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Once a company has established its credit and collection policies, it can use them as a basis for evaluating individual credit applicants. In general, the credit evaluation process consists of these main steps: The credit evaluation process is limited by both time and cost. Often a business may have only a few days—or, in some cases, only a few hours —in which to evaluate a credit request. Delaying this decision too long may result in the loss of a potential customer’s order. The credit evaluation process is also limited by the amount of resources the credit department has available. The amount of time and money a company spends on evaluating a customer’s request for credit should depend on the size of the losses the company would experience if it made an incorrect decision. These potential losses stem from either denying credit to a creditworthy customer or offering credit to a customer who is not creditworthy.
Once a company has established its credit and collection policies, it can use them as a basis for evaluating individual credit applicants. In general, the credit evaluation process consists of these main steps:
The credit evaluation process is limited by both time and cost. Often a business may have only a few days—or, in some cases, only a few hours —in which to evaluate a credit request. Delaying this decision too long may result in the loss of a potential customer’s order. The credit evaluation process is also limited by the amount of resources the credit department has available. The amount of time and money a company spends on evaluating a customer’s request for credit should depend on the size of the losses the company would experience if it made an incorrect decision. These potential losses stem from either denying credit to a creditworthy customer or offering credit to a customer who is not creditworthy.
The larger the potential losses, the more time and money a business should spend on evaluating the credit applicant.
Gathering Information on the Credit Applicant
Information for evaluating the creditworthiness of a customer is available from a variety of sources, including the following:
- Financial statements submitted by the customer
- Credit reporting organizations
- The company’s own prior experience with the customer
These sources differ with respect to their costs and the reliability of the information they provide. Financial Statements A company can ask a credit applicant to supply various kinds of financial information, such as income statements and balance sheets (preferably audited ones), and possibly even a forecasted budget. This information can be used to evaluate the applicant’s financial strength—and the applicant’s ability to repay credit obligations. Unwillingness on the part of the applicant to supply financial statements may indicate financial weakness and suggest the need for more detailed checking, the outright refusal to extend credit, or both.
Credit-Reporting Organizations A number of national and local organizations collect information on the financial position and credit standing of businesses. Other companies and lending institutions that are considering extending credit to a company may obtain information about it from these organizations, usually for a fee. The most widely known credit -reporting organization is Dun & Bradstreet Credit Services, which provides its subscribers with a credit reference book and written credit reports on individual businesses. D&B’s reference book is published bimonthly and contains the names and credit ratings of over 3 million businesses located in the United States, including manufacturers, wholesalers, retailers, business services, and other types of businesses.
A D&B credit report provides far more detailed information about a company’s financial position than the reference book does. A typical report contains a summary of trade credit payments to existing suppliers, which can be extremely valuable to companies that are considering extending credit to a particular company. Also included in a typical report are financial data from the firm’s balance sheet and income statement, a review of its banking relationships, historical information about the owners, and a description of its operations, including the location of facilities and the kinds of products sold. The National Association of Credit Management also fills requests for information on the repayment patterns of specific companies. In addition, a number of other organizations collect and disseminate credit information within given industries, such as the toy and furniture industries, as well as within given geographical areas, such as Chicago and New York.
Banks Many banks will assist their business customers in obtaining information on the creditworthiness of other businesses. Through its contacts with other banks, a customer’s bank can often obtain detailed information on the payment patterns and financial status of the company under investigation and pass this information on to a customer.
Prior Experience with the Customer A company’s experience with a credit customer can be extremely useful when deciding whether to continue extending credit, increase the amount of credit it currently grants to the customer, or both. If, for example, the customer tends to remit payments well beyond the due date and/or if the company must employ expensive collection methods in obtaining payments, the credit analyst should weigh this unfavorable information in making the credit extension decision.
Analyzing Creditworthiness and Making the Credit Decision
Credit analysts ideally should obtain information about an applicant from as many sources as possible, but they should also consider the time and costs involved. Specifically, analysts should weigh the expected returns to be derived from any additional information against the cost involved in obtaining it.
A good way to structure information collection is to proceed sequentially, beginning with the least costly and least time -consuming sources. If the results of this initial check indicate that more information is needed, the analyst can proceed to additional sources. For example, the analyst may begin by consulting the customer’s past credit history with the company. If further information is needed, the analyst can then check the D&B reference book and/or ask the applicant to supply financial statements and a list of companies that have extended trade credit to it in the past.
Finally, if still more information is needed, the credit analyst can request a D&B credit report on the applicant and/or request credit checks through banks and the applicant’s trade creditors. Because a great deal of information is usually available about a credit applicant, the credit manager must be able to sort through this information and extract the key elements that will enable a reliable overall assessment of the applicant’s creditworthiness to be made. There are no magic formulas for making unerring credit decisions, but there are some traditional guidelines that can serve as a framework for analysis. These guidelines are called the “five Cs of credit”:
- Character refers to the applicant’s willingness or desire to meet credit obligations. Past payment patterns are useful in gauging this aspect of creditworthiness
- Capacity refers to the applicant’s ability to meet financial obligations. A reasonable estimate of an applicant’s capacity can usually be obtained by examining its liquidity position and projected cash flows
- Capital refers to the applicant’s financial strength, particularly with respect to net worth. Evidence about a company’s capital can usually be obtained by evaluating the balance sheet using financial ratios
- Collateral represents the assets that the applicant may pledge as security for the credit extended to it.However, collateral is often not a critical consideration because the primary concern for the company offering trade credit is the timely repayment of the credit, not foreclosing on the pledged assets
- Conditions refer to the general economic climate and its effect on the applicant’s ability to pay. A good credit risk in prosperous times might be unable to make payments during a recession
Many credit analysts feel that the first two Cs, character and capacity, are the most important insofar as they help to ensure that the firm considering extending credit will not leave anything important out of the analysis. Numerical credit scoring systems are another technique that has been found useful, particularly in the area of consumer credit. This technique allows the credit-granting business to quantitatively rate various financial and personal characteristics of the applicant, such as the length of the time in business, its D&B credit rating, and its current ratio.
The total credit score can then be computed based on the characteristics thought to be related to creditworthiness. The applicant’s credit score is next compared with those of other applicants, or with a minimally acceptable cutoff score. Although numerical credit scoring systems can be beneficial in credit screening, they can be difficult and expensive to install. Guidelines and techniques such as these can aid in the analysis of an applicant’s creditworthiness; the ability to make sound credit decisions, however, ultimately depends on the decision maker’s experience and judgment in evaluating the available information.
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What is the procedure for evaluating credit applicants? ›
In general, the credit evaluation process consists of these main steps: Gathering relevant information on the credit applicant. Analyzing the information obtained to determine the applicant's creditworthiness. Deciding whether to extend credit to the applicant and, if so, determining the amount of the line of credit.Why is credit evaluation important? ›
Credit Evaluation Is Important
Evaluating the credit worthiness of a potential credit customer in an efficient, repeatable, and accurate manner helps to minimize credit risk/exposure, protect margins, and maximize profits.
What is Bank Credit Analysis? In bank credit analysis, banks consider and evaluate every loan application based on merits. They check the creditworthiness of every individual or entity to determine the level of risk that they subject themself by lending to an entity or individual.What does credit department do in bank? ›
The function of selecting and vetting borrowers is the role of the credit department of the bank, and the department is required to ascertain the borrower's competency to utilize the funds to generate an income, and their ability to pay back the principal amount and interest.What are the 3 Cs of credit? ›
Character, Capacity and Capital.What is 5 Cs credit? ›
Bottom Line Up Front. When you apply for a business loan, consider the 5 Cs that lenders look for: Capacity, Capital, Collateral, Conditions and Character. The most important is capacity, which is your ability to repay the loan.