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 options.

1. Grant credit - customer pays – seller makes a profit. 
2. Refuse credit - customer would not have paid – seller saves cost of sale. 
3. Grant credit - customer does not pay – seller loses cost of sale. 
4. 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 says differently.

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 profits.

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 concerned.

I wish you well.  

This 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.