Credit Analysis

In addition to analyzing financial statements, the credit analyst will consider the character and strength of the company and its management, the business risk associated with its operation, and various other matters. Then the analyst attempts to determine the ability of the applicant to service trade credit, the probability of an applicant's not paying on time and of a bad debt loss. On the basis of this information, together with information about the profit margin of the product or service being sold, a decision is reached on whether or not to extend credit.

Discriminant analysis' a statistical technique described in the appendix to .this chapter, is being used increasingly. On the basis of a weighted overall score provided by this technique, an applicant is judged to be a "good" or a "bad" credit risk. Discriminant analysis has been used with success in consumer credit and other forms of installment lending in which various characteristics of an individual are quantitatively rated and a credit decision is made on the basis of the total score. The plastic credit cards many of us carry often are given out on the basis of a credit scoring system that takes into account such things as age, occupation, duration of employment, home ownership, years of residence, telephone, and annual income. Numerical rating systems also are used by companies extending trade credit. With the overall growth of trade credit, a number of companies are finding it worthwhile to screen out "clear" accept and reject applicants. In other words, routine credit decisions are made on the basis of a numerical score. Marginal applicants, who fall between "clear" accept or reject signals, can then be analyzed in detail by the credit analyst. In this way, a company is able to achieve greater efficiency in its credit investigation process. It uses trained credit analysts to the best advantage.

Sequential Investigation Process. The amount of information collected should be determined in relation to the expected profit from an order and the cost of investigation. More sophisticated analysis should be undertaken only when there is a chance that a credit decision based upon the previous stage of investigation will be changed. If an analysis of a Dun & Bradstreet report resulted in an extremely unfavorable picture of the applicant, an investigation of the applicant's bank and its trade suppliers might have little prospect of changing the reject decision. Therefore, the added cost associated with this stage of investigation would not be worthwhile. With incremental stages of investigation each having a cost, they can be justified only if the information obtained has value in changing a prior decision.'

Figure 15 4 is a graphic representation of a sequential approach to credit analysis. The first stage is simply past experience to see if the firm has sold previously to the account and if it has, whether that experience has been satisfactory. Stage 2 might involve ordering a Dun & Bradstreet report on the applicant and evaluating it. The third and last stage could be credit checks of the applicant's bank and creditors. Each stage costs more. The expected profit from accepting an order will depend on the size of the order, as will the opportunity cost associated with its rejection. Rather than perform all stages of investigation, regardless of the size of the order and the firm's past experience, the firm should investigate in stages and go to a new stage only when the expected net benefits of the additional information exceed the cost of acquiring it. When past experience has been favorable, there may be little need for further investigation. In general, the riskier the applicant, the greater the desire for more information. By balancing the costs of information with the likely profitability of the order, as well as with information from the next stage of investigation, added sophistication is introduced only when it is beneficial.