Credit analysis

Having collected credit information, the firm must make a credit analysis of the applicant. In practice, the collection of information and its analysis are closely related. If, on the basis of initial credit information, a large account appears to be relatively risky, the credit analyst will want to obtain further information. Presumably, the expected value of the additional information will exceed the cost of acquiring it. Given the financial statements of a credit applicant, the credit analysts should undertake a ratio analysis. The analyst will be particularly interested in the applicant’s liquidity and ability to pay bills on time. Such ratios as the quick ratio, receivable and inventory turnovers, the average payable period, and debt-to-equity ratio are particularly relevant.

In addition to analyzing financial statements, the credit analysts will consider the character of the company and its management, the financial strength of the firm, and various other matters. Then the analyst attempts to determine the ability of the applicant to service credit and 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 on the product or service being sold, a decision is reached on whether or not to extend credit.

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 on the previous stage of investigation will be changed. If an analysis of a report resulted in an extremely unfavorable picture of the applicant, an investigation of the applicant’s bank and trade suppliers might have little prospect of changing the reject decision. Therefore, the added cost associated with this sage of investigation would not be worthwhile. Each incremental stage of investigation has a cost, which can be justified only if the information obtained has value in changing a prior decision.

The first stage consists of simply consulting past experience to see if the firm has sold previously to the account and if it has, whether that experience has been satisfactory. Stage two might involve ordering a report on the applicant and evaluating it. The third and last stage could be credit checks of the applicant’s bank and creditors coupled, perhaps with a financial statement analysis.

Each stage adds to the cost. 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 is 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 next stage of investigation, added sophistication is introduced only when it is beneficial.