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
- 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 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 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 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 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.
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 jewelry, 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.
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.