Method of credit evaluation
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
One indicator of how quickly clients repay their financial commitments is the average collection time. It shows the typical number of days a business must wait before receiving a customer’s cash payment after a credit transaction. It goes without saying that a company’s investment in receivables and, therefore, its cost of issuing credit to consumers, increase the longer the average collection duration.
Default risk is the possibility that a consumer won’t pay back the credit that was given to them. The percentage of total receivables that a business never collects, or the bad-debt loss ratio, is used as an overall, or aggregate, indicator of this risk. A company may determine its loss ratio by looking at credit losses experienced in the past with clients of a similar profile. The cost of issuing credit rises with a firm’s loss ratio.
Credit Period
Industry norms are typically what decide a company’s credit period, which is how long a credit client has to settle the account in full. As a result, credit periods tend to fluctuate across various businesses. The length of the credit term ranges from seven days to six months. The amount of variation seems to be positively correlated with how long the product has been in the buyer’s inventory. In contrast to distributors of items with larger inventory turnover times, such as food products, producers of relatively low inventory turnover goods, such as jewellery, often give merchants longer credit terms.
Sales might be impacted by a company’s credit conditions. For instance, if a product’s demand is somewhat influenced by its credit terms, the business can think about extending the credit duration to boost sales. For instance, it seems that IBM sought to increase the PCjr home computer’s lagging sales by extending the credit term during which dealers were required to make payments. But while making such a choice, a business must also take into account its main rivals. If they also extend their credit terms, every business in the sector would experience about the same amount of sales as well as much greater receivables investments and expenses and a worse 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 a lot of research that rating agencies do on them. A borrower will try to get the best credit rating possible because it has a big impact on the interest rates lenders charge. However, rating agencies must look at the borrower’s finances and ability to pay back the debt in a fair and objective way.
A person’s credit score not only affects whether or not they can get a loan, but it also affects how much interest they will have to pay on the loan. Since companies rely on loans for many start-up and other costs, getting turned down for a loan could be disastrous, and a high interest rate makes it much harder to pay back. Credit ratings are also a big part of whether or not a person wants to buy bonds as an investor. A bad credit rating is a risky investment because it means there is a higher chance that the company won’t be able to pay back its bonds.
It’s important for a borrower to work hard to keep their credit score high. Credit scores are never the same. In fact, they change all the time based on the most recent information, and even the best score can drop because of one bad debt. Building up credit also takes time. A person or business with good credit but a short credit history doesn’t look as good as someone or something with the same credit score but a longer credit history. Creditors want to know that a borrower can keep their credit in good shape 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.