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Performance Risk

What is performance risk?

Trade finance providers who finance for trade receivables or single trade receivable has to face performance risk.

Performance risk can be considered as the risk which the buyer, who owes money, can avoid paying as the exporter failed to do the expected task or we can say shipment of quality products.

Give me some examples

A trade receivable can be an “invoice”. Trade receivable denotes a charge being made for the provision of products, commodities as well as services. It is usually governed with the help of signed contract between the importer and his exporter – which on the contrary includes what the exporter is supposed to do in order for the importer to be obliged to pay. If the exporter, somehow, fails in performing any of his obligations, then the importer’s obligation might get reduced or can even become zero. This is performance risk.

For example:

  • A consignment is shipped but later on the buyer found, that the products don’t meet the specification which were being mentioned within the contract.
  • The shipment is a short shipment (quantity delivered is highly less than the expected one).
  • There are some quality related problems with a manufactured commodity – for instance: misspelled labels, mismatched colours, dimensions are wrong, defective parts.

In such circumstances, the importer can normally raise a credit note and as a result will pay less than the actual or face amount of the invoice. The amount being paid will be less than the expected amount of the invoice or receivable.

In global trade, performance risks and performance related issues are common. Sometimes it can be a minor matter which will amount to just a few per cent. It rarely happens when the performance risk that much significant that it could affect the whole shipment.

How is performance risk mitigated?

Performance risk can be mitigated by considering a number of techniques:

  • The exporter is generally paid less than the face amount of the receivable i.e. the invoice. Thus, it tends to create a reserve which can be used for absorbing credit notes legitimately issued by the buyer.
  • If somehow the credit notes amount seems to exceed the reserve, then there could be a claim on the exporter for the shortfall.

Is past performance relevant?

In many aspects, the past performance can be a relevant guide for levelling up the performance risk within a given supply chain.

Thorough analysis of the historical level of credit notes helps to get accurate indication about the reserve level that will be appropriate for the current business situation and the issues which commonly could arise.

Well a past performance data cannot be useful in predicting if entire shipment would be written off which means a high impact but low probability event. An importer who go through from such situations generally drop the exporter immediately. Thus, historical information for the current exporter’s performance will likely show no major issues.

How do I understand performance risk as an investor?

As an investor of trade receivables, you should aim to figure out a diversified portfolio of both the parties i.e. buyer and supplier. But apart from this, more importantly, you must analyse how large the individual shipments as well as individual invoices are relative to portfolio.

Typically, the minor “business as usual” related performance risks have to be dealt with by the reserve which the finance provider creates when he pays less amount than the face value amount of the invoice to the exporter upfront and with the help of the paperwork put in place with the importer. Hence, there can be little chance for these performance risks which may cause an issue for an investor.

The failed shipment is a very rare condition which generally leads the importer to drop the exporter. For this the contractual position becomes highly important. For such situation, there exists a long negotiations as well as recovery processes for the finance provider. Apart from this, selecting an experienced finance provider who usually works with reliable supply chains along with the involvement of professional counterparties can be the best way for avoiding such high impact but low probability event.