Credit risk refers to the borrower’s uncertainty in meeting obligations on time, according to the contract. When you apply for a new loan, the bank bears credit risk, i.e., you may not be able to repay on time. If you are a bondholder, the risk you take is that the bond issuer doesn’t pay the coupon and pay the principal on time. Likewise, if your company offers credit to customers, customers cannot pay their invoices.
To assess credit risk, lenders (creditors) will usually look at five main factors:
- Historical credit
- Capacity to pay
- Loan requirements
If you cannot meet the loan (interest or principal), the loan defaults. It happens when your cash flow is inadequate to pay creditors. Or, you don’t have enough assets to sell to pay off creditors. If your default risk is high, the lender will ask for a higher interest rate.
Unlike interest loans, loans to customers, such as accounts receivable, usually do not involve interest. Therefore, if a customer is late paying, your company only charges additional billing fees.