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

Download Link:

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.

History of SSN

President Roosevelt in 1932 came up with term Social Insurance which means: "To address the permanent problem of economic security for the elderly by creating a work-related, contributory system in which workers would provide for their own future economic security through taxes paid while employed". With this ideology in mind SOCIAL SECURITY ACT was signed into law by President Roosevelt on August 14, 1935.

PRESIDENTIAL STATEMENT SIGNING THE SOCIAL SECURITY ACT. AUGUST 14,1935

Part of the act was to established a Social Security Board (SSB). First task of this board was the need to register employers and workers by January 1, 1937, when workers would begin acquiring credits toward old-age insurance benefits. By deadline over 30 million SSN cards were issued through this early procedure, with the help of the post offices. By June 30, 1937, the SSB had established 151 field offices.

Social Security Number Chronology

SSN Timeline from Google

SSN evolved with above motto and now world revolves around it.

Few SSN timelines Related to Credit World:

• IRS adopted SSN in 1961
• Banks and Credit firms started adopting SSN from 1970
• Since 1982 all applicants for loans under any Federal loan program required to furnish their SSNs to the agency supplying the loan.

Experian Study Shows 30 Percent of U.S. Consumers Improved Their Credit Score Up to 50 Points in Six-Month Period

Experian’s National Score Index further finds 15 percent of consumers with a PLUS Score® between 600 and 649 in January 2007 increased their score by 50 to 100 points in June

Irvine, Calif., Oct. 16, 2007 — Three out of every 10 U.S. consumers improved their credit score by up to 50 points in a six-month period from January to June 2007, according to the latest National Score Index® study by Experian Consumer DirectSM, the leading provider of online direct-to-consumer credit reports, scores and monitoring products.

...read further at Experian website

Using Business Credit Reports

In my previous posts i talked about USA consumer bureau report contents. In this I will discuss USA business credit report content.

Major of the Reports come in two types:

1. Based on Trade Tape Data [Account Receivable Data]
   
2. Based on Financial Data

In both the reports firmograph [Company Name, Address, Company hierarchy information and key contacts at the company] data is common.

1. Based on Trade Tape Data:

 

Every small and big company does business among each other and all the bureaus collect this information from the companies willing to share. Industry term for this data is trade tape file. There is a some sort of industry standard reason every bureau does not want to share there trade secrets. Bureaus clean, collate and apply there so called secret logic to come up with a payment score. There are two types of score, one is called current score and second is predictive payment score based on the past and current data. More information on the score differences in the future blogs.  

Usually to buy bureau reports you need to be a contributor some of the bureaus do not insist on this. 

2. Based on Financial Data:

This is a straight forward report it contains a score derived from current and past financial and contains companies financial line items. Private companies that do not share financial to the world, secretly share with bureaus for their own well being. It is up to end company to trust private companies financial. For the public companies financial data is available freely on EDGAR database.

Credit Manager buy bureau reports based on there company risk policies. Usually all the credit managers do not make credit decision just based on bureau score. They do additionally analysis on top of the score. 

Give SSN or No and What does my report contain?

Employers, finance company, Insurance, landlord and others do not need SSN to pull your bureau report from any of the three [Experian, Equifax, Transunion] consumer bureaus. Your name and address is sufficient to find your report. Then why do above people request SSN, these is my assumption; just to confirm you are who you are. Report returned from the bureaus contains your SSN, current address and past addresses. If you provide incorrect information bureau report will flag.  If you give incorrect address or invalid first and last name bureaus will not return any report. Some times even if you gave right address/name and bureau did not return report that means they might not have your report.  Not every bureau will have your information and some time all three bureaus will have different scores [Depends on which credit card and loans you have]. Also note each bureau has better coverage in certain parts of the country and take note when you relocate.

What exactly does your report contain: Below are sections:

1. Section 1:   Name, Alias Names, Current Address, Past Addresses, Employer
   
2. Section 2: Profile Summary [public records, past due amount, number of inquires, number of accounts, total balance in the credit cards, total on all your credit cards, total mortgage amount]
   
3. Section 3: Your FICO score and score factors used [Request your lenders to explain this]
   
4. Section 4: Your open/closed/neutral trade lines [all open and closed credit cards, open and closed student loan, car loans, house loans and any back accounts]
   
5. Section 5: Information about who pulled your report. 
   
6. Section 6: Any flags either by homeland security or by other lenders
   

Every bureau bylaw is suppose to provide you a free copy of your report without a score, when you get your report make sure you look into section 4 [Trade Lines] and section 5 [Inquires]. Make sure all the opened credit card are yours and also make sure nobody is pulling your report without you knowing. My advice is to utilize this free report and make sure review your report once a year to avoid identity theft.

You can also call bureau and set a lock on your report, bureaus will lock your report and will not give away until you provide the approval. This is one extreme way of protecting your identity.  If you have done this then just have it unlocked before you go for a loan. 

In the next blog I will post few technical stuff on consumer reports.

Good Night

Using Consumer Credit Reports

Government [via Fair Credit Reporting Act] regulates how finance companies/insurers/land lords/employers/Bureaus access and provide your personal credit information.

Below are few links from Government WebSite

The Fair Credit Reporting Act regulates the collection, dissemination and use of consumer credit information. If your businesses uses credit reports to extend credit to your customers; as a pre-employment check for potential employers; or furnishes customer information to credit reporting agencies, there are rules and regulations you must follow to ensure privacy of credit information.

Emperor of Business Credit Data

• Make informed decisions when you access the world's largest source of commercial insight with over 100 million companies listed.
• D&B solutions allow you to effectively manage business relationships based on the D&B D-U-N-S number, the global standard for business identification.
• D&B has 165 years of experience creating credit management tools so that you can focus on your core business while we provide the right information to help you mitigate credit risk and increase cash flow.
• D&B's patented DUNSRight quality process helps you make informed, profitable decisions by ensuring that our data is high quality, consistent, and timely with over 2,000 continuously automated checks.

I will post more on them in my future blogs, read all the interesting facts about them, few are listed below:

• Database with over 100,000,000 companies.
• 639,000,000 payment experiences updated annually.

Stop & Shop reports credit data was stolen

How could this happen? stop and shop employee or the employee from the company which services have access to these machines... thieves are using more and more hi-tech methods to cheat the system.

With help from US Secret Service agents, Stop & Shop Supermarket Cos. executives scrambled yesterday to determine how many consumers may have had their credit and debit card data stolen by high-tech thieves who apparently broke into checkout-line card readers and planted the equivalent of bugs to steal information.

Must for Risk Decision Makers and Risk Software Vendors

FICO 8.0....

Banks do not just rely on FICO score alone to give credit to their customers, everybody knows to get a good rates they evaluate more. Now why would banks in case of subprime borrowers they just rely on FICO score...when i am giving out money i would be extra careful...anyhow all the three consumer bureaus are upgrading the FICO score basically fine tuning:

model will continue to look at the same factors, including consumers' level of credit indebtedness and payment histories, length of credit histories, number of recent credit openings and inquiries, and the type of credit used, to determine scores.

But the new model will more finely slice and dice the information in consumers' credit files to do a better job of separating the "good risks" from the "bad risks," particularly for subprime borrowers; those with "thin," or young, credit files; or consumers who are actively seeking new credit. "Those are the communities that lenders are most interested in" to determine credit risk, says Craig Watts, spokesman for Fair Isaac.

below link you can download PDF version explaining everything about your credit score.

Understanding your credit score

Better "early" than late!

Welcome to my first blog. I’m late by six years, I am going to get over the ignorance of blogging and not think about what people would say about me or my opinions.

I will try to blog daily, let us see how long will this go.  I will write about credit world, both business and consumer side. Will talk about current practices and touch what future holds in credit world. I will also discuss things that I do not know.