What is credit risk in trade finance?
Investors who finance a portfolio of trade receivables or an individual trade receivable face credit risk. Credit risk is the risk that one or more parties involved in a trade receivable are unable to meet or do not meet their financial obligations.
Whose credit risk should I worry about?
There are quite a few organisations involved in most trade receivable transactions and in most trade receivable portfolios. The most important are:
- The buyer –owes the money
- The supplier –supplies the goods or services that the buyer should be paying for
- The servicer – originates the receivables, keeps the books and records, manages the cash, chases the buyer if he does not pay
As a general matter, it is the buyer that is the biggest credit risk to worry about. But the other risks can become important – and even lead to major issues for an investor.
Buyer credit risk
This is the obvious risk and quite simple. This is the risk that the buyer does pay the amount due in respect of the trade receivable being financed. There are two dimensions: ability and willingness.
Ability to pay can be considered using conventional credit metrics, ratios and analysis. Key considerations include: profitability, tangible net worth, and cash conversion. Since trade receivables are unsecured claims, it is generally important only to finance businesses that are profitable and have positive operating cash flow.
Willingness to pay involves an assessment of the buyer’s engagement with his supply chain and his past track record in dealing with suppliers over payments, the understanding of the obligations that are involved in a trade receivable financing – and ideally also his relationship with other financiers that may be involved in his operations.
I understand credit risk on the buyer, but what other credit risks are there?
For example – suppliers:
- Supplier Concentration Risk
When a supplier has a problem, experience tells us that buyers can often become difficult about paying. If there are many suppliers in a portfolio, then this is a low risk. But sometimes there is only one supplier, or one supplier has generated a large share of the receivables – for example, in a typical securitisation of trade receivables for a single large corporate. This becomes a single source of additional credit risk.
- Performance risk
If nothing is done to mitigate the performance risk, then buyers can have the right to “set off”. What this means is that they pay less than expected or even none of the trade receivable. There would be a claim against the supplier for the shortfall – but here the credit risk has become a mixture of buyer and supplier combined.
For example – on servicers:
- Fraud Risk
It is usually the servicer who also originates the receivable, and who vouches for its authenticity. But if there is a fraud even if it was undetectable – the investor will look to the servicer to make things right. This means that there can be servicer credit risk in the mix of risks.
- Commingling risk
If the buyer pays into a bank account of the servicer and the cash is mixed with other balances, then investor money can end up being used by the servicer for other purposes, or taken by other creditors. This is another form of servicer risk.
- Servicer replacement
If the servicer goes out of business, then there can be no one to look after the investor’s interests.
How do I understand the risks that I have?
There is no single and easy answer, no “one size fits all” way to appreciate the risks involved in a trade receivable or a portfolio of trade receivables. The credit risks involved in financing a trade receivable depend on many factors – not just the credit risk of the buyer or the performance history of the supplier.
Strong structures, like the ones that PrimaDollar uses for itself, include:
- Controlled bank accounts for cash collections, separated from our own funds
- Notification to the buyer to prevent set off and legally perfect the purchase of the receivable
- Advance rates that are set to take into account the performance risk on the supplier given the history and the credit standing of the supplier
- Diversification of risk across many buyers and many suppliers to avoid single points of failure
- A standby servicer with a high credit rating and strong reputation contracted to step in if there is any failure on the part of the servicer
How can I find out more?
With a global network and global coverage, talk to us.