Method of credit evaluation (Traditional & Numerical-Credit Scoring)

Credit Analysis

Credit analysis is a process of drawing conclusions from available data (both quantitative and qualitative) regarding the credit worthiness of an entity, and making recommendations regarding the perceived needs, and risks.

The 5 c’s of credit analysis

Character

• This is the part where the general impression of the protective borrower is analysed. The lender forms a very subjective opinion about the trust worthiness of the entity to repay the loan. Discrete enquires, background, experience level, market opinion, and various other sources can be a way to collect qualitative information and then an opinion can be formed, whereby he can take a decision about the character of the entity.

Capacity

• Capacity refers to the ability of the borrower to service the loan from the profits generated by his investments. This is perhaps the most important of the five factors. The lender will calculate exactly how the repayment is supposed to take place, cash flow from the business, timing of repayment, probability of successful repayment of the loan, payment history and such factors, are considered to arrive at the probable capacity of the entity to repay the loan.

Capital

• Capital is the borrower’s own skin in the business. This is seen as a proof of the borrower’s commitment to the business. This is an indicator of how much the borrower is at risk if the business fails. Lenders expect a decent contribution from the borrower’s own assets and personal financial guarantee to establish that they have committed their own funds before asking for any funding. Good capital goes on to strengthen the trust between the lender and borrower.

Collateral (or guarantees)

• Collateral are form of security that the borrower provides to the lender, to appropriate the loan in case it is not repaid from the returns as established at the time of availing the facility. Guarantees on the other hand are documents promising the repayment of the loan from someone else (generally family member or friends), if the borrower fails to repay the loan. Getting adequate collateral or guarantees as may deem fit to cover partly or wholly the loan amount bears huge significance. This is a way to mitigate the default risk. Many times, Collateral security is also used to offset any distasteful factors that may have come to the fore-front during the assessment process.

Conditions

• Conditions describe the purpose of the loan as well as the terms under which the facility is sanctioned. Purposes can be Working capital, purchase of additional equipment, inventory, or for long term investment. The lender considers various factors, such as macroeconomic conditions, currency positions, and industry health before putting forth the conditions for the facility.

Credit Standards

Credit standards are the criteria a company uses to screen credit applicants in order to determine which of its customers should be offered credit and how much. The process of setting credit standards allows the firm to exercise a degree of control over the “quality” of accounts accepted. The quality of credit extended to customers is a multidimensional concept involving the following:

• The time a customer takes to repay the credit obligation, given that it is repaid
• The probability that a customer will fail to repay the credit extended to it

The average collection period serves as one measure of the promptness with which customers repay their credit obligations. It indicates the average number of days a company must wait after making a credit sale before receiving the customer’s cash payment. Obviously, the longer the average collection period, the higher a company’s receivables investment and, by extension, its cost of extending credit to customers. The likelihood that a customer will fail to repay the credit extended to it is sometimes referred to as default risk. The bad-debt loss ratio, which is the proportion of the total receivables volume a company never collects, serves as an overall, or aggregate, measure of this risk. A business can estimate its loss ratio by examining losses on credit that has been extended to similar types of customers in the past. The higher a firm’s loss ratio, the greater the cost of extending credit.

Credit Period

The length of a company’s credit period (the amount of time a credit customer has to pay the account in full) is frequently determined by industry customs, and thus it tends to vary among different industries. The credit period may be as short as seven days or as long as six months. Variation appears to be positively related to the length of time the merchandise is in the purchaser’s inventory. For example, manufacturers of goods having relatively low inventory turnover periods, such as jewellery, tend to offer retailers longer credit periods than distributors of goods having higher inventory turnover periods, such as food products.

A company’s credit terms can affect its sales. For example, if the demand for a particular product depends in part on its credit terms, the company may consider lengthening the credit period to stimulate sales. For example, IBM apparently tried to stimulate declining sales of its PCjr home computer by extending the length of the credit period in which dealers had to pay for the computers. In making this type of decision, however, a company must also consider its closest competitors. If they lengthen their credit periods, too, every company in the industry may end up having about the same level of sales, a much higher level of receivables investments and costs, and a lower rate of return.

Credit Terms

A company’s credit terms, or terms of sale, specify the conditions under which the customer is required to pay for the credit extended to it. These conditions include the length of the credit period and the cash discount (if any) given for prompt payment plus any special terms, such as seasonal datings. For example, credit terms of “net 30” mean that the customer has 30 days from the invoice date within which to pay the bill and that no discount is offered for early payment.

Credit Scoring

A credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money an individual, corporation, state or provincial authority, or sovereign government.

Credit assessment and evaluation for companies and governments is generally done by a credit rating agency such as Standard & Poor’s (S&P), Moody’s, or Fitch. These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.

Why Credit Ratings Are Important?

Credit ratings for borrowers are based on substantial due diligence conducted by the rating agencies. While a borrowing entity will strive to have the highest possible credit rating since it has a major impact on interest rates charged by lenders, the rating agencies must take a balanced and objective view of the borrower’s financial situation and capacity to service/repay the debt.

A credit rating not only determines whether or not a borrower will be approved for a loan, but also determines the interest rate at which the loan will need to be repaid. Since companies depend on loans for many start-up and other expenses, being denied a loan could spell disaster, and a high interest rate is much more difficult to pay back. Credit ratings also play a large role in a potential investor’s determining whether or not to purchase bonds. A poor credit rating is a risky investment; it indicates a larger probability that the company will be unable to make its bond payments.

It is important for a borrower to remain diligent in maintaining a high credit rating. Credit ratings are never static, in fact, they change all the time based on the newest data, and one negative debt will bring down even the best score. Credit also takes time to build up. An entity with good credit but a short credit history is not seen as positively as another entity with the same quality of credit but a longer history. Debtors want to know a borrower can maintain good credit consistently over time.

Factors Affecting Credit Ratings and Credit Scores

There are a few factors credit agencies take into consideration when assigning a credit rating to an organization. First, the agency considers the entity’s past history of borrowing and paying off debts. Any missed payments or defaults on loans negatively impact the rating. The agency also looks at the entity’s future economic potential. If the economic future looks bright, the credit rating tends to be higher; if the borrower does not have a positive economic outlook, the credit rating will fall.

For individuals, the credit rating is conveyed by means of a numerical credit score that is maintained by Equifax, Experian, and other credit-reporting agencies. A high credit score indicates a stronger credit profile and will generally result in lower interest rates charged by lenders. There are a number of factors that are taken into account for an individual’s credit score including payment history, amounts owed, length of credit history, new credit, and types of credit. Some of these factors have greater weight than others. Details on each credit factor can be found in a credit repo rt, which typically accompanies a credit score.

Short-Term vs. Long-Term Credit Ratings

A short-term credit rating reflects the likelihood of the borrower defaulting within the year. This type of credit rating has become the norm in recent years, whereas, in the past, long-term credit ratings were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of defaulting at any given time in the extended future.