the list of seminar topics my company, Business Education Services,
provide are credit analysis and risk analysis. Prospective clients often ask us, “What
is the difference between credit analysis and risk analysis, aren’t they
the same thing?” Our response to this question is, no they are not.
Credit analysis involves determining the
probability of payment and is the most common practiced of the two analyses.
Probability of payment involves gathering bank and trade payment experience,
analysis of the customer’s balance sheet and the overall evaluation of
character, capacity and capital. It is short-term analysis and most often
the only analysis used in determining whether or not to approve a customer
for credit terms.
Risk analysis involves identifying the
potential loss or gains in selling to the customer over a period of time and
is considered by many to be advanced credit analysis.
In today’s business environment risk
analysis often plays a more important role than credit analysis. The reason
being that more and more businesses are informing their credit departments
that the credit sale is a given and though it is the responsibility of the
credit professional to identify and control risk, “not to sell on
credit” is not an option. This is not a new concept; many organizations
have operated their credit departments employing risk analysis for decades.
To understand the concept of risk analysis
one has to focus on profit and loss. Under this premise there are four
- Grant credit - customer pays – seller
makes a profit.
- Refuse credit - customer would not have
paid – seller saves cost of sale.
- Grant credit - customer does not pay –
seller loses cost of sale.
- Refuse credit - customer would have paid
– seller loses profit.
As one can see, the ultimate question is,
“What is the potential gain or loss in taking the risk?” Keep in mind that the first principle of credit is that risk
is inherent in every transaction conducted on credit terms. The key to risk
analysis is first being aware of your company’s margin of profit in their
products or services and second, where is the break-even point. The credit
professional that utilizes these two tools will make credit decisions that:
Improve company revenues.
Eliminate the impact of bad debt on company
operations and finances.
Make the credit department a hero in the
eyes of the sales department.
Credit analysis relies on the use of
customer provided information. Risk analysis uses our company information,
primarily revenue and cost of sales, to determine how much risk there is in
selling to the customer on open terms over a period of time. The use of risk
analysis can produce a favorable decision to sell even when credit analysis
In our seminars we employ several examples
to illustrate risk analysis. The following is one of those examples.
Let’s assume a very marginal prospect
applies for credit. Their credit references are less than sparkling and if
we were to credit score them they would not qualify for credit. The sales
department wants to sell them $30,000 each month.
Knowing our profit margins we use
break-even analysis to identify the time line where our company’s cost of
sales and profit equal zero. Utilizing this tool we can determine the
necessary credit limit and provide it with restrictions. If we sell through
the break-even month and have to write money off to bad debt, we will still
recover our costs. Thus, any purchases and payments made after the
break-even month will produce a profit.
Now, let’s assume our break-even point is
two months. We’ve established a credit limit of $30,000 and our margins
are 33%. The customer purchased and paid through twelve months and then
experienced problems in the thirteenth month. Our revenue through thirteen
months is $390,000 and profits would be close to $120,000.
If we write off the purchases made in the
thirteenth month to bad debt it would appear, on the surface, to put the
credit department in a bad light. However, when offset against the profit
made during the twelve months, it no longer is material. The company will
still realize eleven times the amount written off, in profits.
In our example, had the credit manager
refused to grant credit based solely on credit analysis, the company would
have not realized over $350,000 in additional revenue and over $100,000 in
We also employ examples using lower profit
margins that may take longer to meet the break-even point and thus require a
lower credit limit. However, it becomes easier to justify the assigning of
credit limits and the basis for the credit decision to the sales department
with information that reflects the differences in overall profit vs. loss
then just relying on prior payment history and a “feeling” that the
customer will fail.
The efficient credit department, today,
utilizes both credit and risk analysis in making decisions that benefit all
I wish you well.
information is provided as information only and not legal advice.
Legal advice should be obtained from a competent, licensed attorney,
in good standing with the state bar association.