Synopsis: A proper credit risk management process helps you avoid payment defaults and maintain a positive cash flow to keep your operations running. This article covers the best credit risk management practices to help you create a robust strategy for your business.

A proper credit risk management process can help you manage and better operate your small business’s finances by allowing you to evaluate and manage the risk of payment defaults. 

A good credit management strategy can help any business maintain a healthy cash flow, which is essential for running their operations. Cash flow is important for all businesses irrespective the size of the org, but especially for micro, small, and medium-sized enterprises that may have limited access to other sources of financing. Yet, the credit gap in the sector is expected to be Rs. 98 trillion by 2024. The credit gap is the difference between the addressable demand for external credit and the supply of formal financing sources. 

MSMEs must employ robust credit risk management processes to help bridge this gap and safeguard their businesses. In this article, we will discuss why MSMEs need a credit risk management process and provide five best practices to manage the business’s credit risk effectively. 

Importance of Credit Risk Management For SMEs 

A comprehensive credit risk management strategy reduces the risk of financial losses by minimizing the credit risk exposure. It helps SMEs recognize what could be making them risk-prone, minimize payment defaults, and maintain constant cash flow.  

Credit risk management also enables SMEs to make more informed decisions, whether as a borrower, creditor, or supplier. 

A few more ways through which it benefits SMEs are: 

  • Expand Sales Opportunities: Suppliers usually negotiate with businesses with proper credit risk management, ensuring that they will be paid on time. 
  • Upholds Reputation: It showcases your reliability and responsibility to customers, suppliers, and other businesses, enhancing their confidence in working with you. 
  • Cost Savings: With an effective credit risk management strategy, you can negotiate better terms with your suppliers, extend payment periods, and even get discounts for bulk purchases.  

5 Best Credit Risk Management Practices In SMEs 

While you cannot completely avoid risks in a business, you can mitigate them with a credit risk management process. It helps you assess, monitor, and manage your customer’s credit risk while ensuring that your decisions align with your business’s goals. 

Here are some five best credit risk management practices that you must know to reduce payment defaults: 

1) Assess The Customer’s Background 

According to The Risk Management Association, understanding the client is the first step in reducing the likelihood of default. 

 A standard method is to assess them using the ‘Five Cs of Credit’ to create a profile of their financial risks. The five C’s are: 

  • Character 
  • Capacity 
  • Capital 
  • Collateral 
  • Conditions 

This assessment is based on the notion that a customer’s past payment performance (as well as current finances) might help predict their future actions. 

2) Credit Check Potential Customers 

Assessing the vendor and customer’s background is only one part of credit risk management. You must also check their credit history as part of your onboarding process. 

When granting credit to a client, you must examine two factors:  

  • The client’s creditworthiness
  • The potential impact on your cash flow if the client defaults. 

You can use the following sources to gather this information: 

  • Credit bureaus  
  • Financial institutions and banks 
  • Public financial records 
  • Other sources, such as personal guarantees 

Additionally, you can leverage automated solutions to track your customer’s payment history and notify them of any late payments.  

3) Create An Online Form 

Introduce an online credit application form to facilitate and accelerate customer and vendor onboarding. This form will also help you gather, store, and analyze customer information. 

Ideally, your credit application must include the following information: 

  • Information about the company, bank, and commercial trade 
  • Provisions in the event of non-payment 
  • The maximum time required to report a quality/quantity issue  
  • Terms of payment  
  • Description of how disputes would be resolved  
  • Your rights to end credit terms  
  • Data verification 

Plus, having accurate and detailed client information strengthens your credit risk analysis process. 

4) Create A Credit Control Policy 

A credit control policy ensures that everyone in your organization is on the same page and understands what needs to be done in case of payment defaults. 

The policy should clearly outline the actions for contacting and following up with defaulted customers. 

Your business’s credit control policy should clearly define the following: 

  • The mission of the credit team 
  • Collection process 
  • Roles and responsibilities of team members 
  • Goals of the organization 
  • Terms of sale  
  • Credit evaluation process 

5) Communicate Payment Terms 

It is critical to communicate payment terms to consumers properly and on time to avoid late payments and maintain healthy customer and vendor relationships.  

Here are some other pointers to assist you in improving client communications for improved credit risk management: 

  • Clearly state the payment terms 
  • Clarify interest rates and taxes 
  • Specify due dates and penalties for late payment 
  • Specify clauses for dispute management 

To Sum Up 

A late-paying customer can wreak havoc on SMEs with little or no external capital. So, maintaining a robust credit risk management system is the answer to minimizing payment defaults, and managing rigorous credit controls while maintaining your market share. 

Moreover, various software options can assist you in automating and streamlining your credit risk management process. These tools help you analyze payment patterns, identify high-risk customers, adjust credit terms, and enhance your cash flow. 

Implement a robust credit risk management strategy to position your business for increased stability and growth.