How To Aggregate and Report on Portfolio Credit Risk to Management

By Michael C. Dennis, CPC, CCP, CBF, MBA, CLM

Credit pros can calculate the overall risk exposure of the basket of customers by aggregating the individual risk ratings or scores, weighted by the accounts receivable (AR) balance. Here's how you can do it, step-by-step:

• Determine the AR balance for each customer at month end.
• Calculate the proportion of the total AR balance represented by each customer's AR balance.
• Multiply each customer's risk score by the proportion of the total AR balance they represent. (Note: You'll need to assign a numerical risk score to each customer in order to generate a portfolio risk score)
• Sum up the weighted risk scores to get the aggregate risk score for the basket of customers.

Here is a simplified example:? Let's consider a situation in which you have exactly 3 active customers with the following AR balances and risk scores:

·?????? Customer A: AR balance = $50,000, Risk score you have assigned = 6

·?????? Customer B: AR balance = $100,000, Risk score assigned = 8

·?????? Customer C: AR balance = $75,000, Risk score assigned = 7

We'll follow these steps to calculate the aggregate risk score:

Determine the total AR balance: Total AR balance = $50,000 + $100,000 + $75,000 = $225,000

Calculate the proportion of the total AR balance represented by each customer's AR balance:

·?????? Customer A: Proportion = $50,000 / $225,000 ≈ 0.2222

·?????? Customer B: Proportion = $100,000 / $225,000 ≈ 0.4444

·?????? Customer C: Proportion = $75,000 / $225,000 ≈ 0.3333

Multiply each customer's risk score by the proportion of the total AR balance they represent:

·?????? Weighted risk score for Customer A = 6 * 0.2222 ≈ 1.3333

·?????? Weighted risk score for Customer B = 8 * 0.4444 ≈ 3.5556

·?????? Weighted risk score for Customer C = 7 * 0.3333 ≈ 2.3331

Sum up the weighted risk scores to get the aggregate risk score: Aggregate risk score = 1.3333 + 3.5556 + 2.3331 ≈ 7.222

So, the aggregate risk score for these three customers is approximately 7.222. This weighted approach considers both the risk level and the financial exposure associated with each customer's AR balance.?

Reporting to management on the comprehensive risk of doing business with a basket or a portfolio of customers could and I would argue should include the following key elements:

• Current Aggregate Risk Score: Provide the current aggregate risk score for the basket of customers, calculated based on the weighted risk scores of individual customers.
• Trend Analysis: Track the aggregate risk score month over month to identify trends and changes in the overall risk profile. Highlight any significant fluctuations or patterns observed in the data.
• Customer-Level Analysis: Identify the individual customers driving the biggest month-over-month changes to the aggregate score, both positive and negative. This analysis helps pinpoint specific areas of concern or areas of improvement within the customer portfolio.
• Root Cause Analysis: Conduct a root cause analysis to understand the factors contributing to the changes in the aggregate risk score. Determine whether the changes are driven by external factors (e.g., economic conditions, industry trends) or internal factors (e.g., customer financial health, payment behavior).
• Mitigation Strategies: Propose mitigation strategies to address the identified risks and minimize potential impacts on the business. This may include adjusting credit terms, setting credit limits, implementing risk-based pricing, or enhancing collection efforts for high-risk customers.

Thoughts? Comments? What did I miss?