Trade credit risk is a term used to describe the risk that a business assumes in order to extend credit to clients, allowing them to pay for purchases over time. Typically, trade credit accounts allow clients to make purchases and take possession of the goods or services, then pay for those purchases over a period of anywhere from 30 to 180 days. While providing this type of credit option is helpful in securing business, the strategy also means that the company is at risk of clients defaulting on the open balances before the accounts are settled in full.
Businesses attempt to limit the amount of trade credit risk assumed by using some sort of standards or qualifications for clients who wish to make purchases then pay for them over an extended period of time. As part of the financial terms of the revolving credit account, the company will require that the client agree to a credit check. Customers with lower credit ratings will usually be granted a lower credit limit and may also be subject to a higher rate of interest on the open balance. Doing so means that the business is somewhat protected from default, since even if the customer in question does fail to settle the account according to terms, the loss has been kept to a minimum.
While taking the time to qualify customers for trade credit privileges on the front end is essential, many companies will also continue to periodically evaluate customers to determine if the level of trade credit risk has changed in some manner. This often is based on how responsible the client has been with the credit limit, especially in terms of retiring balances within the agreed upon period of time or consistently paying more than the minimum balance due. In addition, the company may choose to pull credit reports every year or two as a means of ascertaining if the customer’s credit rating has increased or decreased. A decrease in that rating may lead the company to lower the client’s credit limit as a means of avoiding the assumption of greater trade credit risk.
Company owners that choose to extend trade credit realize that there is no way to completely eliminate the possibility of default on at least a small percentage of the outstanding payables at any given point in time. The goal is to keep the trade credit risk as low as possible, taking quick and decisive action when changes in the financial circumstances of customers occur. Doing so is not only in the best interests of the company, but also beneficial to other clients. This is because limiting trade credit risk means the business is in a better position to continue providing goods and services to those other clients at reasonable prices.
