Managing your company’s B2B credit risk is crucial for ensuring the financial health of your business. One of the best and most efficient ways to do that is through a credit risk rating system to help you make quick, sound lending decisions. If you don’t have a risk rating system or if it’s been a while since you updated it, here are some considerations to keep in mind.
Importance of risk ratings
A risk rating system is an essential tool in managing credit risk for your business. It is a scoring system that provides consistent guidelines for evaluating credit worthiness. Such a system will allow you to assess a company’s probability of default and help you make quick lending decisions.
A risk rating system helps you avoid credit policies that are too strict or too lenient, both of which can hurt your bottom line. Having a definitive credit scoring system can also help reduce conflicts between the sales and credit departments, as well as reduce overhead.
Factors used in rating risk
There are a lot of factors to consider when assigning a company’s risk rating. Here are some obvious ones as well as some you may not have thought about:
- The borrower’s financial health. Research the borrower’s cash flow, liquidity, profitability ratio, credit scores, etc.
- Quality of management. Consider things such as tenure and experience, as well as more subjective judgments such as reliability and relevance of the experience.
- Trade references. Check with other companies they’ve done business with to discover any problems.
- State of the industry. How well is the industry doing during current economic conditions: Cyclical industries may be more volatile. Industries with low barriers to entry may entail more risk.
- Political and environmental conditions. Consider current political leaders’ policies, threats of war, and effects of pollution or climate change.
Putting your scorecard together
A risk scorecard brings all the borrower’s relevant information into one formula that determines a threshold of risk tolerance to help you make sound credit decisions. Credit professionals often don’t have a lot of time to look at spreadsheets and credit reports or to call references and perform all the other manual tasks in credit decisions. A risk scorecard can eliminate much of that time-consuming process and make decision-making more efficient, reducing overhead and freeing up staff for other key tasks. To get started, here are some best practices for creating your scorecard:
- Get granular in your scoring. Split your ratings into smaller, more precise categories for more intelligent decision-making.
- Use consistent rating results across lines of business, customer, and time.
- Use clear, definitive data (objective data should be given more weight than subjective data).
- Be transparent. Analysts should be able to determine how a rating was derived.
- Use the latest technologies and platforms to store, analyze, and report the data.
- Make your scoring system easy to use and provide clear instructions on its use.
Having a credit risk rating system is essential for efficient credit risk analysis. If your credit department has not created a rating system or an older one needs an update, MSCCM can help.