What is a Credit Risk?

Establishments that lend money to other companies are normally very critical about all the requirements needed for the loan to be approved. Usually, the credit risk of the borrower is one of the most prominent requirements.

The credit risk is, simply put, a risk associated with the borrower’s inability to pay back what they owe. Naturally, if that’s the case, the lending party won’t just lose whatever it is they are owed, but also the potential revenue associated with cash flows from credit obligations. In short, high credit risks are bad for everyone.

Credit Risks Explained

Loans represent excellent revenue sources for both parties. The borrowing party is able to generate income using money or other assets that constitute the loan. The lending party, on another hand, counts on passive income generated by cash flows, dictated by the obligation. That, though, only happens in theory.

In practice, businesses can go bankrupt for various reasons. The higher the chance of this happening, the bigger the credit risks of the particular company. So, for everyone’s sake, it’s better to avoid building up a credit risk altogether. Obviously, it’s not so easy, and not just because you can’t avoid making mistakes, but also because it partially doesn’t even depend on the company.

Suffice it to say, the credit risks are usually common knowledge for everyone in the respective niche. Credit risks can not only be used to justify refusing the loans, but also to determine whether or not the company can sustain the value of its stock. Although it doesn’t show it directly, the trends are interconnected.

How is Credit Risk calculated?

There are plenty of calculators that follow specific formulas to give you an answer for each particular business.

Unfortunately, these formulas are rather complex. They don’t just take into account the credit history of the business, but also loan conditions, capital of the business, repaying capacity, and collateral. To know more about each of these elements, you can simply search for the ‘5 C’s’.

The general logic is that the business is less likely to fail if they have deep enough pockets. Exactly how deep you want these pockets to be is up to you, and it also depends on the size of your loan.

Moreover, collateral and loan conditions exist to sweeten the pill. If the requirements demand excess cash flows or special other payments over the course of the entire credit period, it’s going to minimize the losses for the loan-giver. Additionally, collateral gives a better stimulus for the lender to actually give the loan, as it also reduces the losses.

Interest Rate

Interest rate is usually the cornerstone of the entire deal when it comes to deciding whether or not the applicant for a loan is going to be approved. Poor credit history, insufficient capital, lack of collateral, or some other problems can be compensated by astronomical interest rates.

Now, obviously, it’ll mean the borrower will have to give much of their income to the lender just to cover the interest. Fortunately (or unfortunately), there are plenty of lenders who provide high-risk high-interest deals to companies and individuals with poor credit background.

Although it’s definitely an option, you should think about improving your credit reputation rather than go for an abysmal high-interest option.

Components of Credit Risk

The 5 C’s of credit risks are the common parameters used by professionals to calculate how unreliable the borrower can be. Among them, the credit score is by far the most prominent.

  • Credit historyCredit history refers to the client’s history of returning credits. It’s not just a question of whether or not the previous credits have been paid up. A credit score takes into account the timeliness of payments, the contents of previous loans themselves (including interest rates and size), the past ability to pay back, and more.In general, if you’ve struggled with credits before, it’ll show. Obviously, if you’ve struggled even with smaller loans, the lenders will think twice before trusting you with something bigger. On the contrary, if you’ve successfully paid back bigger and bigger loans (and done it on time), your loan-taking ability will grow (while the interest rates will go down).
  • Capacity for paying backIt’s a somewhat more obvious parameter, and it’s actually derived in part from the credit background. Struggling or reluctance to find money to pay back your loans qualifies as incapacity to pay back. But it’s also about having enough actual income to cover the interest and the loan.
  • CapitalCapital refers to the equity business has or the property an individual possesses. These are important because borrowers with deeper pockets can withstand more financial problems and still continue paying on time. It’s also important for borrowers to have some spare capital because it’s a direct contributor to a good credit score in the future.
  • ConditionsConditions of the loan include the size, the interest rates, the special provisions, duration, etc. Softer conditions (a smaller loan for a shorter time) can actually be approved even if you don’t have outstanding history. So, it’s all about balancing your current situation with your desires.
  • CollateralCollateral can be anything from a house to some collection of stock. In short, it’s a property you leave with the lender as insurance that you’ll indeed pay back. Collateral is normally part of the loan requirements, but it’s still considered a separate parameter because of how important it is.