What is credit risk? Definition, types, and examples

What is credit risk?

When a borrower fails to repay a loan or fulfil the repayment terms as agreed upon, it represents a credit risk. It denotes a possibility of financial loss for your business. Whenever you extend credit, whether through trade credit, loans, or regular terms of payment, there's an inherent risk that the borrower won't repay you.

Cash flow serves as the foundation of your business, and credit risk can disrupt it. As a business owner, you face credit risk in your daily operations. Sometimes, it's a customer postponing payment, and other times, a vendor goes missing after you make the payment.

In practice, even one unpaid invoice can disrupt your payroll, slow down your operations, or force you to borrow at higher costs. In such times, a minor default can lead to significant financial strain for your company.

Types of credit risk

Credit risk is the possibility of losing money because of someone else's incapacity (or reluctance) to make payments. It appears in several forms; here are the most common:

Standard credit risks

Default risk

Default risk is one of the most common forms of risk, and it refers to the potential that a borrower or client may not repay the money they owe you.

Example: Your company extends a 90-day credit to a long-term client, but they hit a financial snag at their end and shut down their operations due to lack of cash flow. This leaves you and your business with a substantial unpaid invoice.

Concentration risk

Concentration risk arises when a significant portion of your business's revenue is derived from a single consumer, industry, or geographic market.

Example: Your business relies on an overseas client for approximately 80% of its revenue, but due to geographical unrest, the client ceases to place orders. Suddenly, due to a lack of revenue from this client, your business is in financial distress.

Other risks that may impact credit exposure

Operational risk

Operational risks can occur due to system failures, human errors, or disruptions in the payment process. These risks aren't part of credit risks, but they may trigger or exacerbate credit risks.

Example: While onboarding a client, you fail to conduct due diligence on their delivery pattern, and this miscalculated risk can result in production delays, leading to misalignment with vendor payouts and operational losses.

Counterparty risk

When your business relies on trading, foreign exchange contracts, or vendor relationships, you may face situations where the other party fails to fulfil their commitment. This isn't a pure credit risk as it arises from non-payment activities, but it can amplify your credit risks.

Example: You prepay your vendor for an urgent shipment; however, due to unforeseen circumstances at the vendor's end, there is a delay, which results in a loss of business opportunity. H

Country/cross-border risk

When your business relies on cross-border trading, foreign exchange contracts, or overseas vendor relationships, you may face situations where the other party can't or won't deliver on their commitment because of political decisions, regulatory changes, or FX settlement failures.

Example: you prepay a supplier for an urgent shipment, but regulatory clearance is delayed in their country, and the consignment is held up, causing you to miss customer deadlines and lose sales.

How credit ratings work and what they mean

Credit ratings tell you how likely a business or borrower is to repay their debts. Think of them as a financial “report card” that helps lenders, suppliers, and investors decide how risky it is to work with someone.

Independent rating agencies or financial institutions assign these ratings based on factors such as cash flow, debt levels, payment history, and the overall stability of the business.

The ratings usually fall into two broad groups:

• Investment grade (AAA to BBB): Low risk. These businesses are perceived as reliable and capable of repaying on time.
  
• High yield or non-investment grade (BB and below): Higher risk. These businesses may have weaker cash flow or a history of late payments.
  

A higher credit rating means you're more trusted, and that usually leads to lower interest rates, better loan terms, and easier access to trade credit from suppliers. A lower rating means lenders may charge higher interest rates or require additional collateral or guarantees.

Why credit ratings matter

• They can impact your interest rate. High credit ratings = lower interest rates.
  
• Investors evaluate your risk profile with your credit rating
  
• Other businesses leverage credit ratings to extend trade credit.
  

How MAS guidelines and credit ratings affect your business

The Monetary Authority of Singapore (MAS) sets credit risk management standards for financial institutions such as banks and licensed lenders. While these guidelines don't directly apply to small and medium-sized enterprises (SMEs), many businesses benefit from adopting similar credit risk assessment and monitoring practices.

Credit ratings may still apply indirectly to SMEs in areas such as::

• Evaluation of your debt
  
• Due diligence of customers and vendors
  
• Decisions on trade credit insurance
  

By understanding how credit ratings work, your business can better anticipate borrowing costs and financing conditions, enabling you to negotiate more favourable terms with lenders and partners.

How lenders and businesses measure credit risk

As a business owner, you should understand how lenders, financial institutions, investors, and even SMEs use organised systems to assess credit risk. Quantitative risk metrics, qualitative factors, and the five Cs of credit are the two most widely used. Let’s look at each of them:

Quantitative methods

These are data-driven models used by lenders; they are:

• Probability of Default (PD): The chance of borrowers defaulting within a certain period refers to PD
  
• Loss Given Default (LGD): The repercussions on the lender in case of the said default is the LGD.
  
• Exposure at Default (EAD): The expected risk value due to said default denotes EAD.
  

These metrics are formally linked to calculate the Expected Loss (EL) for a given exposure, which is the foundational calculation in credit risk modelling. The formula is:

Expected Loss (EL) = PD x LGD x EAD

This calculation directly influences how much capital lenders set aside, how they price loans, and whether credit is approved at all. Understanding this relationship is key to accurate risk provisioning and capital allocation.

Qualitative Factors

Apart from the number, lenders also look at:

• The sustainability capacity of your business
  
• The quality of leadership
  
• Market standing of your business
  
• Stability of your business sector
  

The Five Cs of Credit

The Five Cs framework is a long-standing credit assessment model used by banks and lenders globally.

[Table:1]

Before granting credit or approving loans, lenders and businesses refer to this well-rounded approach to making decisions.

Key real-world examples of credit risk

Example 1: Delay in clearing invoices can destabilise the next quarter

You own an architecture firm that has completed an SGD $1 million project. At the end of your project, your client requests 45 days to clear your invoice. You grant them the extension, but are also aware that if they don’t pay you by the date they committed, you may not have cash to cover your employees’ salaries and make vendor payments.

To make up for that, you borrow money for a short period at a high interest rate. This can disrupt your cash flow for the next quarter.

Example 2: Supplier failure leading to lost revenue

You're a restaurant owner and get your ingredients from overseas. For a large order, you pay your vendor 30% upfront.

However, the supplier encounters weather issues, which delay your consignment. Since there's no inventory, your business is unable to source the same quality ingredients on time, and you have no alternative but to provide refunds for customer orders.

Example 3: Overreliance on one major customer

You own a tech business, and your anchor client makes up over 65% of your annual revenue. Unfortunately, they encountered a financial setback and downsized their operations, which has an indirect impact on your business.

They decrease their work volume to only 10% of what they initially signed up for. Despite having sound infrastructure and a robust organisation, your reliance on a single client increases your credit risk significantly.

Example 4: The FX settlement delay

Your trading company carries out transactions that span international borders. An error in your settlement system has resulted in a payment delay of over 48 hours. Due to this delay, you miss a crucial deadline for a vendor, which can lead to potential penalties that impact your bottom line.

Example 5: Lending based on poor credit analysis

You sign a contract with a vendor without checking their past delivery report. When it is time for submission, there is a constant delay from their end, and they eventually request an extension. You find out from their previous clients that this is normal behaviour, and they're tardy with timelines.

This leads to a delay in time-to-market, resulting in financial losses. Had you done due diligence on the vendor before starting work with them, you’d not be in this situation.

Example 6: Pandemic-era credit risk spike

You own a travel business, but during the COVID-19 pandemic, the travel and retail industries experienced sudden drops in revenue. As a result, you have incurred significant debt because of the lack of cash flow. This serves as a clear example of how external conditions can elevate credit risk almost instantly.

These examples highlight the importance of implementing organised credit risk evaluations and engaging in proactive monitoring.

Practical credit risk management checklist for Singapore SMEs

As a business owner, follow this simple checklist for optimally managing credit risk:

• When dealing with a large order or new clients, request them to pay a portion upfront.
  
• Identify unpaid invoices and follow up on them before the due date.
  
• Create a credit criterion that characterises ideal clients and evaluate any new clients before onboarding them based on that criterion.
  
• Try to avoid relying on only one or two clients for more than 40-50% percent of your sales. Having an anchor client is good, but one or two slow months with them will disrupt your cash flow.
  
• Establish an emergency cash reserve that covers three to six months of expenses.
  
• Ensure that your business aligns with government regulations by conducting periodic credit evaluations.
  
• Determine credit limits for each of your vendors, along with their corresponding categories, industry sectors, and locations, to effectively mitigate concentration risk.
  
• Develop a credit risk assessment to classify your clients based on their likelihood of delinquency and track the risk profile of your holdings.
  

By following these simple steps, you can prevent your SME from losing significant amounts of money when cash flow disruptions occur.

Regulatory and local considerations for Singapore

The Monetary Authority of Singapore (MAS) establishes precise standards for the way financial institutions are expected to identify, quantify, and mitigate credit risk concerns. To name a few key components:

• Evaluating devalued assets
  
• Compliance with paperwork and internal procedures
  
• Regular assessment of customer credibility.
  
• Stress checking and analysing customer status
  

Although these policies are specifically applicable to financial institutions such as banks, SMEs stand to benefit from the practices too.

• Regular financial health check
  
• Consistent credit regulation
  
• Clear and compliant records (agreements, purchase orders, bills)
  
• Timely invoice tracking
  

Given the highly multifaceted nature of Singapore's economy, many businesses like yours often work in collaboration with global clients and vendors. This leads to an increased risk of processing delays, foreign exchange risks, and operational difficulties that your business may encounter.

You can reduce your vulnerability to domestic and international risks by leveraging fintech platforms that provide electronic bookkeeping, invoice tracking and foreign exchange controls.

How technology and fintech change credit risk management strategy

In the credit risk management landscape, relying solely on spreadsheets and manual inspections is no longer an option. Fintech tools have transformed how you evaluate and respond to potential financial challenges in your business. Here are some ways you can engage technology to mitigate credit risk:

Vendor and customer monitoring

As a business owner, you can reduce the risk of missed payments by setting up timely reminders, notifications for invoice due dates, and automated follow-ups.

Real-time insight

Fintech platforms provide your business with quick insights into key areas such as:

• Billing for both inbound and outbound transactions
  
• Overdue invoices
  
• Cash flow inefficiencies
  
• Consumer payment trends
  

Based on this insight, you can recognise possible risks and take necessary precautions for your business.

Automation in Bookkeeping

You can eliminate human error and generate accurate financial data for credit evaluation by seamlessly syncing with Xero, QuickBooks, and other relevant programmes.

Digital credit scoring

Using AI-powered tools can help your business analyse:

• Cash flow trends
  
• Transaction patterns
  
• Payment reliability
  

These assessments provide a precise forecast of potential risks.

Corporate card controls

You can promote the use of corporate cards (physical or virtual) for the purchase of raw materials, services, and other production requirements to maintain compliance and transparency. For better control and to reduce operational risk and misuse, set up spending limits, category restrictions, and approval channels.

If you are running a small business without a dedicated financial department, fintech solutions enhance the efficiency, transparency, and proactivity of credit risk management.

How can Aspire help your business?

When you use Aspire, you get access to tools to confidently manage your business’s credit risk. Some of these services are:

• Business credit cards that allow smart budgeting, helping you mitigate operational and fraud risks
  
• Accounting dashboards for real-time information, enabling you to immediately spot when a single customer's share exceeds your defined risk tolerance
  
• Cashflow and expense management to help you avoid overspending and fraud risks
  
• Digital balancing and invoice monitoring that provides precise, granular data on customer payment behaviour, giving you the necessary "Character" data for a digital credit assessment.
  
• Unified bookkeeping reports
  
• Centralised procurement and payment management
  

You can simplify your financial administration and take control of your business risk with an Aspire account. Aspire offers smarter, faster, and transparent solutions designed specifically for growing teams.

Conclusion

Your business, regardless of its size, is vulnerable to credit risk. This applies to startups offering trade credit as well as SMEs that handle suppliers and lenders assessing loan applications. By learning more about the various types of credit risk, you can achieve a more accurate assessment of your customers and implement best practices. This approach will enable you to enhance your cash flow and safeguard your business against future uncertainties.

A disciplined strategy fosters better financial stability and long-term growth, whether you're tracking receivables or evaluating a new customer.

Frequently asked questions

What is the meaning of credit risk?

Credit risk in a business occurs when a borrower or client is unable to meet their financial obligations or delivery commitments, potentially leading to losses for your company. This applies to any agreement you enter into that involves delayed payment, including but not limited to lending, trade credit, and contracts with your suppliers.

What are the 5 Cs of credit risk?

The 5 Cs of credit risk are essential concepts for financial management and are integral to platforms designed for growing businesses, such as Aspire's finance operating system:

• Capacity
  
• Capital
  
• Character
  
• Collateral
  
• Conditions.
  

You can evaluate the reliability and ability to repay of your vendors or borrowers based on these 5 Cs.

How do you identify credit risk?

Before engaging in a business relationship with a customer, you can assess their credit risk by reviewing their payment history, cash flow, financial statements, credit reports, and any outstanding unpaid invoices. You can assess the company's financial health by reviewing historical reports and utilising automated dashboards.

What’s a good credit risk score?

Unlike individuals, businesses in Singapore don't have a single, universal credit score. Banks and financial institutions assess SME creditworthiness using a combination of internal risk models, credit bureau data, and financial information.

In practice, lenders typically evaluate factors such as:

• Your company’s cash flow and revenue stability
  
• Payment history with lenders, suppliers, and vendors
  
• Outstanding debt and credit utilisation
  
• Financial statements and balance sheet strength
  
• Industry risk and business track record
  

A “good” credit profile generally means your business demonstrates consistent repayment behaviour, healthy cash flow, and manageable debt levels. This lowers your perceived risk and can lead to better loan terms, lower interest rates, and easier access to trade credit.

How can an SME improve its credit profile quickly?

To improve your business' credit profile, ensure you:

• Clear all your invoices on time, pay your loans and vendors before the due date
  
• Maintain your financial records
  
• Keep credit utilisation under 30% of your line of credit.
  
• Separate personal and business accounts for compliance
  
• Keep debt to a minimum and don't enquire for a fresh loan in quick succession.