Credit Analysis

Credit Analysis is an integral part of any Credit Manager’s brief. This article sets out to summarise the numerous components that ought to be taken into consideration when vetting new and existing customers.

Credit Analysis can be defined as the process of investigating and evaluating the factors that influence the Credit Manager’s decision to extend credit. When credit is extended a “relationship” is formed, which inadvertently exposes the creditor to the debtor’s vulnerabilities. The creditor is risking the possibility of loss (or gain for that matter) i.e. the debtor’s own exposure to decrease in income, increase in expenses or reduction in assets.

It is the creditor’s expectation to be paid on time and in full according to terms. However, the risk prevails that the debtor may default because he is 1) unwilling and 2) unable to discharge the obligation. It is the objective of the Credit Analysis to evaluate these sources of risk by looking at past payment history (willingness), the company’s past and proforma statements of income and condition (ability) as well as the personal, financial condition and business dealings of the firm’s principal officers.

Non-Financial Analysis

A significant part of the analysis forms the non-financial investigation and evaluation of the principals, the business and the industry sector.

Principal

• Who owns/operates the business

• Reputation

• Record of bankruptcies, fraud, fire

• Personal worth, other interests, habits

• Age distribution (blend of energy and wisdom)

Business

• Treatment of customers, suppliers, creditors

• Marketing (4Ps)

• Debt payment record with banks/lending institutions

• Basic function of business (manufacturer, wholesaler, retailer)

• Degree of vertical/horizontal integration

• Competitors

• Normal buying/selling terms

• Seasonal buying/selling factors

• Labour contracts and relations

• Company Culture

• Plant/Equipment

Industry

• Multiproduct

• Multinational / Subsidiaries

• Country Risks

• Industry product increasing/decreasing/stable in relation to GNP

• Market structure

• Ability to pass along cost increases in form of higher prices

• Profit trends

• Technology changes impacting capital requirements

Financial Analysis

Many credit decisions can be made based on non-financial analysis. However, when this information proves to be inadequate or contradictory, the credit decision, based on its size and importance, merits fuller investigation, the steady increase in debt financing together with falling profits signals danger, the credit manager must proceed with an in-depth investigation.

Financial statements provide vital information about the firm’s expected ability to repay its obligation. The Credit Manager must be confident that the financials are reliable and is particularly interested in the unqualified/qualified opinions of the accountant.

The balance sheet measures the “cushion” (assets minus liabilities = owner’s equity or net worth) that creditors rely on to protect their interest should the firm fail.

The income statement (P+L) concentrates on the firm’s sources of revenue, expenses and net income. Establishing trends give an insight into the firm’s expected profitability and managerial efficiency.

The funds statement provides a useful picture of the possible over-reliance on short-term financing, excessive investment in stock or A/R as well as over generous dividend policy.

Equally, Financial Ratio Analysis also forms an integral part of the evaluation process. Ratios are used to 1) make inter year comparisons 2) make comparisons with those of other firms and industry averages and 3) as inputs for models to predict business failure and for numerical credit scoring systems.

Ratios accumulated over several years recognise potential problems of the decrease/improvement/stability of the firm’s liquidity, profitability, efficiency or debt-carrying capacity:

Summary Of Ratios Used In Financial Analysis

A useful exercise is to benchmark a firm’s financial ratios with those of firms of similar size within the industry sector, revealing much about the firm’s relative strengths and weaknesses. In that regard a number of financial and scoring models have been developed, which can save a considerable amount of time, but may become overrated within the overall scheme of things.

If you are fortunate enough to get your hands on a firm’s financial projections – all the better. Future projections reveal how the debtor expects to generate future funds for operations or for liquidation of assets. Depending on the type and maturity of the business documents such as:

• Cash budget

• Pro forma income statement

• Pro forma statement of condition

• Pro forma sources and uses of funds statements

• Projected cash flow statement

are produced in the normal course of business to analyse a company’s expected financial needs and ability to pay its obligations.

Last but not least, further sources of credit information are usually sub-divided into information about the firm and information about the industry:

The Firm

• The Firm’s principals

• Your sales force

• Banks

• Credit Agencies

• Trade References (suppliers and customers)

• Public records

The Industry

• Investor Services

• Trade Publications and Journals

• Government Publications

• Credit Agencies

• Country Risk publications

In conclusion, having regard for the many intricacies of credit analysis (domestic and export) this summary merely scratches the surface of the art of credit management, which is based on the knowledge, experience and wisdom of the credit manager in the daily pursuit of building trust into his/her customer base.

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