Credit risk is the risk of loss by a person or entity that has extended credit to another party. Credit risk is considered to be higher when the borrower does not have sufficient cash flows to pay the creditor, or it does not have sufficient assets to liquidate to repay the creditor. If the risk of nonpayment is higher, the lender is more likely to demand compensation in the form of a higher interest rate.
The credit being extended is usually in the form of either a loan or an account receivable. In the case of an unpaid loan, credit risk can result in the loss of both interest on the debt and unpaid principal, whereas in the case of an unpaid account receivable, there is no loss of interest. In both cases, the party granting credit may also incur incremental collection costs. Further, the party to whom cash is owed may suffer some degree of disruption in its cash flows, which may require expensive debt or equity to cover.
Credit risk is a lesser issue where the selling party's gross profit on a sale is quite high, since it is really only running the risk of loss on the relatively small proportion of an account receivable that is comprised of its own cost. Conversely, if gross margins are small, credit risk becomes a substantial issue.
Credit risk is a particular problem when a large proportion of sales on credit are concentrated with a small number of customers, since the failure of any one of these customers could seriously impair the cash flows of the seller. A similar risk arises when there is a large proportion of sales on credit to customers within a particular country, and that country suffers disruptions that interfere with payments coming from that area.
There are several ways to mitigate credit risk. A company that is contemplating the extension of credit to a customer can reduce its credit risk most directly by obtaining credit insurance on any invoices issued to the customer (and may even be able to bill the customer for the cost of the insurance). Another alternative is to require very short payment terms, so that credit risk will be present for a minimal period of time. A third option is to offload the risk onto a distributor by referring the customer to the distributor. A fourth option is to require a personal guarantee by someone who has substantial personal resources.
A lender that wants to reduce its credit risk can do so by increasing the interest rate on any loans issued, requiring substantial collateral, or requiring a variety of debt covenants that allow it to call the loan if they are breached, and to force the customer to pay off the debt before it is allowed to spend funds on other activities (such as paying dividends).
Credit risk is also known as default risk.