Financial Glossary
Credit risk
Credit risk is the possibility that a counterparty -- a borrower, customer, or business partner -- will fail to fulfill a financial obligation, resulting in a loss to the creditor or investor. For lenders, credit risk is assessed through borrower creditworthiness analysis covering capacity (cash flow), capital (net worth), conditions (industry and economic environment), character (payment history), and collateral. For businesses extending trade credit, it includes the risk that customers will not pay invoices on time or at all. Credit risk management involves setting credit policies, monitoring exposure, diversifying counterparty concentration, and reserving for expected losses through an allowance for doubtful accounts.
Problem & Application
A marina that sells fuel, slip rentals, and boat storage extends 30-day net terms to commercial fishing fleets and charter operators. When a major charter company representing 18% of the marina's receivables files for bankruptcy, the marina faces a write-off of $85,000 in uncollected invoices. Post-event analysis reveals the charter company had shown warning signs: increasingly slow payment over six months and one returned check. Implementing a credit risk policy -- credit applications for accounts above a threshold, a watch list for slow payers, and a cap on any single customer's outstanding balance as a percentage of total AR -- would have flagged the exposure and prompted early collection action or a deposit requirement before the receivable grew to an unrecoverable size.
In Short
Managing credit risk is essential for financial stability. Companies should implement strong credit policies and diversify risk exposure.