage their credit risks to avoid significant credit losses.
Credit risk management
Credit risk management is the process of minimizing credit losses by formulating and regularly monitoring the credit policies of an entity. This is a challenging task but an important one. Businesses may include the following measures in their credit risk management policies:
- Credit risk should be reasonably diversified and not saturated, if possible. For example, if an entity has only one or two large customers and if they default, it will be major concern for the business and its going concern. If this risk is spread on numerous customers, the default of one or two parties will have lesser impact.
- Credit history of customers should be properly documented and regularly evaluated.
- Parties having the history of defaulting should be categorized separately and should not be offered any future credit facility.
- Based on the credit history of customers, credit limits can be set for customers beyond which credit sales should not be offered.
- Before offering credit sales, customers can be evaluated by reviewing their financial statements.
- For risky customers, businesses can opt for credit insurance facilities to mitigate their credit risks.