Ultimate Credit Analysis Guide: How to Assess Credit Scores and Improve Your Financial Decisions

Credit analysis is a way of finding out if individuals or businesses who owe debts are likely to pay their debts on time without default. One of the most obvious indicators is whether they have a past default.

Prompt payment of your obligations serves as a good indicator of your character and creditworthiness; however, this indicator is not without exploitation, some individuals with this in mind, can exploit the credit analysis process by establishing a good reputation at the beginning in an attempt to get a good character then later begin to default.

The existence of financial access to information by credit bureaus and rating agencies can protect sellers of financial products in their businesses.

The five C’s of credit provide an objective way for credit risk assessors, credit unions, banks, lender and underwriters to determine your eligibility for a loan.

How to check credit worthiness

There are a number of ways to undertake a risk assessment to check the risk of default inherent within a customer contractual relationship, you can task an external collections manager, specialized credit agency, credit bureau, a banker or financial consultant. However, these ways may come at a cost, if these prove expensive, and you would like to undertake your own due diligence, then, the five Cs of credit provides a way to make a good judgement of the customer credit worthiness.

What is 5 Cs of credit? And how can you use it?

5 Cs of credit is a way to undertake due diligence when undertaking a customer risk analysis. The 5 Cs of credit is best used when a firm has small, regular clientele. The five-C's-of-credit method of evaluating a borrower incorporates both qualitative and quantitative measures. In such a scenario, a credit manager or credit risk assessor handles the process of determination to provide an informed judgement on the client.

Most lenders or businesses have their own method for analyzing a borrower's creditworthiness but the use of the five C's—character, capacity, capital, collateral, and conditions—is common for both individual and business credit applications.

Familiarizing yourself with the five C’s—capacity, capital, collateral, conditions and character—can help you get a head start on presenting yourself to lenders as a potential borrower. Let’s take a closer look at what each one means and how you can prep your business.

1. Capacity: Capacity measures the borrower's ability to repay a loan by comparing the monthly income against recurring liabilities and debts in order to assess the borrower's debt-to-income (DTI) ratio. Lenders calculate DTI by adding a borrower's total monthly debt payments and dividing that by the borrower's gross monthly income. The lower an applicant's DTI, the better the chance of qualifying for a new loan as he or she will be able to meet repayments when they fall due. For businesses, lenders look at the revenue, expenses, cash flow and repayment timing to determine the credit score.
2. Capital. The initial cash you put toward starting your business is referred to as capital, and it’s a good way to show a lender how serious you are about success. It’s unlikely that you’ll be able to finance 100 percent of your startup or acquisition costs, so to get a loan, you’ll need to make an investment in your business first. This may come from deposits or money from other sources

Lenders also consider any capital the borrower puts toward a potential investment or financing. A large contribution by the borrower decreases the chance of default. Borrowers who can put a down payment on a home, often find it easier to receive a mortgage finance.

1. Collateral. When evaluating a loan application, a lender will generally look at collateral as a secondary source of repayment for the loan. They’ll want to make sure that if the loan payments stop for some reason, they can recover what they’re owed through collateral. This could be equipment, vehicles or inventory. The loan amount will be based on a percentage of the collateral’s value, which is called the loan-to-value ratio (LTV). Different types of collateral have different LTVs. Collaterals are not always required, for unsecured loans, collateral may not be necessary.
2. Conditions. To be able to access credit for your business, you should be prepared to demonstrate that there’s a market for your business and a clear purpose for the loan. The competitiveness of the business, the type of industry and your experience managing a business will be of essence to your credit score.

Also, the conditions of the loan, such as the interest rate and amount of principal, influence the lender's desire to grant finance to the borrower. Condition can also refer to how a borrower intends to use the money. A borrower who applies for a car loan or a home improvement loan is likely to have the loan granted since it is an investment toward an asset rather than for consumption that provides no further benefit.

1. Character. The final C includes a look into who you are as a borrower, including your educational background, business experience and personal credit history. A borrower's credit reports credit reports contain detailed information about how much an applicant has borrowed in the past and whether they have repaid loans on time. These reports also contain information on collection accounts and bankruptcies. Statistics show that the way a person handles personal credit generally indicates how he or she will manage business credit.

For example, if you apply for card or loan you will be asked to answer questions about your job, income, home and financial position. The information gathered is used to compute a credit score to determine your credit worthiness.

Large firms or firms who deal with a lot of clients and businesses, often employ a multiple discriminant analysis to separate creditworthy firms from others, thus producing a measure of Solvency called Z Score. Edward Altman’s Z score suggested a relationship between a firm’s financial ratio and its credit worthiness (Z).

Z1= EBIT/Total sales

Z2= sales/total sales

Z3= market value of equity/ total book debt

Z4= Retained earnings/ total assets

Z5= working capital/ total assets

A Z score above 2.7 is credit worthy

CONCLUSION

The Altman’s Z score is applicable to businesses only.

In all credit analysis processes, the cost of undertaking the assessment should not be more than the cost savings to be derived.