Blog Risk & Credit Scoring

What exactly is a credit score?

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We know all about it from our everyday lives. You want to rent a new flat, sign a new mobile phone or insurance contract, buy the washing machine in instalments or even apply for a loan but somewhere in the small print it always says “subject to a credit check”. When companies enter into a contractual relationship with private individuals or other companies, a credit check is carried out in the background, often without the client noticing.

In simple terms, a credit check determines whether a private person, a company or even a state is able or willing to repay its liabilities. This check of a person’s or company’s creditworthiness is a key factor in all risk management – and this is where a credit score comes into play.

The score — a mythical number

The credit score – the mathematical and statistical determination of a number that indicates how solvent a client or supplier is – is a procedure that uses past experience in the form of data as a basis for making a prediction for the future. It therefore involves the most reliable possible forecast of an event that is still to occur. This is not only possible in credit management, but in all areas of our lives – whether for weather forecasts, the insurance industry or in medicine. A score makes it possible to estimate the probability of an event occurring, for example a storm, a heart attack or a claim.

Why is a credit score so important for both contracting parties?

Credit scoring procedures enable the standardisation of creditworthiness checks, and this is particularly important in bulk business. When hundreds or even thousands of such checks are required, for example for new mobile phone contracts or in online shops, it is crucial that companies implement reliable and very quick decision-making processes. Credit scoring offers the possibility of mapping out the probability of whether the buyer or contractual partner will meet their payment obligations in the future and is thus also an essential component for a healthy economic system. It provides both contracting parties with security. The lending party protects itself against potential bad debts that may arise, while consumers can be protected against overextending themselves.

Nevertheless, credit scoring is seen as negative in the eyes of consumers and transparency is repeatedly questioned. However, you should always bear in mind that without credit scoring, credit would be granted less often or default rates would be higher, and this would ultimately lead to higher credit costs. And last but not least, credit scoring makes it possible to grant credit to groups of people and also to companies that could be classified as too risky in principle. Credit scores are not subjective assessments, so they also prevent discrimination.

Credit scoring as a part of the decision-making process

Every new business relationship gives rise to questions at the outset. Can the new client be supplied on account? Would it be better to request payment in advance, what payment terms should be agreed and where should credit limits be set?

Credit scores are also available in different forms, with a distinction made between application scores and behavioural scores, for example.

Application scoring is important for lending companies to make the basic decision to enter into a business relationship. The score at the time of application is crucial and determines whether or not the application gets the thumbs up as well as the contract conditions, credit limits and payment terms.

Behavioural scoring is used in existing business relationships to predict how a client will behave in the future. For example, key questions are: Who are your most valuable clients? Are some of your clients having difficulty meeting their payment obligations with you or elsewhere? The use of behavioural scoring enables the right clients to be accepted while reducing payment default risks by making adjustments and optimisations such as credit limit monitoring or modifying conditions.

Which factors play an important role in credit scoring?

Credit scoring plays a major role in moving away from a credit manager's “gut feeling” and personal subjective experiences to a data-driven decision-making process that incorporates a wide variety of historical data. But which factors play a decisive role in these credit scoring models? These include, for example:

  • Demographic data – These influencing factors include, for example, the legal form of a company, its size and also its age, historical information on office holders, industry-specific factors and many others.
  • Payment experience – Accounts receivable and accounts payable provide an accurate picture of how a particular company meets a variety of financial obligations. The Dun & Bradstreet Paydex is an index that shows how quickly a company pays its bills based on the world's largest pool of payment experiences.
  • Financial information – Overall financial information, such as cash flow from the business, current liabilities, current assets, working capital and net assets, provides insight into a company's financial strength and its ability to pay on time.
  • Firmographic information – Data such as geographic location, industry, size (employees, turnover), years in business, business history (e.g. change in ownership) and business type (e.g. headquarters or branch office) can help identify higher risk business segments.

The benefits of credit scoring

In our fast-moving world, credit managers must above all:

  • manage the credit risk
  • reduce the DSO
  • optimise cashflow
  • comply with regulations

So how can credit managers quickly identify clients who may be pay late or pose other serious credit risks, while still approving all reasonable credit applications to keep the business going? Using credit scores can simplify these time-consuming manual reviews and enable more consistent credit decisions.

Conclusion

Credit scoring offers enormous advantages for companies that have to make business-relevant decisions on a daily basis. However, a credit score is only one part of a well thought-out and effective credit policy that aligns your business goals with business operations and helps your company reduce bad debt and depreciation and yet, to date, not all companies have even put their policies in writing. Credit policies can be "institutional knowledge" in some companies, where experienced credit specialists seem to innately know the company's appetite for risk and so the best process for each client seems to come naturally. However, newer team members in the credit department and sales staff are often left in the dark when it comes to knowing how to handle requests for extended terms, for example. When it comes to credit policy, there should be no grey areas that lead to misunderstandings or miscommunication with colleagues or clients.