How Credit Decisions are Made
Get in control. Understand the credit process, what factors influence your
credit rating and how to shape up credit that may be less than perfect.
From Personal Loans, to Auto Financing to Home Loans-applying for a loan can be
an intimidating experience, particularly if you have credit problems or a
troubled credit history. Put yourself in control. Understanding the loan
process, related costs, and your options is a good place to start.
HOW LENDERS MAKE CREDIT DECISIONS
When lenders review a credit application, they look at these three factors:
Credit history:-How well you’ve paid
debts in the past.
Current obligations:-How much you
currently owe each month.
Income and assets:-How much you currently
earn and own.
Most lenders use computerized scoring systems to rate you on each factor. Your
credit score can determine if you will be offered credit, the amount of credit
you may be offered, and may even determine how much you will pay for credit
(your interest rate and fees). Keep in mind that different lenders have
different scoring systems, so if you’re turned down by one lender, you might be
approved by another.
HOW LENDERS CANNOT MAKE CREDIT DECISIONS
Federal law is very specific about what lenders cannot do. Credit practices are
prohibited if they discriminate on the basis of the following factors:
Age (provided the applicant has the understanding and ability to enter into a
HOW TO MAKE BETTER CREDIT DECISIONS
Extending credit -- it's the careful balance of limiting risk and maximizing
profitability while maintaining a competitive edge in a complex, global
marketplace. How can you do this effectively for your business? Many financial
managers use the "Four C's of Credit" as their guide. We've listed the "Four
C's" below and added some additional guidelines to help you make more
profitable business credit decisions.
Apply the "Four C's of Credit" in Your Non-Financial Analysis
The "Four C's of Credit" include character, capacity, capital and conditions of
the times. The significance of each factor may vary from case to case. The
credit executive must measure the account against each factor before giving a
The history of the business and experience of its management are critical
factors in assessing a business ability to satisfy its financial obligations.
Look at how long the business has been under the same control, and check for
any previous litigation or bankruptcy information. Also, get a clear
understanding of who owns the business, and who is ultimately liable if a
problem arises. Always get a list of the business's officers with their ages
and backgrounds. Research the financial worth of principals for proprietorships
and partnerships. Identify the exact business name and legal form of the
organisation. What products does it sell? On what terms? Is it a seasonal
business? What are its margins? Get a sense of the character of the owners and
the business's ability to compete in its markets.
Make sure to assess the capacity of the business to operate as an ongoing
concern in every credit decision. Principals in small businesses are often
forced to wear many hats. Businesses must be able to allocate resources evenly
to the various functions of the organisation such as marketing and sales,
production and finance. If the production manager has to put production work
aside to make collection calls, or if finance is asked to telemarket,
efficiency within the business could deteriorate. Keep an eye on management.
Assess their experience and their ability to manage all aspects of the business
without compromising efficiency. Does the organisation have the facilities to
handle your business needs?
Analyse the financial capacity of the organisation in order to determine its
ability to meet financial obligations in a timely fashion. Above we discussed
the willingness of a business to pay its obligations, however, its ability to
pay may be much more important. It is critical to understand the difference.
For example, you may conduct business with customers unable to pay quite
differently than with those unwilling to pay. Terms could be worked out for
customers unable to pay immediately, but customers unwilling to pay on time
could be priced for the inherent risk or denied altogether.
Watching customer payment habits over time is an excellent indication of cash
flow. Also, check, as well as any pending litigation or contingent liabilities.
Check for a parent business relationship. A parent business's guarantee may be
available. Inter-business loans might affect financial solvency. Check agency
ratings that predict slow payment or default to complete your investigation.
Conditions of the times
General economic conditions in the nation, in the community, and in the
industry will exert a modifying influence on the financial analysis of an
account. What industries are growing or shrinking? Is your prospect in a dying
industry? During prosperous times, risk of credit loss is generally less than
during a depressed period. Watch for any news items or special events that
could affect the firm's ability to continue as an ongoing concern.
USE FINANCIAL RATIO ANALYSIS
When entering into a relationship with a new customer, consider these two very
important questions. Will I be paid slowly? And, will I be paid at all? Some
businesses are willing to accept some level of slow pay based on their goals
and objectives and how much risk they are willing to take. Few firms are
willing to accept no payment at all. Financial analysis will help you determine
a prospect's financial capacity to pay obligations in a timely fashion as well
as their ability to maintain an ongoing relationship. Your decision to conduct
business with this firm will vary based on whether they appear to be a one-time
purchase or a long term account.
When trying to understand the financial capacity of a prospect, a financial
ratio analysis is a good place to start. Ratios can be grouped into three main
Solvency Ratios -To determine the cash available to pay obligations
and the amount of debt of the prospect
Efficiency Ratios -
To determine how efficiently the firm runs its operations such as the
collection period and inventory turnover
Profitability - To determine the firm's reinvestment in the business for
Other areas of interest: