It's no secret that over the last three years, small businesscredit risk has increased at a distressing rate. Since 2007, fivekey 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 growtheir portfolios.

Based on a review of more than 400,000 small businesses in theUnited States over the past two years, Experian has identifiedthree key factors that contribute to small business lending risk:how well the business was doing before the economic downturn, thepresence of derogatory events or triggers that lead to delinquentpayments, and the industry or geographic region in which thebusiness 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 withno delinquencies, bankruptcies, collections, judgments or tax liensagainst them-fared significantly better than the overall smallbusiness population during the recession by about a two-to-onemargin. While 14% of the best-run businesses had a significantnumber of negative events in their credit history, this numberincreased to 26% for all small businesses. A simple conclusion canbe drawn from this data: Businesses that were well-run prior to therecession more often continued to be so during the recession. Bymanaging their cash position and cash flow well, they were betterequipped to survive the downturn and had the necessary resources toweather the storm.

Does the business have derogatory events or triggers?

Being able to recognize early signs of trouble with borrowers iscrucial. The presence of a derogatory public record item or acollection significantly increases the chance a small business willbecome severely delinquent within the next six months. Against theoverall baseline rate for severe delinquency at approximately 4%,small businesses with a tax lien showed a severe delinquency rateof 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, needsto be taken seriously and acted on quickly since the odds of thatdelinquent payment becoming severely delinquent are high.Objective, quantifiable data on derogatory events enables creditmanagers and lenders to filter and segment accounts to focus onlyon those at the most serious risk of delinquency, rather thanentire portfolios. Observing derogatory events within 24 hours oftheir occurrence can minimize exposure, allowing potentially badaccounts to be more actively managed, which translates intoimproved cash flow and loss avoidance.

In which industry and geographic region does the businessoperate?

While positive signs for economic recovery are evident, someindustries and parts of the country are still struggling. Some ofthe industries with the riskiest credit scores includeconstruction, hospitality and retail. The collapse of the housingmarket was a devastating blow to the construction industry. Withwidespread job insecurity amid substantial unemployment levels, thehospitality industry was also significantly affected as many peoplereduced their travel plans. Additionally, when consumer spendingdried up in the downturn, retail trade was adversely impacted.Meanwhile, sectors such as educational services, health servicesand public administration are improving, with payment performancefor these groups strong relative to other industries. The healthservices sector in particular has been less vulnerable to theeconomic downturn-a trend that may continue with the passage ofhealth care reform.

Continued diligence is necessary as the economy recovers.

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

Risk assessment methods have accurately identified good frompotentially bad accounts, helping lenders and credit managers gaugerisk and better identify businesses that fit within their portfoliostrategy. By looking closely at the data on small businesses,lenders and credit managers can detect indicators that mightportend severely delinquent payment. Such triggers should bemonitored to help minimize exposure. Notification services providedata that sheds light on underlying factors, as well as valuableinsights into small business performance. Armed with thisinformation, credit managers and lenders are better able to reducerisk and find opportunities to grow their portfolios.

Dan Meder is vice president of marketing and productmanagement for Experian. He can be reached at 714-830-5700 or[email protected]