Credit Analysis Defined
If you’re in the business of extending business credit to companies, you’re likely aware of the various financial risks involved. Customers can be late on payments, or worse, they can default entirely. Either way, delinquent customers can pose a serious threat to your company’s bottom line, which is why it’s important to always conduct a credit analysis on all potential borrowers.
But what exactly is credit analysis? Credit analysis (or credit evaluation) is just one of the many terms used to describe the process that a business credit manager goes through to determine a customer’s creditworthiness after they apply for a line of trade credit.
In this article, we’ll explore the credit analysis process, how it works, and how your company can implement the process as quickly and effectively as possible to help ensure minimal risk to your own financial health.
The Credit Analysis Process
The credit analysis process involves a thorough review of a business to determine its perceived ability to pay. To do this, business credit managers must evaluate the information provided in the credit application by analyzing financial statements, applying credit analysis ratios, and reviewing trade references. In addition to the information requested in the application, it is important to consult a business credit report from a reputable third party. The information gathered during this process allows companies to decide whether or not to offer the customer credit, and if so, precisely how much credit to extend.
To further illustrate the credit evaluation process, we explain in more detail below the three most important criteria that companies should analyze before extending credit to a new customer.
Credit Analysis Ratios
Financial statements provide a lot of valuable insights, making it easier for business credit managers to assess a potential customer’s creditworthiness. However, not every company can or will provide a financial statement, and not every credit manager should ask for one to support every credit request. Credit applicants that are major companies or those that seek a large line of credit can be asked to provide a financial statement, and these applicants can request that suppliers sign a non-disclosure agreement to ensure confidentiality.
Should a customer provide a financial statement as part of the credit analysis process, it’s helpful to understand credit analysis ratios, which highlight the relationships between items on the financial statement. There are dozens of ratios available, which are covered in detail in Understanding Financial Statements, but here a three common credit analysis ratios:
- Working Capital - Working capital represents the funds available to finance current business operations. It’s the difference between current assets and current liabilities. Since a company's sources to pay its current debt come partly from current assets, a business with a comfortable margin (at least 2 to 1) should be able to pay its bills and operate successfully.
- Quick Ratio - The quick ratio, sometimes called the "acid test" or "liquid" ratio, measures the extent to which a business can cover its current liabilities with those current assets readily convertible to cash. Only cash and accounts receivable are included, as inventory and other current assets would require time and effort to convert into cash. A minimum ratio of 1:1 ($1 of cash receivables to $1 current liabilities) is desirable.
- Current Liabilities to Net Worth - The current liabilities to net worth ratio indicates the amount due to creditors within a year as percentage of the owners’ or stockholders’ investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80%.
Trade references are sometimes requested in a credit application to show that the applicant has honored previous credit requests. Companies know their customers will only submit positive references in the credit application, but it’s important to have these positive references to balance any detrimental payment experiences that may have been reported to a credit bureau.
Many business credit vendors do report their accounts receivable data (their customers’ payment experiences - both positive and negative) to business credit bureaus. These trade references are an incredibly useful resource to business credit managers to assess the payment habits of how a company has paid its other vendors. This data, once verified, is factored into some of the bureaus’ credit scores and ratings. They can appear anonymously in a company’s credit report as well (see example below):
Dun & Bradstreet has the world’s largest network of companies submitting their trade payment data, and this data is used as a factor in such scores as the D&B PAYDEX®, the D&B® Delinquency Predictor Score, and the D&B® Failure Score.
Consult a Business Credit Report
Business credit reports are an essential tool for any business credit manager looking to determine a prospective customer’s creditworthiness, as they provide valuable third-party information regarding a company’s financial health, in the form of proprietary scores and ratings, recommended credit limits, and public information such as lawsuits, judgments, and liens. This information can help to indicate whether a company is likely to pay you on time and according to your terms.
Having easy access to these ratings and scores allows companies like yours to minimize manual research and fact-checking and more quickly understand the potential risks associated with extending credit to another business.
Quick and Easy Credit Analysis Solutions
A thorough credit analysis process is critical to protect your company’s financial well-being, but the process can be labor-intensive and time-consuming if done manually (without the aid of automated resources and tools).
Smaller businesses that evaluate a limited number of customers may choose to keep the credit analysis process manual, which can take anywhere from one day to several days to make an informed credit decision.
Companies that process a large volume of credit applications typically manage their accounts using more sophisticated credit risk management software and solutions. These types of solutions offer automated decision-making using credit scorecards, custom credit scores (based on the supplier’s risk tolerance), integrated online credit applications, and the ability to support international credit customers.
Credit analysis is a major component of risk management, and it is essential for making sound lending decisions and protecting your company’s cash flow. While it’s impossible to eliminate all risk, the wealth of data and risk management tools available to you will help you guard against bad debt and financial loss.