Credit Risk Reduction Techniques

Questions and Answers

What is the preferred type of guarantee from the seller's viewpoint?

Guarantee of payment (correct)

Third-party guarantee

Personal guarantee

Guarantee of collection or performance

What is required of the seller in a guarantee of collection or performance?

To first attempt to collect from the buyer (correct)

To waive the right to collect from the buyer

To collect from the buyer and guarantor simultaneously

To first attempt to collect from the guarantor

What is a potential issue with a small business owner personally guaranteeing a payment?

The owner's net worth may be closely tied to the fortunes of the business (correct)

The owner may have unlimited personal assets

The owner may have issued no personal guarantees to other suppliers

The owner may not be willing to personally guarantee the payment

Why might a personal guarantee be appealing to a seller?

Because it provides an additional layer of security Signup and view all the answers

What can be a useful alternative to a personal guarantee from a small business owner?

A guarantee from the parent company Signup and view all the answers

What is a potential advantage of a third-party guarantee?

The assets of the third party may not be so closely tied to the fortunes of the buyer Signup and view all the answers

What should be requested when researching the possibility of a third-party guarantee?

Documentation of the net assets of the third party and any guarantees that may take precedence Signup and view all the answers

Why might a seller require a personal guarantee from a new business customer?

To ensure the business has a reliable payment history Signup and view all the answers

What is the primary goal of credit risk reduction techniques?

To reduce the amount of bad debt Signup and view all the answers

Why is credit risk important?

It has broader impacts on the economy Signup and view all the answers

What is the main purpose of payment guarantees?

To ensure payment or collection in case of default Signup and view all the answers

What is credit risk?

The risk of a borrower's failure to repay a loan Signup and view all the answers

What is the benefit of using a mix of credit risk reduction techniques?

It reduces the amount of bad debt risk Signup and view all the answers

What is one way to retain ownership of goods?

By retaining legal interest in goods sold Signup and view all the answers

Who can provide a payment guarantee?

The owner of a business, a corporate parent, or a third party Signup and view all the answers

What is the result of offloading ownership of an invoice?

A third party bears the risk of default Signup and view all the answers

Study Notes

Credit Risk Reduction

Credit risk reduction techniques can significantly reduce bad debt for a company.
Effective risk reduction alternatives allow a business to issue a large amount of credit to customers while minimizing receivables risk.

What is Credit Risk?

Credit risk is the risk of loss due to a borrower's failure to repay a loan or meet contractual obligations.
Credit risk is a major risk faced by banks and other financial institutions, impacting their financial health and stability.

Classification of Risk Reduction

Find alternative payer: someone besides the customer becomes liable for payments or pays insurance for bad debts.
Retain ownership: retain legal interest in goods sold to recover them in case of default.
Offload ownership: transfer ownership of an invoice to a third party in exchange for cash, transferring default risk.
Pay early: a mix of these tools can achieve significant bad debt risk reduction.

Payment Guarantees

Main sources: owner of a business, a corporate parent, fellow subsidiary, or a third party.
Two types of guarantees: Guarantee of Payment and Guarantee of Collection/Performance.

Guarantee of Payment

Preferred type from the seller's viewpoint.
Seller can protect payment from the guarantor without first attempting to collect from the buyer.

Guarantee of Collection/Performance

Requires the seller to first attempt to collect from the buyer, then pursue collection from the guarantor.

Owner of a Small Business as Guarantor

May be willing to personally guarantee payment using personal assets.
Problems with this approach:
- Owner's net worth may be closely tied to the business's fortunes.
- Owner may have issued personal guarantees to many suppliers.
- Demanding a personal guarantee may not foster long-term loyalty.

If Business is a Subsidiary

Obtain a payment guarantee from the parent company.
Parent entity may have more assets, making it an excellent backup payer.

Guarantee from a Third Party

May be a related party with an interest in the buyer's operations.
Assets of a third party may not be closely tied to the buyer's fortunes.
Request documentation of the third party's net assets and preceding guarantees.

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Description

Learn how to reduce credit risk and minimize bad debt recognition. Understand the importance of credit risk management and its alternatives in business.