The "Five C's" of Credit Analysis

Coined by NY Fed:

Must read for anybody with business credit background or anybody applying for business credit.

Complete Article Link: The Credit Process

Credit Analysis

Regardless of where you seek funding—from a bank, a local development corporation, or a relative—a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The basic components of credit analysis, the "Five C's," are described below to help you understand what the lender will look for.

The "Five C's" of Credit Analysis

• Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships—personal or commercial—is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.

• Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

• Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that—someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.

• Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

• Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.

Financial Analysis

In addition to the "Five C's," a prospective lender will use four primary financial statements to make a credit decision.

A Personal Financial Statement
Indicates your net worth. Each partner or stockholder owning a substantial percentage (for example, 20 percent or more) of the business should submit one. A personal financial statement is important to the lender, particularly if you have never received financing for your business before, because it gives the lender evidence of personal assets you could pledge to secure a loan.

A Balance Sheet
Provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of your company's assets, or what the company owns (including its cash), and the company's debts, or liabilities (generally loans from others). It also shows the capital, or equity, put into the business.

A Profit and Loss Statement
Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses.

A Statement of Cash Flows
Presents the sources of cash in your business—from net income, new capital, or loan proceeds—versus the expenditures, or uses of the cash, over a specified period of time.
It's at this stage that you will appreciate having an effective accounting system. Without this system, you won't know if you are profitable or not, let alone if you are liquid enough (simply put, have enough cash on hand) to pay for the next order of merchandise. A good system also will help you track your company's growth and anticipate future cash needs.

Ratio Analysis
Another tool the lender will use is financial ratio analysis. Ratios permit review of a company's current financial performance versus that of previous years. In the same way that a medical checkup tests one's heart, lungs, and changeable factors such as body weight, an analysis of a company's financial performance considers the status, changes, and relationships of critical components of a company's health.

The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.

Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company's "peer group" of similar companies within its industry. To find out what the benchmarks are for your type of business, you may refer to guides published by Robert Morris Associates [RMA] and others.

The following section presents some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover. Your lender's analysis also may include ratios specific to your particular industry. For additional information on financial analysis and calculation of ratios, check with an accountant, your lender, or one of the sources listed in the information guide.

Profitability
Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its "after-product-costs" cash.

Gross Profit Margin
One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin.

Operating Profit Margin
Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and "extraordinary items" such as the sale of property or other assets.
Higher profitability from one year to the next is generally considered a good sign for a company.

Liquidity
How much cash does your business have on hand for immediate use?

Quick Ratio
The quick ratio shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.

Current Ratio
The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.

Leverage
The leverage ratios measure the company's use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.

Debt Ratio
The most common leverage ratio is called, simply, the debt ratio:

Turnover
The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.

It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Those sales you make on the customer's promise to pay at a later date (also known as credit sales) may not actually produce cash for 30 to 60 days. You can get squeezed if you don't understand this cycle and find that you have to pay for new supplies before your customers have paid you.

Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.

The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.

Collection Period Ratio
First, the collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work purchasing more inventory or paying for current orders; so the lower the number, the better.

Days to Sell Inventory Ratio
Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you've accurately forecasted the demand for your product. That way excess inventory isn't accumulating on your shelves and adding to costs.

Days Purchases in Accounts Payable Ratio
The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.

Pro Forma Financial Statements and Financial Projections
Pro forma financial statements are the entrepreneur's best guess about what next year will look like for the business. These tools will help you anticipate whether next year's cash flow will be sufficient to cover all your costs, and if not, how much money you will need to borrow.

For a longer horizon, financial projections permit you to make estimates about future sales levels, expansion costs, or general business conditions and see how such conditions would affect your company's financial results in the years to come.

The preparation of pro formas and projections is a complex exercise that requires a sound knowledge of financial accounting. A comprehensive discussion of these tools is beyond the scope of this text. However, with the help of your accountant or the advice of one of the sources listed in the Information Guide, the exercise can provide both you and your potential lenders with valuable insights into your business.

3 c's of Credit

Image is from Dallas Fed website

Business and consumer lender follow above rules to determine yours or your company credit worthiness. Lenders use above image as foundation to build there own scorecards. Scorecards will determine where you stand in a give risk scale.

Federal Reserve Explained

Federal Reserve: The central bank of the United States; an independent organization created by Congress to keep our money valuable and our financial system healthy; one of three federal bank regulatory agencies in the United States; guardian of payments system efficiency and effectiveness; lender of last resort

Business Credit Bureau Trade Tape Data

q) What is trade tape data?
a) It is credit industry term for account receivable data.

q) What is trade tape data used for?
a) All the major business credit bureaus use it to calculate risk of a company.

q) What is the advantage of submitting trade tape data to bureaus?
a) Two advantage, Other companies before extending credit will review credit worthiness calculated by credit bureaus using yours and other trade tape data files. Second advantage is you will get better rate on the reports you pull from the credit bureaus.

q) Can I submit same trade tape to multiple bureaus?
a) Yes you can.

q) Is there a standard format or layout for trade tape data?
a) No, all bureaus accept in any format.

Every small, medium and large company should submit trade tape data to at least one bureau or to your credit groups. By sharing the knowledge among your peers or bureaus you would have shared your customers exposure. This exposure data is out in public and your customers will pay you regularly to avoid delinquency. It is advisable to tell your customers upfront about your trade tape sharing policies.

All bureaus using trade tape data come up with all kinds of charts with following information:

• Current and past payment score
  
• Historical payment trends [6, 12, 24 months]
  
• Current and past company Exposure
  
• Using current and past data come up with predictive future score.

Every major business bureaus/credit groups have a write up on trade tape, below are few links:

D&B

NACM

Experian

Equifax
Transunion

Consumer Bureau: Scoring thin credit files

Very interesting article on the consumer bureau data published by Nilson Report in their September 2007 issue and posted on Lexis Nexis website.

Excerpts from the article, for more read from Lexis Nexis Website:

The three major credit bureaus – Equifax, Experian, and TransUnion — maintain records on 172 million adults that contain enough data on file to create a credit score using automated systems. Those adults represent 75% of the total adult
population in the U.S. There are another 24 million adults about whom the credit bureaus have no information at all. And falling between those files even if the person has not yet established a tradeline. Full files by comparison average 13 to 14 tradelines that have been updated in the last six months.

Understanding Your FICO Score

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Understanding Your FICO Score

How to Improve Your Business’s Credit

Useful article i found for small business

By LYNETTE DENIKE, AllBusiness.com
Published: February 1, 2008

Why is business credit so important? It's the main way companies evaluate whether they want to do business with you, and on what terms.