It's no secret that over the last three years, small business credit risk has increased at a distressing rate. Since 2007, five key measures of risk-bankruptcy, lien filings, judgment filings, collections and severe delinquency in payments-showed a consistent, increasing risk trend. While there are signs of improvement, lenders need to be diligent in order to reduce their risk and grow their portfolios.

Based on a review of more than 400,000 small businesses in the United States over the past two years, Experian has identified three key factors that contribute to small business lending risk: how well the business was doing before the economic downturn, the presence of derogatory events or triggers that lead to delinquent payments, and the industry or geographic region in which the business operates. Let's take a closer look at each of these.

How well-managed is the business?

Businesses that were doing well prior to April 2007-those with no delinquencies, bankruptcies, collections, judgments or tax liens against them-fared significantly better than the overall small business population during the recession by about a two-to-one margin. While 14% of the best-run businesses had a significant number of negative events in their credit history, this number increased to 26% for all small businesses. A simple conclusion can be drawn from this data: Businesses that were well-run prior to the recession more often continued to be so during the recession. By managing their cash position and cash flow well, they were better equipped to survive the downturn and had the necessary resources to weather the storm.

Does the business have derogatory events or triggers?

Being able to recognize early signs of trouble with borrowers is crucial. The presence of a derogatory public record item or a collection significantly increases the chance a small business will become severely delinquent within the next six months. Against the overall baseline rate for severe delinquency at approximately 4%, small businesses with a tax lien showed a severe delinquency rate of 13%. For those with a judgment filed, the rate jumped to 17%, And for those with collection items, the rate leaped to 21%.

Any delinquency on a small business, even if only 30 days, needs to be taken seriously and acted on quickly since the odds of that delinquent payment becoming severely delinquent are high. Objective, quantifiable data on derogatory events enables credit managers and lenders to filter and segment accounts to focus only on those at the most serious risk of delinquency, rather than entire portfolios. Observing derogatory events within 24 hours of their occurrence can minimize exposure, allowing potentially bad accounts to be more actively managed, which translates into improved cash flow and loss avoidance.

In which industry and geographic region does the business operate?

While positive signs for economic recovery are evident, some industries and parts of the country are still struggling. Some of the industries with the riskiest credit scores include construction, hospitality and retail. The collapse of the housing market was a devastating blow to the construction industry. With widespread job insecurity amid substantial unemployment levels, the hospitality industry was also significantly affected as many people reduced their travel plans. Additionally, when consumer spending dried up in the downturn, retail trade was adversely impacted. Meanwhile, sectors such as educational services, health services and public administration are improving, with payment performance for these groups strong relative to other industries. The health services sector in particular has been less vulnerable to the economic downturn-a trend that may continue with the passage of health care reform.

Continued diligence is necessary as the economy recovers.

Although the economy appears to be in recovery, it is still too early to know what tomorrow holds, particularly for small businesses. Certain industries continue to struggle even during the recovery, especially those tied directly to consumer spending. Well-managed small businesses performed significantly better during the economic downturn, yet lenders should remain cautious as they evaluate prospects for portfolio growth.

Risk assessment methods have accurately identified good from potentially bad accounts, helping lenders and credit managers gauge risk and better identify businesses that fit within their portfolio strategy. By looking closely at the data on small businesses, lenders and credit managers can detect indicators that might portend severely delinquent payment. Such triggers should be monitored to help minimize exposure. Notification services provide data that sheds light on underlying factors, as well as valuable insights into small business performance. Armed with this information, credit managers and lenders are better able to reduce risk and find opportunities to grow their portfolios.

Dan Meder is vice president of marketing and product management for Experian. He can be reached at 714-830-5700 or dan.meder@experian.com

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Key Factors in Evaluating the Risk of Lending to Small Businesses

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